Internet-connected television (CTV) has grown into one of the largest consumer categories over the last decade. With the decline of the cable bundle, many people around the globe are forgoing traditional TV viewing and opting for CTV options instead. Advertising dollars have followed this transition. CTV advertising spending was just $2.8 billion five years ago, but it's projected to approach $44 billion in 2026.
Roku (ROKU 0.15%), a leading CTV company with over 65 million active customers, is working hard to capture a lot of this advertising spend. But with margin deterioration and the technology bear market, Roku's stock has taken a dive in 2022 and is now down 80% since the start of this year.
Roku's performance has been a drag for shareholders this year, but will that trend reverse in 2023? Let's take a look.
Why the stock is down: Slowing growth, deteriorating margins, tough business deals
Roku's stock nosedived in 2022 due to a reversal of the reasons it did so well in 2020 and 2021. First, it's seeing declining revenue growth, especially for its important platform/advertising segment. In the third quarter of this year, platform revenue only grew 15% year over year to $670 million. In the same quarter last year, platform revenue grew 82%. This huge deceleration likely has investors worried about Roku's position in the CTV market as it's lagging the overall industry.
More importantly, Roku's margins are deteriorating. Third-quarter consolidated gross margins declined to 46.9% from 53.5% a year ago. Gross margins for its players/TVs are at negative 19% now, while the platform/advertising business declined 9.2 percentage points to 55.8%. As a result, total gross profit declined 2% year over year last quarter.
With research and marketing expenses growing 73% and 91% year over year, respectively, Roku's bottom line has tanked. Over the last 12 months, the company has posted a net loss of $237 million.
Data by YCharts.
Roku's negotiations with major content suppliers for applications on its CTV marketplace have also become increasingly combative. YouTube had a spat with Roku over YouTube TV in 2021, and Disney has yet to bring its ad-supported tier for Disney+ to Roku's platform. Investors are likely concerned Roku will get the short end of the stick when negotiating with huge companies like Alphabet's YouTube, Amazon, and Netflix which have popular applications on its devices.
Is the stock cheap? Only if a few things go right
With the stock down 80%, many investors with a long-term horizon are definitely looking at Roku shares right now. But what needs to happen in order for the stock to work over the long haul? First, it needs to get back to generating positive earnings. We are not living in the capital-flush era of late 2020 and early 2021 with near-zero interest rates. Investors care about profits, not just top-line growth, and Roku's stock will probably stay bombed out until this gets fixed.
Second, and this connects to generating positive earnings, the company needs to fix its expense structure. Growing operating expenses 71% year over year when revenue is only up 12% is not a sustainable model. However, Roku did cut 7% of its workforce last month, and more layoffs could be coming in the near future if the company wants to get serious about returning to profitability.
Third, Roku needs to accelerate growth in its platform/advertising business. As I mentioned above, there are tens of billions of dollars at stake in the burgeoning CTV advertising market. Roku, with less than $750 million in quarterly platform revenue at the moment, should be able to take advantage of this tailwind over the next few years. Look for this segment to continue growing at a double-digit rate, along with stabilizing gross margins, as a sign Roku is turning around its advertising business.
At a market cap of $6.4 billion, Roku stock could look cheap a year from now if it can fix its margin woes and start generating profits. I'm not convinced the company can make this happen given the roadblocks, but if you believe in the appeal of its platform to advertisers, now could be a good time to start a position.
