Roku (ROKU 2.55%) had more bad news for investors in its recent third-quarter update. The advertising industry is still contracting, and the pace of those declines is accelerating, management said. That pressure will cause sales to fall in the core streaming platform segment in Q4 and will likely stick around at least into 2023, they warned.
Roku is in no danger of losing its valuable leadership position in a streaming video niche that's likely to grow for many more years. It is attracting new users and more engagement, and the company has some exciting product and device launches on the way aimed at making the platform even more valuable.
But a few red flags should have investors thinking twice about calling the stock a screaming buy after the price has declined sharply in 2022. Let's look at two of the biggest.
Red flag No. 1: Too much reliance on ad spending
It seems like a lifetime ago when Roku announced strong sales growth for the Q1 period that kicked off fiscal 2022. That late-April report showed a 39% spike in its core platform business and 28% higher revenue overall.
Management at the time cited Roku's diverse approach to monetization in the streaming entertainment that delivered value to TV watchers but also to advertisers and content creators. "We believe the enormous value [we] deliver to consumers, content owners, and advertisers," management said in a shareholder letter, "will continue to drive our growth both in Q2 and for the full year."
It now seems that Roku's business is much more dependent on advertising to fuel growth. The company gained 2.3 million new users in Q3, after all, and engagement expanded as well. Yet weaker digital-ad demand pushed platform-revenue growth down to 15%. And executives projected that this metric will fall into negative territory in Q4.
Red flag No. 2: Net losses ahead
Roku isn't ready to stop investing in areas that add value to its platform or increase diversity in its revenue streams. The company is pushing into smart home services, for example, and is busy building up new offerings like the popular Roku-branded streaming channel that nearly doubled engagement in Q3. "We continue to innovate and execute," management said in their recent letter.
Yet spending has still clearly overshot the current pace of earnings growth. Roku said their efforts to slow hiring and other expenses began in Q2 and accelerated in Q3. It will still be a few more quarters, though, before these cuts begin lifting profitability.
ROKU Operating Margin (TTM) data by YCharts
In the meantime, investors can expect a second straight quarter of adjusted losses. That red ink landed at $12 million in Q2 and $34 million in Q3. Roku is forecasting a $135 million loss on that basis in Q4.
Temporary profit slumps are no reason to throw out an investing thesis. And Roku's long-term outlook still appears bright, given its growing influence in the streaming industry.
Advertisers should have every reason to return to the platform once conditions improve in that niche. For now, though, shareholders will have to endure ballooning losses and a pause in growth that might last into early 2023.
