Shares of streaming TV platform company Roku (ROKU -0.95%) are down more than 70% in 2022 as of this writing. And taking the words of founder and CEO Anthony Wood at face value suggests the rest of the year could be difficult as well.
In the conference call to discuss financial results for the third quarter of 2022, Wood said, "In Q3, advertisers pulled back on spending, consumers were further pressured by inflation, and overall economic uncertainty remained high. We expect these conditions will continue and are likely to worsen in [the fourth quarter]."
Here's why some investors may believe Roku is a contrarian stock to buy. But there are also a couple of long-term risks to be aware of today.
Why Roku stock could be a contrarian buy
The importance of Roku's holiday quarter can't be understated. As consumers engage in gift-giving, brands advertise their products like crazy. This dynamic benefits Roku tremendously because the majority of its revenue comes from displaying ads to its users. The chart below clearly demonstrates an annual spike during Q4.
Roku's annual revenue boost might not come this year. As management elaborated in its Q3 letter to shareholders, "As we enter the holiday season, we expect the macro environment to further pressure consumer discretionary spend and degrade advertising budgets." Therefore, management is guiding for Q4 revenue to drop from Q4 last year.
Rosenblatt analyst Barton Crockett downgraded Roku stock following its Q3 report, calling the company's outlook for Q4 "grim," according to The Fly. Words from Pivotal Research analyst Jeffrey Wlodarczak were much harsher; he called Q4 guidance "horrific." Other analysts downgraded Roku stock as well because of the company's upcoming holiday quarter.
On one hand, Roku's guidance was bad. On the other hand, investors shouldn't make investing decisions by looking at just the next three months -- they should be looking at the next three years, at least.
In the advertising industry, no one denies that the long-term trends appear to be in connected TV's (CTV) favor. Consumers are streaming more than ever, and advertisers are increasingly shifting their budgets. Roku has one of the largest CTV audiences with 65.4 million active accounts as of Q3, which was up 16% year over year. In time, it's reasonable to assume that advertisers will increase spending back to normal levels and Roku will benefit.
Because of its "horrific" and "grim" outlook for the next three months, Roku stock has dropped to its cheapest price-to-sales valuation ever, meaning now is an attractive entry point if Roku's business picks up in 2023 and beyond. This is why it could be a great contrarian buy right now.
Two substantial risks to Roku's business
Circling back to Wlodarczak, the analyst admits softness in the overall ad market but maintains that Roku is doing poorly compared to other companies. And there's some meat on this bone that Wlodarczak is picking. Consider that CTV is The Trade Desk's largest source of revenue, and its total revenue was up 31% year over year in its third quarter. By comparison, Roku's total revenue was up just 12%.
Moreover, The Trade Desk is guiding for at least 24% year-over-year growth in Q4. Roku is guiding for a drop in revenue even though it anticipates growing its user base. This indeed looks like a problem.
Here's another problem for Roku. The company isn't just forecasting a drop in advertising revenue; its hardware sales are also expected to decrease during the holidays. Hardware sales bring in new Roku users. And management is trying to incentivize adoption by making its hardware cheap. In Q3, its gross profit margin for player revenue was negative 17.5%.
In Q4, Roku's management is dropping prices even more, as evidenced by its statement that hardware gross margin will be "significantly lower sequentially." Therefore, expect Roku's losses to grow next quarter -- and they could grow beyond that as well. The company is diversifying into more hardware devices like video doorbells and smart lights as it tries to grab a larger slice of the smart home market.
These hardware sales will also be loss leaders for Roku. As CEO Wood said, "Our business model is to sell devices, smart devices that are low cost and great value for customers and then monetize those through service revenue streams."
In conclusion, Roku stock is cheap because investors are fretting about the next quarter. But the ad market should bounce back eventually. Investors should really be fretting about these larger issues. Roku is potentially underperforming its ad peers, and its losses will likely worsen as it slashes hardware prices and launches new hardware products.
Roku may still be a contrarian buy. But these risks need to be fully accounted for before buying shares.