In March, connected-TV platform company Roku (ROKU -10.29%) did something it hadn't done before: It started selling branded smart TVs of its own design and manufacture. Now entering the holiday season, the company hopes its smart TVs are a big hit.
For consumers, this might seem like a big step up for Roku. The company started by selling small devices that plug into TVs, allowing them to stream video content from the internet. Then, it partnered with TV manufacturers to power their TVs with the Roku operating system. Now, it's gone a step further by making branded TVs of its own.
Roku's management doesn't intend to stop here, either. Founder and CEO Anthony Wood envisions powering an entire smart home, complete with video doorbells, security systems, and more.
While most consumers only think of Roku's devices when they think about the company, devices only accounted for 14% of the company's revenue over the last 12 months. The rest of its revenue comes from something else.
Roku's real money-maker
The other 86% of Roku's top line during the past year is what it calls "platform" revenue. There are multiple components to its platform revenue, but the core of this segment is digital advertising.
Here's what may be shocking to most investors: It costs Roku more money to make its devices than what it sells them for. Through the first three quarters of 2023, the company has generated $335 million in device revenue, but its cost of revenue was $358 million -- a $23 million gross loss from the start.
If Roku's only business were hardware sales, it would be on the path to bankruptcy with these economics. However, Roku views hardware sales as simply the path to customer acquisition. Once someone starts using Roku's software -- whether it's plug-in dongles, smart TVs, or eventually doorbells -- the company then has an opportunity to start generating higher-margin revenue. It goes from a one-time money-losing sale to a recurring high-margin revenue stream.
But the gross margin for Roku's platform revenue has been slipping in recent quarters too. In Q3 2022, its platform revenue had a gross margin of 55.7%, but a year later, its gross margin slipped to 48.1%. That's a huge one-year swing.
Unsurprisingly, this is having a dramatic impact on Roku's overall profitability even though revenue is at an all-time high:
Data by YCharts.
Platform revenue is supposed to be Roku's real money-maker, so it needs profitability in that segment to pick back up. Fortunately for investors, there's reason for optimism. Management is restructuring the business right now, and as part of its restructuring, it's removing certain licensed and produced content from The Roku Channel.
By removing certain content, Roku had to take impairment charges that hurt its margins. Without these charges, Roku's gross margin for platform revenue would have been slightly up year over year in Q3. Therefore, the company could be back on track after it moves past these charges.
Could Roku's profits be on the cusp of soaring?
Generally speaking, advertisers have reduced their spending in recent quarters, hurting revenue for companies like Roku. That said, spending will absolutely pick back up at some point, and the best advertising platforms will be the biggest beneficiaries.
Is Roku one of those best advertising platforms? There's reason to believe it is.
Roku is growing in its ability to offer what few players can: measurability. Between partnerships with Walmart, Kroger, Cox Automotive, and more, Roku can directly connect purchases with advertisements, so advertisers can clearly see the results of the money they spend.
Assuming these capabilities live up to the hype and grow, Roku will be in a good position to capture really great rates on its ad inventory in the future, allowing its revenue and profit potential to grow.
The caveat to this, however, is what I shared at the start: Roku is willing to sell products at a loss in order to gain users. Therefore, investors shouldn't necessarily expect profits to come pouring in right away. As long as management believes it can grow its user base, it's likely to continue to lose money on hardware.
Steep, ongoing net losses do make Roku stock more risky than other investment opportunities. That said, with the company's growing capabilities and the potential recovery of the ad market in 2024, there's good reason for Roku's shareholders to continue holding today.
