Huge news reverberated across the financial world last week when Netflix (NFLX 4.17%) released a disappointing first-quarter 2022 earnings report. The video streamer lost subscribers for the first time in many years, sending the stock down almost 40% in the past week. This sell-off bled into other consumer internet and connected TV (CTV) stocks, including the CTV platform Roku (ROKU 5.41%). Roku's stock is down 6% in the last week, 20% in the last month, and over 70% in 12 months. However, investors may have the wrong thinking about Roku as Netflix's weakened position could actually strengthen Roku's financial prospects.
Should you buy Roku stock on the recent Netflix dip?
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Netflix's loss can be Roku's gain
Roku is a CTV platform that makes money on revenue-sharing agreements across streaming subscription services and advertisements that get played on its TV operating system (OS). It also earns money through selling advertisements on its home screen and across its own free ad-supported streaming service called the Roku Channel.
There were two things about Netflix's report that stood out in relation to Roku. First, a general weakening of Netflix's position in the streaming marketplace should benefit a neutral viewing platform like Roku. An evening of the playing field means that the streaming wars might get even more competitive over the next few years as companies vie for subscriber growth. With 60.1 million active accounts as of the end of 2021, Roku stands to benefit as the access point for so many people who watch CTV.
Second, on the conference call, Netflix announced it was working on a lower-priced advertising-supported tier, similar to how Hulu operates. At first, investors might think this will be a negative for Roku because it is another advertising-supported streaming service competing with the Roku Channel. But any losses -- if they ever occur -- will be made up for with advertising revenues Netflix will pay Roku as part of its revenue-sharing agreement. These deals are not public, but it is speculated that whenever an advertisement is played through Roku's OS, the company keeps a cut of the revenue for itself. If Netflix launches an advertising-supported tier, that could be a boon to this segment.
What to watch for in this earnings report
There are two things potential Roku investors should be checking when it reports earnings on April 28: resolving supply chain issues and advertising revenue growth.
Supply chain issues have hurt gross margins in its player/TV segment. Typically, Roku likes to sell these devices at around 0% gross margins, since it makes the majority of its revenue through its platform segment. However, given rising supply costs, hardware gross margins fell to a negative 28.4% in the fourth quarter, severely hurting consolidated gross margins. Roku will need these costs to abate if it is to see operating leverage over the next few years.
Advertising revenue is under Roku's platform revenue segment, which essentially just includes all software/licensing revenue. In Q4 of 2021, platform revenue was $704 million, up 49% year over year, and had 61% gross margins. This segment has grown rapidly in the past few years with the overall growth of CTV plus the continued growth of the Roku Channel. In 2017, the segment did only $225 million in revenue. Four years later, that has grown tenfold to $2.285 billion in revenue.
Over the long term, Roku's business will be driven by the growth of platform revenue and the profit/cash flow margins it can achieve. Investors should expect it to continue growing at a double-digit rate this year.
Valuation looks appealing
After the big drawdown, Roku stock now has a market cap of $13.7 billion. Based on just platform revenue (remember, player/hardware revenue is meant to operate at 0% gross margins and will never create any value on its own), the stock trades at a trailing price-to-sales ratio (P/S) of 6. This isn't too crazy if you believe in the long-term growth of CTV advertising and Roku's position in the market.
Supply chain problems need to get resolved, and there will still be tough competition from Apple, Samsung, and Amazon, but Roku looks like a promising stock that will benefit from the hypercompetitive video streaming market. Now could be a great time to pick up some shares.
