Since reporting second-quarter financial results on Aug. 4, Roku (ROKU +3.86%) stock has fallen 15%. Investors weren't happy with the sequential drop in streaming hours following the rapid growth experienced in previous quarters. Making things worse was the fact hardware sales recorded a negative gross margin as higher input costs weren't passed on to customers.
There was a major bright spot, however. Roku's fast-growing platform segment eclipsed $500 million in quarterly revenue, a first for the company. Let's find out why this matters for the streaming business and its shareholders.
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It's all about the ecosystem
The platform business registers sales from subscription and advertising fees. A large retailer like Walmart pays to place ads on Roku's home screen, and the ability to reach new audiences is quite remarkable. For example, during the fourth quarter last year, 80% of viewers who saw a Roku ad for Walmart didn't see one on traditional TV, highlighting the immediate value Roku's platform provides.
Additionally, big content creators like Netflix and Walt Disney are able to utilize Roku's scale to reach new viewers too. And if someone signs up for a streaming service through Roku, the company takes a cut. Platform gross margin is about 65%, which is why growth in this segment is so important.
In the most recent quarter, platform revenue soared 117% year over year to total $532 million. Instead of focusing their attention on that growth, investors were disappointed with the player segment. Selling hardware has been a shrinking part of Roku's business, representing just 17.5% of overall revenue in the second quarter, compared to almost a third of the top line in the prior-year period. Sure, Roku lost money on its players in the quarter with a negative gross margin of 6%, but that's actually not a bad thing when management's goal is to increase its number of active accounts, now at 55.1 million, as quickly as possible.
The real bread and butter for the company comes after a consumer becomes a Roku user. With more accounts, the company becomes even more valuable to its content and advertising partners. And as Roku gains more content and grows its sales, it's able to offer viewers a constantly evolving experience. The low-margin hardware business is to get you in the door, but Roku's lucrative platform business is where the magic lies.
Anthony Wood, Roku's founder and CEO, wants to build the TV operating system of the future.
What does this mean for investors?
Up until the beginning of 2018, Roku's player segment accounted for most of its revenue. The tables have clearly turned, and it's a net positive for the company. Selling hardware wasn't Roku's ultimate ambition, though they still play the important role of bringing users into the ecosystem in order for the company to then monetize viewers via its best-in-class platform.
And that's where the real money lies. Dollars spent annually on TV advertising in the U.S. hovers around $70 billion. Now that corporations have a way to target consumers in a more efficient and measurable way using Roku's connected-TV service, the ad spend market could grow significantly in the future.
Don't be mistaken. Roku hasn't been a hardware company for years, and the $500 million milestone its platform segment just hit shows the direction this innovator is going. Investors have plenty to be excited about.
