A few factors have contributed to the recent bout of market volatility, including concerns about rising inflation and changes to the Federal Reserve's monetary policy. Specifically, rising prices often lead central banks to boost benchmark interest rates, and the Federal Open Market Committee this week signaled that we could see three 0.25% fed funds rate hikes in 2022. As recently as September, half of its members were forecasting one or two such hikes next year, while the other half expected none.
Not surprisingly, in light of these conditions, growth stocks have been hammered on Wall Street. Rising interest rates make it more costly to borrow money, and high-growth companies need capital to fund their expansion efforts. Additionally, growth stocks are often valued based on their expected future cash flows, and rising interest rates reduce the present value of future money.
In the case of entertainment technology developer Roku (ROKU +2.85%), the macroeconomic headwinds have intensified Wall Street's concerns regarding its deceleration in end-user engagement. As a result, the stock has fallen sharply over the last few months, and it currently trades 52% below its all-time high. But with that plunge behind it, is this a good time to buy a few shares of Roku?
Image source: Getty Images.
A strong competitive position
At the heart of Roku's business is Roku OS, the only operating system purpose-built for connected TVs. Competing products like Amazon's Fire OS are based on Android, an operating system originally designed for mobile devices. As such, Roku's platform theoretically should make for a better viewer experience since is was originally designed with the living-room experience in mind. Certainly, its streaming products -- from external players to smart TVs -- have earned a good reputation for the simplicity of their design and their unmatched ease of use.
Roku has parlayed that small edge into a more substantial competitive advantage. During the third quarter, its platform accounted for 31% of connected TV viewing time worldwide, while Amazon took second place with 17%. In other words, Roku is the most popular streaming platform by a wide margin, and that's worth gold in an ad-based business because ad dollars tend to follow viewers.
On that note, the top 10 cable TV advertisers doubled their spending on Roku's platform over the past year, and that trend has translated into solid financial results.
|
Metric |
Q3 2020 (TTM) |
Q3 2021 (TTM) |
Change |
|---|---|---|---|
|
Revenue |
$1.54 billion |
$2.55 billion |
66% |
|
Free cash flow |
($32.0 million) |
$266.2 million |
N/A |
Source: YCharts. TTM = trailing-12 months.
So why is the stock down? Streaming hours rose by 21% to 18 billion in the third quarter, a significant deceleration from 54% growth in the prior-year period. Understandably, some investors are feeling nervous about what they perceive as waning engagement -- but consider the context.
As we all know, throughout 2020, the pandemic supercharged streaming video viewership as many consumers spent a lot more time at home. Following such an unprecedented period of growth, this recent deceleration makes sense. But Roku still posted growth. The same cannot be said for the broader television industry. Linear TV viewing time in the U.S. dropped by 8% year over year during the third quarter, and among the highly prized 18-to-49-year-old demographic, viewing time fell by 19%.
A smart growth strategy
The company recently put its original content strategy into motion, launching 30 Roku Originals in May and another 23 titles in August. Management hopes these will help differentiate its ad-supported service, The Roku Channel. And the initial reception has been encouraging.
In fact, Roku saw record streaming following the first wave's debuts in May, and The Roku Channel ranked among the top five most-viewed channels on the platform during the third quarter. That's impressive, considering Roku connects viewers with virtually every premium and ad-supported streaming service.
It's also noteworthy that the Roku Channel affords the company more flexibility in its ad strategy. In March, it launched an advertising brand studio to help marketers create short-form TV programs and interactive video ads. And in June, the brand studio debuted Roku Recommends, a weekly program that highlights trending TV shows and movies. Not only does that drive user engagement -- Roku Recommends has been a top 10 video-on-demand series since its launch -- but it also allows advertisers to reach consumers who stick to ad-free services like Netflix.
Why Roku is worth the risk
According to research firm Omdia, connected TV ad revenue will surpass $120 billion by 2024. That puts Roku in front of a massive addressable market, and it's well-positioned to capitalize on that opportunity. Roku has established itself as the industry leader, and management is executing on what could be a rewarding growth strategy in the long run.
Moreover, the stock currently trades at a price-to-sales ratio of 11.9, which is significantly cheaper than its three-year average ratio of 15.7. With that in mind, Roku does indeed look like a smart buy right now.
