With Rising Threats and Falling Profitability, Stay Clear of ROKU Stock

Stocks to sell

Roku (NASDAQ:ROKU) has bypassed the brutally expensive content-creation game and figured out a way to build a massive streaming audience/platform based on advertising rather than blockbuster-content driven subscriptions. As a result, Roku stock has soared from its late-2018 low of $27 to nearly $140 per share.

With Rising Threats and Falling Profitability, Stay Clear of ROKU Stock

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There’s been a great deal of chatter about video streaming stocks over the past year. Competitors are flooding into the arena. Disney (NYSE:DIS), Comcast (NASDAQ:CMCSA), AT&T (NYSE:T) and many more have launched services to try to knock Netflix (NASDAQ:NFLX) off its podium.

Not unreasonably, investors are nervous. Netflix stock, in particular, has underperformed the broader stock market as traders fret that the rise of numerous services will drive down everyone’s profits.

Let’s face it, not everyone wants to subscribe to a dozen different streaming services. It’s ironic how consumers cut the cord and the media industry’s response was to try to force everyone to sign up for a bundle full of different streaming services.

Just as broadcast television remained a robust option for many consumers that didn’t want cable, Roku can offer a great alternative to the Netflix/Disney model.

Roku Versus Amazon

They say that imitation is the best form of flattery. That could apply to Roku as well. As our Todd Shriber pointed out, the streaming wars could be a “blessing in disguise.” For awhile, Roku appears to have a dominant position in the smart TV platform. But, seeing its success, rivals have come to take Roku on. Not surprisingly, investors are growing nervous as they see Amazon (NASDAQ:AMZN) encroaching on Roku’s territory.

Amazon’s Fire TV streaming device has pulled ahead of Roku in user numbers. On top of that, the Wall Street Journal recently wrote that Amazon is in talks to start selling advertising to other platforms such as Microsoft’s (NASDAQ:MSFT) Xbox. Amazon is making a clear play for Roku’s business, attacking both its hardware and advertising revenue streams.

Investment firm Rosenblatt defended Roku and The Trade Desk (NASDAQ:TTD) shares following the Amazon news, saying that they didn’t foresee many advertisers switching to Amazon yet. Still, it shows the sort of competition that will be coming in this space.

Competition Is Inevitable

We reached out to University of Hawaii marketing professor Nathaniel Hartmann, who gave his expert analysis on Roku and other streaming companies’ strategies going forward:

The primary means of revenue generation for streaming in the media space has traditionally been subscription pricing and hardware. As competitive and technology developments put more pressure on subscription pricing and hardware pricing, media streaming companies like Roku are looking to digital advertising to grow revenue and profits. As streaming becomes more common and recognized as the future of media consumption by those placing advertisements, advertising revenues of companies like Roku is likely to grow.

That all makes sense, and Roku is following that model perfectly, as its surging revenue numbers confirm. Before you get too excited for Roku’s future, however, take the professor’s sobering conclusion into account:

“But as competition amongst media companies practicing streamlining creeps into the selling of digital advertising, margins on digital advertising will face pressure.”

ROKU Stock and Profits

Roku’s last earnings report surprised some traders. That’s because the company beat on both revenues and earnings per share. Yet the stock initially sold off sharply following the news release. Roku stock recovered after the earnings report, but has subsequently failed to follow the broad stock market to new highs.

Just judging by the numbers, you’d think things were going well. Roku announced 50% year-over-year growth. Furthermore, it raised guidance for the full year. And, importantly, the company’s platform revenues are booming; they soared 79% last quarter.

Over time, Roku is aiming to bring in more from platform and less from hardware. That, in turn, should lead to more stable revenues and higher profit margins.

Yet, despite all the good news, the company’s overall profitability declined. The company’s comprehensive net loss grew from $9.5 million for the September quarter of 2018 to $25.2 million this past quarter.

On the one hand, you could still excuse the losses as expected for a company that is relatively new and rapidly-growing. On the other hand, Roku pulled in more than $250 million in revenues last quarter and still lost money. At what point does the business model start to generate significant profits, particularly if Hartmann’s warning about margin pressure plays out?

Roku Stock Takeaway

At the right price, Roku is a compelling play on the future of streaming and smart TVs. At this price, however, Roku has a lot less upside left unless everything continues to go well. If the company can continue growing revenues at its torrid rate and margins hold up, then the stock will continue to win, even from this elevated starting point.

If rivals such as Amazon take a major chunk of the market, it will likely deflate Roku’s valuation going forward. Even if the overall market continues to grow at a decent clip and Roku gets a fair chunk of that marginal revenue, there is still risk. As Hartmann said, more advertising platforms entering the space may cap prices. That would stop Roku from earning a strong profit margin on its business.

At the time of this writing, Ian Bezek held no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.

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