3 Reasons to Buy Roku, and 1 Reason to Avoid It

Since Roku (ROKU -3.05%) went public in Sept. 2017, its stock price has risen by a factor of 30. The streaming device and platform company IPO'd at $14 per share, and it opened at $15.78. Now, the stock sits in the neighborhood of $420. With those massive gains already on the books, some investors might be wondering if it's too late to buy Roku.

In my view, there are three good reasons why investors ought to consider buying this stock -- but there's also one compelling reason to be wary.

1. Roku's user and revenue growth have been impressive

When Roku went public, skeptics warned that its streaming hardware would face tough competition from the Amazon Fire TV, Apple TV, Alphabet's Google Chromecast, and other dongles and devices.

Image source: Getty Images.

However, Roku's rapid growth in active accounts, average revenues per user (ARPU), and total revenue since its IPO quickly silenced the naysayers.

Data source: Roku. YOY = Year over year.

Roku's growth accelerated throughout the pandemic as people largely stayed at home and sought out entertainment like streaming content. But even as conditions in the U.S. are returning to something resembling their pre-2020 normal, analysts still expect the company's revenue to rise 55% this year.

2. It has an evolving business with stable gross margins

Roku's business model initially looked shaky. Back in 2018, it generated 44% of its revenue from sales of its streaming media devices -- a lower-margin business as these had to compete with cheaper rival devices. The other 56% of its revenue came from its higher-margin streaming platform business, which makes most of its money from integrated ads and content partnerships.

But in 2020, Roku's devices generated just 29% of its revenue, while 71% came from its platform business. That rising share of higher-margin platform revenue enabled Roku to sell its hardware at cheaper prices to stay competitive -- and its gross margin stabilized, then expanded.

Source: Roku.

For the full year, Roku expects to maintain a gross margin in the mid-40% range while it sells its players at gross margins "close to zero." In other words, Roku isn't really a hardware company anymore. Analysts expect those stable gross margins, along with tighter spending, to lift Roku's bottom line and give the company its first full-year profit in 2021.

3. Roku has a firm foothold in ad-supported streaming

The heart of Roku's software platform is The Roku Channel, a free streaming option that offers movies, TV shows, and live TV channels. The Roku Channel runs on its own devices as well as smartphones and its competitors' devices.

Earlier this year, Roku bought the short-lived streaming platform Quibi. It then rebranded all of Quibi's content as "Roku Originals" and launched the first batch of them on The Roku Channel in late May. It says a "record number of unique accounts" streamed The Roku Channel between May 20 and June 3 after it added those new shows, improving its foothold in the market for ad-supported streaming services.

The expansion of The Roku Channel will help the company's platform business attract more advertisers and partners while increasing its overall exposure to the secular shift away from traditional pay-TV services.

One reason to avoid Roku stock: Its valuation

I'm personally bullish on Roku's long-term growth prospects, but there is one red flag investors shouldn't ignore: its valuation. With a market cap of about $57 billion, the company trades at 21 times this year's sales. Also, with the average analyst expecting it to earn a profit of just $0.46 per share this year, it's trading at more than 900 times forward earnings.

By comparison, Netflix trades at about 50 times forward earnings and eight times sales. Netflix may be growing at a much slower pace than Roku, but conservative investors might consider the streaming video leader to be a more balanced cord-cutting play than Roku.

I believe Roku's core strengths justify its higher valuation, but the stock is likely to remain volatile. Therefore, it's wiser for those who want to start a position in Roku to accumulate the stock gradually, rather than buying shares all at once.