One of the things that jumped off the page from Roku’s (ROKU 3.33%) first-quarter earnings report was the platform business. Roku’s platform revenue growth accelerated to 101% and its platform gross margin expanded to 67%. While Roku’s starting to lap the impact of COVID-19 on its business, giving it easier comparable quarters, that top-line growth was better than even 2019.
But investors need to dive deeper into what sparked the acceleration and margin expansion to determine whether it’s sustainable. In the case of Roku, it’s more likely the rest of the year looks similar to 2020 than the first quarter of 2021. Here’s why.
Image source: Roku.
New streaming services and more advertising
Roku added some significant new streaming services at the end of the fourth quarter and the start of the first quarter. It added AT&T’s HBO Max in mid-December and Discovery Communications' Discovery+ in January. March saw the addition of ViacomCBS’s Paramount+.
Whenever a media company launches a new streaming service, it gives Roku an opportunity to renegotiate its distribution agreements. A big part of those agreements are its audience development advertising services -- those ads you see on the Roku home screen. Streaming services will commit to a certain amount of ad spend as part of an overall deal including how much subscription revenue it shares with Roku for new signups. Usually those ads are front-loaded to build momentum at launch, resulting in a lot of revenue recognition.
As a result, Roku saw a significant increase in audience development revenue. Audience development ads have higher margins than Roku’s video ads. What’s more, the performance they drive -- i.e., new subscription signups -- directly benefits Roku’s platform business as well.
Adjusting the value of old contracts
Not only did Roku sign several big new contracts with media companies, but it also found the value of its existing contracts increased substantially in aggregate. As a result, it had to make a 606 accounting adjustment, which gets recorded as revenue for its platform business.
Essentially, every quarter Roku estimates the remaining lifetime value of its contracts of its content licensing and distribution agreements. Some go up and some go down depending on the progress of performance obligations for each contract. When the aggregate change is big enough, it records the change as revenue (or contra-revenue).
This doesn’t happen every quarter, but after a strong year of increased engagement and spending on streaming, Roku’s existing contracts saw a sizable bump in value, particularly revenue share agreements. It previously adjusted in the third quarter last year, but last quarter’s adjustment was bigger. It’s unlikely Roku will see such a big adjustment again in 2021, as we probably saw a pull forward in investments from media companies on their direct-to-consumer streaming services last year, and into the first quarter of 2021.
Ramping up spending again
Further down Roku’s income statement is its operating expenses. The company pulled back on some operating expenses starting in the second quarter last year, amid the uncertainty of the pandemic. Operating expenses grew less than 40% in the second half of the year, while they grew about twice that rate in the first quarter last year.
Last quarter, operating expenses grew just 28% year over year. That number will rise considerably as Roku laps its operational changes and ramps its spending back up. Still, management’s calling for EBITDA margin of about 10.5% at the midpoint of its second-quarter guidance. That compares to EBITDA margin of 21.9% in the first quarter. While management didn’t provide a full-year outlook, investors should expect lower EBITDA margin through the second half as well.
The long-term trend
While Roku’s platform business will probably see its profitability decrease throughout the rest of 2021, the long-term outlook for the business is for it to continue improving profit margins over the long run.
As Roku increases in scale and importance as a distribution partner for media companies, it ought to be able to extract more value from its negotiations for distribution and content. And as the Roku Channel, in particular, continues to grow its audience, its content expenses become more economical. In fact, Roku’s recent push into original content is only possible because it now has the scale to recoup the cost of producing content in-house. Roku is able to exercise some owner’s economics on those titles, pushing the margin on its ad-supported streaming service higher.
That’s not to say Roku won’t introduce new services that could have a lower margin than its existing business. That would obviously put pressure on its overall profit margin. But the long-term trend for the business as it exists today is for the profit margin to keep expanding.
