Companies associated with streaming entertainment are getting all the hype from Wall Street these days, and for good reason.
The pandemic only accelerated the cord-cutting trend. According to eMarketer, an estimated 6.6 million U.S. households parted ways with their cable subscriptions in 2020, meaning almost one-quarter of U.S. households have cut the cord. This puts streaming businesses in a pivotal spot to capture our attention, and dollars, for many years to come.
One of the key beneficiaries is Roku (ROKU +0.75%). It has been a fantastic stock since its initial public offering, exploding nearly 13-fold in the three and a half years that it's been publicly traded. With a price-to-sales (P/S) ratio that remains high, some investors might be wondering if the stock is overvalued today given some legitimate questions about the company.
ROKU PS Ratio data by YCharts
Roku is, however, one of the best companies to own in this burgeoning space, and there are some very important elements to the business that warrant a seemingly elevated valuation. Let's walk through some of the key risks with Roku stock.
The shift of advertising
Risk is more than just volatility -- it's the danger that your investment will suffer a permanent loss of capital. So let's start with something fundamental: Because Roku's business is built on the idea that all TV will eventually be streamed, fears that there will be a post-pandemic slowdown in this hot sector are certainly on investors' minds.
But companies that traditionally advertise on linear TV (i.e., broadcast TV that's watched at the time it airs) are increasingly looking to allocate some of those dollars to streaming. For more of them, that means Roku. Despite an advertising slowdown due to the pandemic, Roku's monetized video impressions in the fourth quarter of 2020 more than doubled year over year.
The company also cited strong growth in the retail sector during the quarter. Although retailers spent less on linear TV advertising, the Roku platform experienced a greater than 100% rise in retail advertising spending versus the prior-year period.
Walmart in particular ran a successful campaign on the Roku home screen with video ads. Of the viewers who saw the ads, 80% had not seen a Walmart ad on traditional TV, which demonstrates the value Roku's platform can provide to these companies. To further bring home the point that marketers are reevaluating their strategies to reach consumers, the six largest advertising agencies more than doubled their spending with Roku in the fourth quarter.
Roku is in a position to benefit greatly. The three-sided revenue ecosystem (viewers, content publishers, and advertisers) only gets stronger as the company scales up and drives higher engagement. Based on streaming hours, Roku is the No. 1 TV platform in the U.S. And a stellar 38% of all smart TVs sold in the country in 2020 were equipped with the Roku operating system.
However, probably the most impressive aspect of its competitive positioning is that it really doesn't matter which of the big streaming services ends up with the most subscribers. As long as the cord-cutting trend continues and Roku delivers value to all of its stakeholders, it will keep thriving.
Image source: Getty Images.
Huge expansion opportunities
Another worry for investors is that Roku won't be able to replicate its remarkable success outside of the U.S. This could mean that the stock has some high expectations built in that won't be achieved. Let's look at the company's massive growth to see if this is justified.
Revenue grew 58% in 2020, active accounts soared by 14.3 million to reach 51.2 million, average revenue per user (ARPU) increased 24% to hit $28.76, and the hours streamed on the platform totaled 58.7 billion for the full year. The average active account streamed 3.8 hours of content per day in the fourth quarter.
The pandemic certainly is responsible for some of the gains the company achieved last year, but Roku was already registering extraordinary growth in the years before 2020. Roku TV was the best-selling smart TV in Canada in 2020, and the company has been successful at signing partnerships in Brazil, Mexico, the U.K., and Ireland.
International expansion is still in the early stages. Management stated in its most recent shareholder letter, "TV streaming is a global phenomenon, and in 2020 Roku continued to successfully expand beyond our domestic market using the same business model, capabilities, and products that have worked so well for us in the U.S."
The takeaway for investors
When a stock has an incredible run like Roku has had, it's no surprise that investors question whether the business deserves a seemingly elevated valuation. With the streaming space getting more competitive, this is true now more than ever. Investors should have real concerns.
While valuation multiples can be a useful shortcut to assess how cheap or expensive a stock is, for certain high-quality, fast-growth businesses, they're most likely not sufficient. Roku is in a strong position to benefit significantly as the world, not just the U.S., moves entirely to streaming, mitigating any potential risk for the stock.
