Roku (ROKU -9.30%) recently reported its first-quarter 2023 quarterly results. Unfortunately, investors were disappointed that its outlook for the second quarter of 2023 projects only 1% year-over-year revenue growth after producing similar 1% revenue growth for the first quarter. This anemic revenue growth suggests that a recovery is not imminent, and many investors remain lukewarm toward the company. Consequently, the stock price sits 88% below its July 21, 2021 all-time high of $480. Yet, there is still hope for bulls.
Despite the negativity surrounding the company, the long-term fundamentals of Roku are still attractive. Let's explore why long-term investors may consider adding this stock to their buy list.
Facing an uncertain short-term future
Roku primarily generates revenue by charging service fees to content publishers and providing advertising services to publishers and advertisers -- an excellent business in a growing economy but a terrible one when the economy is slowing.
The company encountered significant problems in 2022; the Federal Reserve rapidly raised interest rates to counter inflation, choking consumer demand. Fearing a recession, advertisers markedly reduced their advertising expenditures in what's known as the ad scatter market, the unsold ad inventory bought shortly before a show airs. Unfortunately for Roku, its advertising business relies heavily on the ad scatter market, and its revenue growth plummeted.
ROKU Revenue (Quarterly YoY Growth) data by YCharts
It will likely take an ad scatter market recovery before this company's revenue growth reaccelerates.
Another problem is although Roku has been around since 2002 and has been a public company since 2017, it is still a relatively early-stage company that has only displayed meaningful profitability in 2021, hot off of a boost from the pandemic.
ROKU Net Income (Quarterly) data by YCharts
Guess what? The market hates early-stage unprofitable companies during times of economic turmoil. So as long as investors believe predictions of an oncoming recession, the stock will have difficulty recovering.
The stock is attractive over the long term
Roku's management has changed its approach in response to the market downturn by shifting from prioritizing growth at any cost to a far more cost-efficient strategy. It's now eliminating projects or activities that have a low return on investment while prioritizing investment in essential streaming platform infrastructure for consumers, content publishers, and advertisers, as well as adding new profitable revenue streams.
You can see one positive effect of the new strategy in the chart below. The relentless rise in operating expenses since 2020 has come to a halt. Roku's quarterly operating expense dropped from $614 million in the fourth quarter of 2022 to $550 million in the first quarter of this year.
ROKU Total Operating Expenses (Quarterly) data by YCharts
If Roku can maintain financial discipline and continue to reduce costs, it should be in an excellent position to return to profitability once the economy recovers and the ad market rebounds -- as long as it remains a desirable place to advertise.
Luckily for Roku, it has desirable attributes for advertisers. For instance, one of its core functions is content discovery, giving viewers many ways to find the TV shows and movies they like. At the same time, streaming services and brand advertisers have recognized the value of targeting audiences before their program selection. Very few of Roku's competitors have that capability. So its search and content discovery engines are exceedingly valuable and explain why the company has recently focused on expanding them.
A recent content discovery engine Roku has developed is "Sports Experience," located on its home screen menu. Live sports are an enormous opportunity for driving viewership. For instance, based on data from Roku and nScreenMedia, Roku was the leading streaming platform for the Super Bowl in 2023, with nearly 50% of all streams. And 12% of those streamers began their journey to watch the game through Sports Experience or a game-related advertisement.
It doesn't stop there. The company has grown its Live TV Guide from 100 free access channels in 2020 to over 350 live TV channels today. The streaming industry's acronym for these live channels is FAST (free ad-supported streaming TV), one of the most rapidly growing streaming areas.
For example, research company Omdia reports that "FAST revenue grew almost 20 times between 2019 and 2022, and is set to triple between 2022 and 2027 to reach $12 billion." So Roku is in a prime position to distribute and drive viewers to FAST channels and be at the forefront of monetizing a vast opportunity.
Roku primarily earns money on the platform through revenue-sharing agreements with content producers. It takes a portion of the subscription fees (20%) from pay channels and a part of the ad inventory (30%) from ad-supported channels for the promotional activities of its guide, search, and content discovery engines.
With Roku's 71.6 million active accounts, proven ability to drive audience viewership to specific content on its platform, and expertise in advertising, the upside could be significant once the ad market rebounds.
Should you buy it?
The chart below compares Roku's valuation to a few similar ad businesses. It trades at a price-to-sales (P/S) ratio of 2.4, well below its median P/S ratio of 8.7 over the last six years. This suggests that the market undervalues the stock based on historical valuations, and also undervalues it against its peers.
ROKU PS Ratio data by YCharts
If you have a time horizon of three to five years, consider investing in this promising undervalued company for the upside from its operational improvements and an eventual advertising rebound.
