The stock market has officially rebounded, rising to all-time highs. That's exciting. However, when the market was down over 30%, it was easier to identify stocks trading at bargain prices. The imminent upside for some quality companies was evident.
They may be harder to find now, but there are still some buying opportunities out there. I believe Roku (ROKU -0.65%) is one such company. It's up only around 10% over the last year. But here's why Roku stock is headed higher.
Make way for smart TVs
Roku operates in two segments: player and platform. Its player segment generates revenue from streaming devices. Its platform segment generates revenue in several ways, including advertising. But it's a software-based revenue rather than hardware. As of the second quarter of 2020, 69% of total revenue was platform revenue.
Roku's hardware doesn't give it a competitive advantage, in my opinion. Other companies offer similar products at comparable price points. However, Roku's operating-system software for smart TVs does give the company a widening moat.
According to Mordor Intelligence, the smart-TV market is expected to grow at a 16.5% compound annual growth rate (CAGR) between 2020 and 2025. In other words, a larger percentage of TVs will be smart TVs going forward. And Roku has already established partnerships to ensure it's running those smart TVs. According to the company, one in three smart TVs sold in the U.S. are Roku TVs.
Much of the growth in smart TVs will come in international markets, and Roku is aggressively pursuing the international opportunity. In Mexico, the company has six OEM partners, giving it a broadening reach. Similarly, it recently launched in Brazil by partnering with a local smart-TV manufacturer.
Roku is becoming increasingly ubiquitous, and with the growth of the smart-TV market, I suspect we'll continue seeing strong growth in active Roku accounts for years to come.
Growth temporarily distorted
Speaking of active accounts, there were 42 million as of Q2, increasing 41% year over year. With more accounts and more hours streamed, platform revenue grew 46% to $245 million during the quarter. This looks impressive enough on the surface. But the COVID-19 pandemic is suppressing this figure. Monetizable video ad impressions were up a more robust 50%.
In the Q2 letter to shareholders, management said that "total TV ad spend will not recover to pre-COVID-19 levels until well into 2021." Therefore, Roku's growth will likely look less impressive in the near term than it actually is. Investors won't fully see its progress until ad spending returns.
There are two reasons why Roku will be a primary beneficiary when ad spending resumes. First, ad spending is shifting from linear TV to connected TV. For example, 59% of connected TV advertisers plan to increase their spending for the remainder of 2020, according to the Interactive Advertising Bureau. To fund the increase, more than half plan to decrease linear TV ad spending.
Second, Roku's platform delivers great returns for advertisers. To prove this, consider its high customer retention rate of 92% for advertisers spending $1 million or more. Furthermore, returns are about to get better. It's currently running a test with Kroger to make ads more measurable.
Roku's revenue will head higher as its audience grows and ad dollars gush toward connected TV. And outsized revenue growth often translates to market-beating stock returns over the long haul.
Compelling risk vs reward
No corner of the economy was unaffected by the COVID-19 pandemic. Some industries, like travel and food-service, were hammered. Others, like grocery, have enjoyed a nice surge in sales, but the gains are only temporary. However, there's a third category investors shouldn't overlook. The coronavirus is increasing the long-term adoption of certain business models. These companies are growing hand over fist, and the market-share gains should be lasting.
Wall Street knows this, and is giving stocks in this third category historically high valuations in anticipation of future gains. These include top companies like Wayfair in e-commerce, Peloton in at-home fitness, and The Trade Desk in programmatic advertising. The valuations of these growth stocks have soared from a price-to-sales perspective. By contrast, Roku's valuation is practically unchanged in 2020.
I'm not saying Roku's stock is dirt cheap. Indeed, a price-to-sales ratio of 14 is often viewed as pricey. However, I believe Roku presents a compelling risk vs reward scenario for investors. The company is well on its way to becoming the dominant operating system for the growing connected-TV industry and its long-term outlook is stronger than ever. You'd be hard pressed to find many stocks like this right now.