Streaming media facilitator Roku (ROKU +1.18%) is on a roll. The stock has absolutely pulverized the market over the last year, delivering a 260% return versus the S&P 500's anemic (in this context, anyway) 14% gain. The surge included a 45% jump in October alone.
But Roku also has a lot of investors betting against it. Short sellers are borrowing nearly 11% of the float, betting that share prices will go down from here.
All of this invites the question: How risky is Roku's stock today?
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Roku's risks
Roku routinely reports negative earnings and EBITDA profits, and its free cash flows oscillate around the breakeven point from quarter to quarter. That alone is enough to keep traditional value investors away. Turning the negative bottom line into a sustainable cash machine would make Roku far more attractive to that class of investors, but that's not expected to happen until 2021.
The lack of profits written in black ink makes it difficult to pin down a fair market value for the stock. Reaching for valuation ratios not based on profitability, Roku's shares trade at 18 times trailing sales and 41 times the company's book value. The average stock in the S&P 500 index can be had for 2.2 times sales and 3.2 times book value. We're talking about the nosebleed section of Wall Street, somewhere between the rafters and the stratosphere.
Apart from that massive valuation risk, which seems to invite a sudden plunge at the slightest of negative news, Roku faces an intensely competitive market. Nearly every maker of TV sets, gaming consoles, and set-top boxes has its own in-house platform for streaming media services, competing directly with Roku's hardware and software products. New streaming services are also seen as a threat to Roku's ad revenues and overall stature in the industry.
Refuting the risks
Let's start with market risk. Roku's management sees the entry of new players in the market more like an upside than a risk.
"Overall, we're excited about the launch of all the new services coming to the industry and to our platform. We think that they are good for Roku in a bunch of ways," said CEO Anthony Wood in Roku's third-quarter earnings call. "Engagement on our platform is very good for us. They're going to increase the interest in viewership moving from traditional TV to streaming. We think that eventually, all TV is going to be streamed and that this will be the rise of all these new services that will help encourage that transition."
The global video streaming market has been estimated to reach annual sales of $125 billion in the year 2025, representing an average growth rate of 20% per year. That estimate says nothing about music services, podcasts, or new content types, and Roku could very well expand its reach into additional markets over the years. It doesn't take a big slice of that enormous market opportunity to set Roku on the road to solid profits.
And the company has a head start in that market, giving Roku a first-mover advantage over other alternatives. According to a June report by research firm Strategy Analytics, Roku devices accounted for 15% of all media streaming devices in the U.S. at the time -- but 30% of new devices entering American homes were stamped with the Roku label. So there's plenty of room for further increases to Roku's market share, and that's exactly what's happening right now. By the end of 2019, the firm expects Roku's lead over second-place rival Sony (SNE 3.44%) to increase from 36% to 70%. The Japanese challenger is relatively stable at an 11% share of the global market -- but both companies rejoice as the market itself grows at an explosive pace.
Risk level: moderate
I see Roku as an enormous investment opportunity with a relatively manageable collection of serious business risks. Keep an eye on Roku's market share, reserving the other eye for the company's journey toward sustained profits. Barring any major disaster, the rapidly growing target market should make up for a reasonable amount of missed opportunities and operating errors in both of those risk buckets.
The bigger issue here is found in Roku's lofty valuation, which can only stay that high as long as the company executes its business operation to perfection. Any slip, trip, or stumble could trigger a big price drop in a heartbeat.
You have to weigh that possibility against the real prospect that the next stumble might be years away and that this could be the last chance to pick up Roku's stock at anything close to their current prices. So whether you buy now and hold on for dear life throughout whatever bumps Roku might find in the road, or stay on the sidelines until the stock becomes available at a better price, you're taking a chance either way.
For a good example of wait-and-see strategies backfiring big time, I can't think of a time in the history of Netflix (NFLX 0.82%) when that streaming media giant wasn't seen as a massive bucket of risk with questionable upside -- on the way to a 25,000% return in 18 years. Please do exercise caution before hitting that "buy" button, but don't let Roku's modest downside keep you from taking part in a massive growth story.
