The Roku Channel (TRC) has grown into the most significant part of Roku (ROKU 0.58%) over the last several years. But many investors have failed to notice TRC becoming Roku's most crucial source of revenue because the after-effects of the pandemic have shifted investors' attention to various short-term concerns. Here are three reasons why investors should take a closer look at TRC's long-term growth potential. 

Family watching TV.

Image source: Getty Images.

1. Consumers want video they don't have to pay for

Consumer demand for free content is the main driver of TRC's growth. Roku launched TRC in part because its data showed that the most searched term on the Roku platform was "free." 

As consumers search for more affordable options for streaming, they have increasingly turned toward free streaming services like The Roku Channel over subscription-based streaming services. 

TV viewers today struggle with too many viewing options and only a limited amount of time to watch TV. Consequently, most consumers refuse to pay for channels that they have little time to watch. Instead, most people reduce their TV viewing costs by limiting the subscriptions they are willing to pay and, at the same time, increase their viewing of free streaming services.

As a result, free ad-supported video on demand (AVOD) grew twice as fast as subscription video on demand (SVOD) in 2021, according to a recent survey. Additionally, AVOD should surpass SVOD in audience size by mid-2022. -- which is excellent for TRC. 

2. Roku gives viewers better ads

TV viewers' frustration with ads has slowed past adoption of AVOD, and Roku intends on correcting that problem by improving the ad experience -- using TRC as a testing ground for its latest advertising innovations.

In addition to using Artificial Intelligence to improve ad targeting, Roku conducts experiments with the number of ads per hour and the length of the ads to improve the viewer experience. For instance, Roku only plays ads for seven to eight minutes per hour -- compared to traditional TV playing double the amount of ads. As a result, fewer ads have attracted more users. .

Evidence suggests that better ads are critical for continued AVOD growth, and that TV viewers will be less annoyed when receiving relevant, informative, and consistent advertisements that consider user privacy concerns -- this involves balancing ad targeting techniques with privacy.

Roku already believes that they are on the right track in creating better ads. For example, one Roku executive partially attributes the recent increased demand for ad-based free-content to improvement in viewers' ad experience.

3. Better ads help Roku fund better content

TRC's business model is a virtuous cycle: demand for free content attracts viewers, who bring in more ad revenue, which buys higher-quality content, which attracts even more viewers.

There is strong evidence that TRC's virtuous cycle is working, as it grows its offerings' quantity and quality. TRC now licenses content from more than 250 publishers and carries an estimated 80,000 on-demand shows and movies. Additionally, TRC became the top U.S. live TV carrier by active account in 2021, now offering more than 200 live TV channels. 

Perhaps the biggest news is that TRC became an original content producer in 2021 with its acquisition of Quibi -- a short-form streaming platform. Quibi, rebranded into Roku Originals, brought in more viewers in its first two weeks than Quibi did during its entire existence. In addition, Roku Originals were half of the top 10 on-demand titles by the number of viewers in 2021.

Roku's management credits its original content gambit  for vastly increasing viewership on TRC, although the company fails to disclose specific numbers.

The perils of picking a side

Media companies initially viewed Roku as a neutral streaming platform, but TRC's recent success has changed that perception.

While Roku claims that TRC helps publishers build an audience -- it is hard for publishers to ignore that TRC became the most popular AVOD on the Roku platform in 2021.

Additionally, publishers fear that TRC will use first-party behavioral data collected from Roku's 60.1 million active accounts -- one of the more extensive data sets in the streaming industry. TRC uses Roku's data to make better content recommendations and more effective advertising than the other AVOD publishers on Roku's platform -- a considerable competitive advantage. 

By competing against those other content providers on the Roku platform, Roku risks driving those services away. However, it seems unlikely that content providers will go at this point, because Roku's platform has the most significant US audience. According to emarketer, as of October 2021, Roku was the top platform in the US market, accounting for 51.7% of streaming users -- with Amazon (AMZN 2.50%) in second place with a 45% share. Even though Amazon owns a streaming platform with a market share close to Roku, Amazon recently decided to remain on Roku's platform. 

Roku's long-term opportunity

The market is currently missing the long-term opportunity in Roku transitioning from mainly a low-margin streaming device business to primarily a higher-margin advertising business. You can see that shift in Roku's gross margins, which rose from 43.8% in 2019 to 51.1% in 2021. Yet Roku's valuation remains close to where it was at the end of 2019, with a price-to-sales ratio around 5.9 -- near its three-year low.

The market has recently driven down Roku's valuation over concerns about the auto industry reducing its advertising spend, as chip shortages leave automakers with fewer cars to sell. However, Roku's ad business should recover from the auto industry's supply chain problems in the second half of 2022.  

When Roku's ad business eventually rebounds, TRC will be the main driver behind the growth. If you can look past short-term concerns, TRC's growth potential gives you a great reason to invest in Roku for the long term.