Short Roku

  • Roku (NASDAQ: ROKU)
  • Date written: Feb 15, 2018
  • Current price: $45
  • Price target: $20-25 (45-55% gain)
  • Time frame: 6-12 months

Recommendation

What:

  • SHORT with price target of $20/share (50% to gain).
  • Time frame: 6-18 months.

Why:

  • Overly ambitious user growth estimates
  • Inferior hardware product
  • Limited potential for company to cut costs

Catalysts:

  • Potential earnings miss (2/21/18)
    • Missed earnings will cause a sell-off
  • IPO lockup period ends March 2018 => stock price will drop
    • Series B converted shares will get sold off => stock price will drop

Risks:

  • Earnings beat => stock price rise
  • New product announcement => increased buying interest => stock price rise
  • Stock listing on SP500 indices => Long only asset managers purchase for first time => stock price rise
  • Mitigate risks by protective calls / covered puts, long the stock of Roku’s suppliers or partners

General company information

Roku is a global consumer electronics/broadcast media company, founded in 2002 and operating in two segments: Players(Streaming devices) and Platform (content delivery, ads, etc.). Total VC funding $208.6M; the IPO at $1.3B valuation in Sept 2017.

  • Market cap: $4.4B
  • TTM revenue ~$470 M
  • EBITDA: $(46M)
  • Revenue growth 25% YoY (Q3 2017)

The consensus view: substantial (30-40% YoY) revenue growth going into 2018+.

The company’s product lines:

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Roku makes most of their money in the platform segment and the trend will continue. This will form the bulk of our thesis.

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General Progress of the company

Stock price has shot up from $28 a share to between $40-50 a share since Needham analyst Laura Martin increased her target price. This is insane considering Laura Martin’s price target was a clear outlier compared to all other analysts. What a joke. alt text

What Roku tells investors (Q3 2017 highlights)

  • Net revenue grew 40% YoY ($124.8 M)
  • Gross profit grew 92% YoY ($49.9 M)
    • 89% of profit from platform revenue in Q317
    • 67% of profit from platform revenue in Q316
  • Gross margin now 40% from 29% in Q316
  • Active Accounts up 48% YoY to 16.7 M
    • Mostly from Roku TVs
  • Streaming hours up 58% YoY to 3.8 B
  • ARPU [platform revenue] up 37% YoY to $12.68
  • 1 in 5 smart TVs sold in USA/Canada were licensed Roku TVs

What Roku tells investors (Q4 outlook)

Roku has optimistic views for Q4 earnings, albeit less growth YoY compared to Q3 2017.

  • Total Net Revenue: $175 million to $190 million; (19%-29% YoY)
  • Total Gross Profit: $58 million to $64 million; (30-43% YoY)
  • Net Income loss: ($14) million to ($8) million; (from -$46M last quarter)
  • Adjusted EBITDA: ($6) million to $0 million. (from $3M last year, -$7M last quarter)

What everyone else thinks

Everyone sees these big numbers and thinks there will be massive growth moving forward into 2018.

  • Market cap: “Roku has 17M users, Netflix has 51M users, yet Roku is 10% the market cap… Roku’s market cap should be higher”
  • “Netflix can’t do advertising but Roku can. Therefore Roku can print a lot of money” (really? really?)
  • “Roku will be integrated into more TV brands in the future. Therefore Roku can print a lot of money”
  • Sell-side analyst projections range from $28-55 per share. Very bullish.

Why everyone is WRONG and Roku is OVERPRICED

The reasoning is several fold.

  • Investors have unrealistic growth expectations
  • Competitive and saturating media streaming/OTT market
  • Roku has an inferior hardware product. The software platform is also inferior and easily clone-able and can be easily out-competed.

  • Roku is losing money. They have never turned a profitable quarter and there is very little room to increase margin

  • Valuation wise, there is absolutely no reason ROKU should be trading at 10x revenues! Netflix [the closest competitor] trades at 10x revenues and is a far superior company.

Unrealistic growth expectations

The stock is still >$40 from spike from Needham’s overly bullish report in October 2017. What should be noted is that Needham’s $50 price target hinges on 40+% growth for 2-3+ more years.

BUT…. Roku’s market share among streaming media market is already 37% – there just isn’t that much room to grow. Roku’s best chance to grow revenues is from maximizing average revenue per user (ARPU). However, it’s very costly to pull off. We already saw Netflix try to milk out over $110 per customer per month in the USA and they’re already operating at 40% gross margins which is similar to Roku. Roku just doesn’t have the chops to milk out money from customers in a cheaply done way.

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Let’s pick apart some parts of Laura Martin’s analyst report, which is a total joke.

    "Like Netflix (NFLX), we view Roku as a pure play on over-the-top (OTT) TV-viewing growth, but Roku has no content risk" 

Really? Really? Other services like Netflix serve content for cheaper. Plus, for services like Netflix, you don’t need some poor quality piece of plastic (aka, the Roku “players”) to view content. Furthermore, Roku doesn’t serve exclusive content. They don’t have exclusive rights to serve any of their TV shows, movies, etc. Their lunch will get eaten by their competitors (which customers prefer to use).

    "Recent announcements and press reports that Disney (DIS), Alphabet (GOOGL), Amazon (AMZN), etc., are launching new OTT services helps Roku but hurts Netflix.”

This statement makes absolutely no sense. You probably won’t be able to share a lot of content. Amazon has their own device (Fire Stick). Google has their own device (Chromecast).

    "Roku's engagement lengths are hours per day per user, well above any internet company, suggesting higher monetization potential per user"

Roku has similar engagement lengths compared to other streaming services. Furthermore, people are willing to pay for ad-free services like Netflix (you can see this in customer surveys).

    "Also, as linear TV viewership falls, it is easy for brands to use their existing 30-second TV spots on Roku to follow younger audiences to OTT."

It is unclear how feasible this is. There is no evidence that these commercial makers will suddenly start putting their commercials on the Roku platform.

The over the top (OTT) media market is VERY competitive

Just look at this market map. Sure, the OTT market is expected to grow 25-50% YoY for a few years. However, the dominant players will probably remain the dominant players.

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Regardless of overall growth, Netflix is still the dominant player and there’s no evidence (as explained above) that Roku can steal their market share!

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“but Roku can sell at lot more Roku TVs!” – WRONG

Most of the top TV makers (by market share) already have their OWN hardware for smart TVs. There’s no way they will integrate Roku’s inferior hardware into their TVs. Further, among the smart TVs Roku has partnered with (i.e. they have the Roku hardware in them), there’s not that much room to grow. TCL already is the #2 smart TV sold by volume. Finally, there’s no evidence that Roku can increase player sales that significantly. They’ve been stagnating for two years. It’s pretty clear that revenue is driven by the platform segment, and not the player segment!

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Others may come out with superior devices

Large tech companies are going to R&D and release streaming devices. Roku is already LOSING MONEY every quarter, there’s no way they can afford to do better R&D. They can’t increase R&D spending without hurting their current balance sheet even more. Only way to stay competitive is via pricing, but this would work for 1-2 years at BEST. Amazon, Apple and Google are the REAL winners here.

Even right now, the Roku device is inferior to competitors. Reviewers across the media sites unanimously agree that Apple TV, Chromecast, and Amazon Fire are better than Roku on almost all metrics other than cost.

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Roku has little room to increase margins

Roku already makes gross margins as high as it can get, at ~40%. For comparison, Netflix’s gross margin last year was 36%. It’s pretty clear Roku has hit a wall with this since gross margin has stayed stagnant for the past 3 quarters. Margin expansion not really likely, yet Roku is still losing money. The EBITDA will stay negative for a while unless they cut something else (i.e., R&D). Once they cut R&D, there’s no way they can keep up with Amazon, Apple and Google on the hardware side. And they probably won’t keep up with Netflix either.

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Roku is toast, there’s very little it can do to become consistently profitable.

Catalysts

No thesis is complete without imminent catalysts. Well, here’s two strong ones.

Catalyst 1: potential earnings miss on Feb 21, 2018

Roku is set to report Q4 2018 earnings on 2/21/18. As mentioned earlier, Company guidance was overly bullish:

  • Total Net Revenue: $175 million to $190 million; (19%-29% YoY, 40-54% QoQ)
  • Total Gross Profit: $58 million to $64 million; (30-43% YoY)
  • Net Income loss: ($14) million to ($8) million; (from -$46M last quarter)
  • Adjusted EBITDA: ($6) million to $0 million. (from $3M last year, -$7M last quarter)

A miss on any of the above metrics can cause a sell-off. Plus, even if Roku doesn’t “miss” on any of these metrics, if they lower guidance for Q2 2018, Q3 2018 and beyond, a massive sell-off will ensue.

Catalyst 2: IPO lockup ends in March

There are about 84 million Series B shares owned by insiders and private equity. These lucky folks who got into Roku at a much lower valuation will be looking to exit their positions. A massive sell-off is imminent, especially if Q4 2017 earnings numbers disappoint.

Risk Factors

Of course, it would be stupid to avoid thinking about risk factors. There are a few, but they are minor and can be mitigated.

  1. New product announcement, leading to speculative buying
  2. Partnerships: Roku can pay a TV manufacturer to build Roku into the TV. Roku can negotiate exclusive partnership with OTT providers streaming via Roku (not that likely).
  3. It’s possible they may be seeing a listing on SP500 index, leading long-only asset managers to buy the stock.
  4. Finally the general OTT market growth rate: projected 14-17% CAGR ~5 years….maybe…

There are several ways to mitigate the risk factors:

  • Long the stock of companies likely to partner with Roku (e.g., OEM TV providers)
  • Long the stock of suppliers (i.e., FoxConn, their ONLY hardware supplier)
  • Protective calls / covered puts if you’re scared about Q4 2017 earnings numbers
  • Long the stock of dominant OTT players / top companies expanding into OTT (Netflix, Google, Amazon, Disney, etc)

Valuation

A DCF valuation and sensitivity analysis shows that in the BEST case, we’re looking at $20-30 stock price. Thats MUCH lower (30-50% lower) than the stock price today (2/15/2018).

The main assumptions that we make:

  • May be reaching terminal growth rate within 3-5 year (1-3% growth rate)
  • Assume R&D expenditure irrelevant by 2020 [it’s really the only way to expand gross margin, unless Roku finds a way to be significantly more cost efficient than Netflix in their platform segment]
  • Assuming R&D is cut, the main driver for cash flow is still the number users, not margin expansion

Even if we use a (very bullish) discount rate of 9% (similar to Netflix), and we assume Roku can attain 50-60% OTT market share at a 50% margin, we’re still looking at a max stock price of $25-30 per share. That’s just abysmal. Remember Fitbit in 2016, and GoPro in 2015? Same deal here. Imminent sell-off will start the moment Roku lowers guidance or misses earnings expectations. If it doesn’t happen this quarter, it will happen at some time in 2018.

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Download model here.

Summary

Short ROKU now to a $20-25 price target. It’s only a matter of time. Even if Roku miraculously beats consensus earnings estimates for Q4 2017, they WILL see a slow-down in growth in 2018. Compound the declining growth over the next several years, and it’s not hard to see that Roku really shouldn’t be worth more than $25-30 per share, in the BEST case. Most likely though, we could see $20 a share within 18 months.

Shorting Roku gives over 45-55% upside compared to a potential 20% downside.

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