Roku was founded by Anthony Wood in 2002. Recall that in 2002, the internet was in its infancy, and streaming wasn’t yet a thing (Netflix didn’t start streaming until 2007). In the early days, Roku was focused on building internet radios, high-definition media players and digital signage. Over the years—Wood was a Netflix employee while also working on Roku, with Netflix’s blessing—the strategy evolved into becoming a pure video streaming business.
Roku’s first streaming customer was Netflix, which used to be 100 percent of Roku’s streams. Over the years, Roku has diversified and is today a platform for television distribution.
Roku builds software that it licenses to TV manufacturers like TCL. It also sells its own Roku sticks, which anyone can plug into an existing TV. In the first nine months of this year, more than one third of all smart TVs sold were Roku TVs. In the editorial results below, which I took from Amazon’s website, two out of the three are Roku TVs:
Roku is not a hardware manufacturer; the hardware it sells is just an on-ramp onto its streaming platform. Because Roku sells its hardware at a small gain (around 4 percent gross margin), it can be thought of as a very low-cost customer acquisition tool. From then on, Roku monetizes that customer through advertising and a revenue share of SVOD (subscription video on demand) channels (called “Platform Revenue,” sporting 63 percent gross margins).
Underlying Roku’s growth is a secular shift from linear TV—such as your local broadcast over-the-air channels—to streaming TV, whether subscription (Netflix and Disney+) or ad-supported (Hulu, Pluto TV, the Roku Channel, Sony Crackle, TUBI, Vudu, and YouTube).
Because of this shift, advertising budgets are also moving, albeit at a slow pace. About 29 percent of TV viewing is already OTT, whereas only 3 percent of ad budgets have moved over. This represents an opportunity that is tens of billions of dollars in size and dwarf’s Roku’s current platform revenues of just over $700m. Put another way, could Roku one day have $5 billion of platform revenues? $10 billion? Yes, it’s possible, given the very large market domestically and internationally.
Advertising on Roku has advantages both for the advertiser and the viewer. Ads can be targeted more precisely than on linear TV. This should, over time, result in higher CPMs (cost per thousand ad impressions) than on linear TV. At the same time, viewers have the benefit of ad loads that are about half that on linear TV, which results in a superior consumer experience.
Currently, content owners like CBS and Viacom earn both subscription and ad revenues from cable distributors like Comcast and Charter. As cord-cutting continues unabated—the industry has lost paid customers every year for several years now—cable companies are trimming their bundle offerings. They are more than happy to do so: video is a low margin offering for them and requires high capital expenditures. Broadband, on the other hand, is exactly the opposite. The endgame of the TV bundle is live sports and news, with nearly everything else moving OTT.
Roku, as the most comprehensive aggregator of OTT content, is the prime beneficiary of this trend. It benefits from the proliferation of SVOD services like Netflix, Disney+ and the upcoming HBO Max, Peacock and others. Each time a customer signs up for one of these services inside Roku, the company earns a revenue share.
Pursuing this strategy of licensing the operating system for Roku TVs and selling Roku sticks at a tiny margin as an on-ramp to the Roku platform, the company has experienced blistering growth in active accounts, from 10 million in early 2016, to 20.8 million in early 2018, to 32.3 million in the latest quarter.
At the same time, the average yearly revenue per user has increased from $5.73 in mid-2015 to $22.58 in the latest quarter. This combination has resulted in explosive platform revenue growth of over 70 percent over the last twelve months. Future active account growth coupled with an increase in engagement and streaming hours leading to increased ARPU should continue to fuel Roku’s revenue growth.
In advertising, Roku recently strengthened its competitive position with the acquisition of demand-side advertising platform dataxu. As advertising moves OTT and becomes more targeted and programmatic, dataxu will allow Roku to stay ahead of rivals by controlling its own ad technology.
The spectacular rise of the stock this year—up 335 percent since we started buying—has pulled forward some returns. But if the company continues to execute well, there are more returns ahead. Based on our modeling of growth and operating margins at scale, we believe the stock could compound in the mid-teens from the current price.
[Note: this post is an excerpt from one of our letters to investors, originally published on December 2, 2019. To learn more, check out our investors section.]