With 76 million active accounts that streamed nearly 27 billion hours of content in the third quarter last year, Roku (ROKU -10.29%) is the leading smart-TV operating system in the U.S., Canada, and Mexico. The business has and will continue to benefit from the ongoing cord-cutting trend.
Although this streaming stock had a monster year in 2023, up 125%, it remains 82% below its peak price. Investors looking to add a beaten-down growth company to their portfolios are probably considering Roku right now.
But before you press the buy button, it's a smart idea to understand a key risk with this business. Let's take a closer look at Roku.
Who has the leverage?
Most readers are probably familiar with Roku as the company that sells those popular media sticks and dongles that make any regular TV into a smart TV that's connected to the internet. But while this segment generated more than half of the sales about six years ago, in the latest quarter, hardware represented only 14% of overall revenue. This is a division that is declining in importance over time.
Roku's main revenue driver now is its platform segment, where it earns money from certain subscription and advertising arrangements it has with its partners. Major content companies that offer streaming subscriptions place their services on Roku's platform to reach a wider audience. In doing so, the typical agreement gives Roku control over 30% of any ad inventory, revenue that it fully gets to keep.
This sounds like a lucrative business model. And it has led to tremendous long-term growth for Roku. The issue, though, is that larger content companies are calling the shots.
For example, in 2021, Roku was at a standstill in its negotiations with Alphabet's YouTube. Ultimately, a deal was reached in December that year to keep the popular video streaming service on Roku. But based on their prior agreement, Roku likely doesn't earn any revenue from YouTube. This is alarming given that YouTube is the second-most-visited website in the world.
I wouldn't be surprised if this is the case with Netflix as well, which has 247 million subscribers, although it's hard to find any definitive information. The conclusion is that Roku might reach nearly 80 million households, but it lacks sufficient negotiating power versus some of the most popular streaming services out there. In other words, Roku needs them to make its platform more valuable to viewers more than the content companies need Roku's distribution capabilities.
From a competitive standpoint, Roku is almost certainly leaving sizable amounts of revenue on the table. The fact that the business doesn't have proper leverage right now over important stakeholders in the streaming industry might be a huge cause for concern for some investors. And it's a risk to keep in mind.
Is Roku a buy now?
Nonetheless, there are some compelling reasons to still want to own the stock.
As I noted, the company has top market share in North America, which positions it well to continue capturing households that decide to ditch their cable TV subscriptions in favor of streaming entertainment. In international markets, the growth opportunity is even bigger.
More recently, Roku is seeing business pick up. Revenue increased by 20% in the third quarter of last year, the fastest rate of growth since Q1 2022. Should the momentum continue throughout 2024, investors can be optimistic that the company will post stellar top-line gains this year.
Because the stock is so beaten down, its valuation is reasonable. Roku's price-to-sales ratio of 3.5 isn't expensive at all, and it might just prompt some investors to add shares to their portfolios.
