Roku went public this past week, and saw its stock soar in its first couple of days on the NASDAQ. The timing of its IPO is closely tied to a shift in its business model the company implemented a few years ago and which is now beginning to bear fruit. Understanding that shift is critical both to understanding the company at this stage, and understanding whether or not the big bets many investors are making on it are sensible.
From Players to Platform
The big shift Roku has made strategically, and is still in the process of executing on now, is a pivot from making money from the sale of smart TV set top boxes to making money from the usage of its TV platform. Roku’s IPO filing provided limited historical financial data, but in the first half of 2015, for example, the company derived 85% of revenue from selling its players and just 15% from its platform, including licensing of that platform to third parties, advertising, revenue share from subscriptions sold through its platform, and so on. By the first half of 2017, by contrast, the revenue split was 59/41, and in Q2 2017 it was 54/46, nearing an even split between player and platform revenue.
Big Implications for Margins
This shift in business model comes with big implications for margins: gross margins on players have never been very high, and Roku now explicitly says that it isn’t optimizing for margins but for creating the largest possible audience for its platform. Platform revenues, however, are pretty high margin, because there are few costs and a growing revenue stream associated with it.
As you can see, gross margins in the platform segment are much higher than in the player segment, and that’s likely to continue to be the case. As a result of the shifting revenue mix, overall gross margins have improved over the past couple of years, but this hasn’t yet flowed through to sustainable profits at the operating or net income level.
As such, to bet on Roku is to bet that it can continue this transition from being focused on selling set top boxes at a profit to maximizing its audience and then monetizing that audience, so that it can finally turn a profit regularly. It’s certainly made good progress on both those fronts so far, growing its active user base from 4 million in early 2014 to 15 million today, while driving average revenue per user from under four dollars annually to over eleven dollars in the past year.
Roku’s Future Remains Uncertain
But there isn’t yet a clear linear correlation between the transition and operating margins, in part because even as gross margins have improved, the company has increased R&D spending from 16% to 20% of revenue in the last two years, to fund the innovation necessary to remain competitive in a market which also included three of the largest consumer technology companies in the world: Amazon, Apple, and Google.
And that’s easily the single biggest challenge to Roku in the future: it’s succeeded in large part by offering decent boxes at competitive prices without tying users into any particular ecosystem, at a time when Apple TV has been missing Amazon Prime Video, Android TV has failed to take off, and Amazon has taken its time adding Alexa voice features to Fire TV. But all of those things either are now changing or could soon change, with Amazon’s video app coming to the Apple TV for the first time, Nvidia and Sharp devices running Android TV getting Google Assistant support, and Amazon adding Alexa to the Fire TV lineup.
As that happens, competition in the smart TV set top box space will intensify, and features like voice control will become table stakes, forcing Roku to hire and attempt to catch up with those very deep-pocketed competitors, which are fighting for dominance of far more than just TV boxes. At the same time, Roku’s future is unusually tied up in advertising-based revenue streams for a company in the streaming and cord-cutting space. To be sure, advertising will have a role there as it has in the legacy TV space, but much of streaming today either eschews advertising entirely or makes it optional, with the largest ad-based streaming property – YouTube – not paying Roku a dime.
As such, there’s plenty of potential upside in Roku’s transition to a platform company, but there’s also plenty of risk. It’s got a decent strategy, and may yet carve out a profitable niche for itself among the consumer tech giants, but it’s going to have to both execute pretty flawlessly and catch its fair share of luck in the next few years.