Roku (ROKU -3.29%) delivered better-than-expected first-quarter sales when it reported earnings late last month. Revenue increased 28% year over year to $734 million, ahead of analysts' consensus estimate of $718 million. The stock price is down about 18% in the past month, but it started to turn higher after the earnings report.
Most of the stock's slide can be blamed on slowing growth in active accounts. Roku added 3.7 million accounts in the fourth quarter followed by 1.2 million in the first quarter. That mirrored the sluggish performance at Netflix (NFLX -1.13%), which reported a net loss of 200,000 paid subscribers.
Still, investors shouldn't assume that the status quo of weak growth will continue. During Netflix's recent first-quarter call, Netflix CEO Reed Hastings said the company is considering adding a lower-priced plan that is supported by advertising. If Netflix follows through, it could lift user growth for Roku and shift the sentiment around the stock.
Growing demand for free streaming
Since Roku is not a streaming subscription service like Netflix, it relies on the appeal of third-party services available on its platform. Roku's primary means of generating revenue is selling advertising space through its TV operating system. Anything that drives higher demand for streaming services is good for Roku's business.
One obstacle to growth for streaming service stocks is subscription fatigue. It's hard to keep up with all the new services that launched over the last few years. A total of 85% of U.S. households have at least one subscription streaming service, according to Kantar.
However, there is momentum behind free ad-supported services. Kantar found that 18% of U.S. households are now using at least one free ad-supported streaming service, and these free services experienced the strongest penetration growth in the fourth quarter.
Hastings has long said he was against the complexity of putting ads on its service. But with the streaming leader hitting a wall in terms of subscriber growth, it makes a lot of sense now.
This move would create more demand for both Netflix and Roku. A key point: Roku CEO Anthony Wood believes an increase in the number of ad-supported services would accelerate the shift of advertising budgets from traditional linear TV to streaming. And Roku is already the leading TV operating system in the U.S.
Roku also has a fast-growing ad-supported option on its platform -- The Roku Channel, where it offers exclusive content. That was a top-five channel on the platform in the fourth quarter. For the platform operator, the introduction of an ad-supported Netflix option would be like adding a second Roku Channel in terms of the opportunity to profit from advertising. The revenue gains could be explosive.
The outlook is good for Roku's ad business
In its first-quarter earnings report, Roku credited the demand for free content on The Roku Channel for expanding the company's advertising opportunities. Platform revenue, which includes ad revenue, grew 39% year over year to $646 million.
The traditional TV advertising market is worth $60 billion. That's almost 100 times Roku's platform revenue. Management continues to remind investors that 46% of TV watching is now on streaming, but only 18% of TV advertising budgets have transitioned to streaming platforms. This gap represents an enormous opportunity, and it will gradually close. It's just a question of when.
If there's one reason to buy Roku stock at its 52-week low, it's the company's robust growth in platform revenue and the massive opportunity in advertising still ahead. An ad-supported Netflix plan would be a strong catalyst to help Roku unlock that opportunity.