Concerns about declining ad spending have been front of mind for investors in the advertising space, which came to light on July 28 when Roku (ROKU 0.16%) reported its second-quarter earnings. The company got hammered by declining demand from consumers and advertisers, painting a bleak outlook for the rest of the year.
However, long-term investors have reason to be optimistic after this stock drop of 22%. The tailwinds pushing streaming and advertising on streaming channels are still in full swing, and Roku looks ready to capture that trend. Therefore, it might not be time to get rid of your Roku shares.
Between a rock and a hard place
Roku faced immense pressure on both sides of its business this quarter. Due to inflation, Roku saw consumers pull back their spending on discretionary items like TVs. As a result, the company had only 1.8 million active accounts join the platform sequentially, totaling 63.1 million active accounts.
The company is also facing pressure from its advertisers, who are cutting back their spending. Roku is seeing businesses worried about a recession, so demand for advertising on the "scatter market" -- short-term, quarterly advertising commitments -- has slowed dramatically. However, it's important to note that while short-term agreements have fallen, deals for year-long commitments have remained strong: Roku surpassed $1 billion in ad commitments for this year's TV season.
Nonetheless, these two forces combined for an ugly quarter. Revenue grew only 18% year over year to $764 million as operating expenses continued to skyrocket 73% over the same period. What was most frightening, however, was Roku's guidance. The company anticipates $700 million in Q3 revenue -- just a 3% year-over-year rise and $200 million below what analysts were looking for -- signaling that the pain will continue, likely for the next few quarters.
Tailwinds can still push Roku forward
However, long-term investors focus on the next five years, not the next five quarters. And on that front, Roku still has glimmers of hope.
Despite the pullback in Q2, ad spending is moving in its favor. U.S. consumers ages 18 to 49 spent over half of their TV time streaming in Q2, yet only 22% of U.S. TV ad budgets are estimated to go toward streaming in 2022. These two figures could converge as streaming becomes a normalized advertising channel.
Additionally, Roku saw relative resilience in ad spending on streaming platforms versus legacy TV in Q2. Advertisements for consumer packaged goods and automotive products dropped 9% in the traditional TV space and yet grew double-digits for Roku. In other words, while ad spending is down for Roku, it is seeing more robust demand than traditional players and shows that the shift in ad spending to streaming is still in full swing.
To capture its opportunity ahead, Roku needs to stay the top dog. In Q2, the company kept its title as the No. 1 streaming platform in the U.S., Canada, and Mexico by hours streamed. Roku wants to be the first place that advertisers think of when they spend their budget on streaming. To do that, it needs to stay on top moving forward.
A long-term mindset is required
The next few quarters won't be pretty for Roku. The company was significantly affected by decreasing ad demand, which could worsen if a U.S. recession becomes more prevalent. That said, the long-term tailwinds could help it succeed when ad spending revives. The key is for Roku to survive this rough patch and remain the leader on the other side. If the company can't do both of those things, it might not live up to its potential.
Therefore, investors should watch the following. First, Roku should remain the top streaming platform in North America by hours streamed. Second, hours streamed and active accounts should be monitored to ensure high engagement. Other platforms could overtake Roku and rule the industry if these metrics stop growing.
Right now, Roku has over $2 billion in cash on the balance sheet with just $85 million in debt. However, its cash burn is worsening. In Q1, the company generated $87 million in free cash flow, but in its Q2 report, Roku reported a year-to-date burn of $62 million. If this increasing cash burn continues, it would beg the question: How long could Roku stay afloat?
Investors shouldn't take this for granted, but if Roku can hold on to its top-dog status over the coming quarters, its shares could rebound over the long term. With the stock trading at just three times sales, Wall Street doesn't appear to have much faith in this company. Therefore, some diversified investors might want to take a little position in Roku and plan to dollar-cost average over the coming quarters.