AGB 2020.3 - Roku (ROKU)
AGB 2020.3 - Roku (ROKU)
Neutrality Wins Until Scale is Achieved
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Roku
When we analyze the evolution of video content consumption, we separate it into two distinct categories: on demand and linear. Most of the improvement so far has happened in on demand.
Consumers looking to gain access to linear content is straight forward. Get content over the air or through a cable provider. On demand content required a bit more work from the consumer. That meant buying a media player, going to a physical location in advance to buy or rent content, and then returning the content. On demand content was available through a cable provider through PPV but the prices were steep.
Then Netflix, YouTube, Prime Video, Hulu and others changed the game by bringing on demand content over Internet for a subscription fee or watching a few ads. At first, it wasn’t the best experience because Internet enabled streaming video was mainly viewed on phones, tablets and computers.
That all changed when the dedicated streaming device for TV was introduced. The first generation AppleTV (2007), Roku (2008), Chromecast (2013) and FireTV (2014) all helped getting consumers access to on demand content to their televisions. Since all their respective launches, Roku has led the charge with its platform neutral approach and Roku enabled smart TVs.
The Roku OS is best in class and has evolved into a strong brand on its own with consumers. The user experience is arguably better than its competition (neutral platform, easy to use interface, ad supported content available). In addition to that advantage, Roku players and Roku enabled TVs are sold at much lower prices than their competition, driving adoption for the platform. The company’s gross margin in their player segment has declined from 18% in FY15 to 4% in FY19, something that was done with purpose. The company aims to grow its installed base with consumers and make high margin dollars through its platform segment.
The market for providing access to streaming content for cord cutters and cord nevers is competitive. Of the four largest streaming access providers Roku leads with 86 million expected devices by 2019 according to eMarketer. Amazon is in second place with 65 million and Google and Apple trail at 32 million and 25 million, respectively.
This has helped Roku accumulate over 39M Active Accounts on its platform as of F20Q1. Growing Active Accounts is at the core of Roku’s growth strategy. While it may seem like Roku isn’t making much money from users that use its Roku OS, the company actually makes $24 in ARPU over a twelve month period and that ARPU is growing over 27% annually. Roku makes money mostly through handling the payments for subscriptions that were originated on its platform, brand advertising on the home screen, purpose built buttons on the Roku remote controller, and targeted advertising campaigns for its ad supported video on demand (AVOD) content.
The other category of video consumption, linear content, hasn’t changed much. Consumers still access linear content from their service providers for a hefty monthly fee. While cord cutting is an accelerating trend, these companies still maintain a large subscriber base because of access to live sports and inertia.
Certain subscription video on demand (SVOD) providers have entered the linear TV game like YouTubeTV and Hulu + LiveTV. The model is better than traditional cable and satellite but the bundle is just as expensive ($64.99 and $54.99, for YouTube and Hulu, respectively). We’ve seen the improvements made in on demand content. We believe that there is an opportunity for a better linear TV experience and the Roku Channel is a start.
The Roku Channel was launched in September 2017 as another channel offered on the Roku platform and has grown to be a top 5 channel on the platform after its first year. The Roku Channel offers over 10,000 free TV episodes and movies and access to premium content like Showtime, EPIX, Starz, which consumers can easily sign up and pay for while inside the channel. But it also provides ad supported linear TV like ABC news and TMZ. The Roku Channel has an opportunity to become the platform for ad supported linear TV.
Why is it a good business?
Roku’s business model has two distinct competitive advantages. The first is scale economies within the player/TV OEM business. Customers buy the Roku players/Roku enabled TVs due to the ease of use and large number of channels available on the Roku OS. More device purchases lead to the company spreading its fixed costs over a larger base of units, leading to higher profit dollars. This allows the company to lower prices for the players and for the TV OEM licenses, which lead to further increases in volumes.
The second advantage is the 2-sided network effect between the Active Accounts and the advertisers that utilize the platform. While it isn’t a traditional market place where there is a buying and selling of goods and services, the network does get stronger with each incremental active account and advertiser added onto the platform. More Active Accounts lead to better aggregate data for advertisers, which brings more advertisers onto the platform. This leads to higher ARPU for Roku, which then can spend money on providing more AVOD content on their platform and invest to improve the consumer experience as well as the advertising engine.
Cord cutting is a big tailwind for Roku. More consumers around the world are opting out of linear TV and consuming on demand streaming content. It goes without saying that streaming provides a much better user experience for the consumer but also it’s much more affordable, for now. In the U.S., pay TV subscriber losses have accelerated since 2014/2015 especially with the growth in the volume of content offered by Netflix, Amazon, Hulu, Disney+, HBO and Showtime.
To take advantage of this tailwind, Roku has chosen to expand its base of Active Accounts as quickly as possible. Every consumer that becomes a Roku costumer is an Active Account that can generate high margin ARPU dollars for years to come. That’s why Roku has elected to operate its player business with a goal of achieving zero gross margin while investing to make it as easy as possible for content publishers to put their offerings on the Roku OS. Roku has developed an SDK that content providers can use to create channels on the Roku OS without writing any code.
Once Roku has the consumer on the Roku platform, the company establishes a direct relationship with that consumer. Roku becomes the TV home screen, handles billing services of content signed up for on the Roku platform and uses data to offer effective content recommendations.
The customer data that Roku collects allows the company to provide advertisers better targeting and outcomes for ad campaigns. Similar to how Google and Facebook are able to show better ROI on ad campaigns within search and social, Roku is able to show superior ROI within AVOD. A study from Kantar found that Roku data is 21% more accurate than IP address data (due to the direct relationship with the user) and there have been many examples of driving 50-60% more effective purchase intent than linear TV advertising.
Returns on capital?
The returns on capital for high growth, market share gainers are difficult to measure for many reasons. First, these companies are growing at a rapid rate and the numbers look messy. Some internal investments take many years to bear fruit, which can distort the annual return numbers. Furthermore, the best companies are continuously reinvesting capital in many different potential growth areas and the returns on these projects are volatile. Even with hindsight as a benefit, it’s still difficult to parse out specific return data from aggregate financial data for Amazon.
Second, many of these companies are not capital intensive businesses and growth is usually organically generated. Their moats were built up using R&D and their important assets are customer relationships, proprietary technology, brand awareness, etc. Roku is no different as it spends a measly amount on capex per year and has only made one meaningful acquisition to date (dataxu in 2019).
Roku’s annual investments come mostly in the form of R&D, which has been 3x-10x their annual capex spend. The difficult proposition as investors is to measure the returns on this R&D. Studies have shown that R&D spending doesn’t correlate to growth in revenues or value. Anyone can analyze the old guard of large cap tech companies like Cisco, Intel, Oracle and IBM and realize that their massive spend in R&D has only led to maintaining or declining market share.
A study by Srategyzer from 2019 shows that innovation is a much better indicator of revenue and value growth than R&D spend. The top 10 companies in innovation beat the top 10 in R&D spend over a 5 year period by a percentage difference of 12%-21% depending on the return metric used. Even the low R&D spend companies as a percentage of revenues have outpaced some of the high R&D spend companies over many years. But the issue is, how do you even measure innovation? It’s most likely more qualitative than quantitative. And the more important question is, how do you measure innovation prior to the outcome?
Another study by Deloitte from 2019 on the pharma industry shows that average R&D returns have steadily declined since 2010 from 10.1% to 1.8% in 2019. A lot of that return decline can be attributed to the slowdown in drug price increases since 2015 and competition from generics and biosimilars. But it also has to do with the pharma industry lacking major breakthroughs in drug formulations over the past decade, while spending record amounts on R&D. Again, more isn’t better.
For us, we can’t say that we are able to measure R&D returns better than anyone else, but we can try our best with our standard return on incremental capital calculation for Roku. Many innovative companies will fall through the cracks with this type of analysis. Netflix, for example, fails this return calculation massively but we would be wrong to conclude that their return on capital has been low. In fact, Netflix may prove out in the end that the billions of dollars spent on original content may be one of the best returning investments in media history.
Another issue that we point to is that the history of financials for Roku isn’t as long as we’d like. 5 years of data gives us a sense for the types of returns that the company is earning on its capital but the return numbers are volatile. Roku’s returns in the past two years have come down as its aggregate growth rates have decelerated, but that’s natural for a company reaching a certain scale. On a 2 year basis, the returns on incremental capital have dropped from the 90%s to almost 40%. The key question is what will returns look like in the next phase of growth for the company? Will AVOD growth on the Roku platform lead enable the company to maintain these high returns?
Reinvestment potential?
Reinvestment potential is high for Roku, even in its 18th year of existence. On the player side of the business, it’s still early days for Roku to grow its TV OEM market share. In the U.S., Roku enabled TVs have increased from 14% share in FY16 to 33% share in FY19. This has to do with the low cost for licensing the Roku OS and the added value that the TV OEMs can bring to their customers. Furthermore, Roku enabled TVs have much lower average price points that their competitors. TVs from the high-end OEMs like Samsung, LG and Sony have steadily lost market share to Roku because their proprietary operating systems are subpar to that of Roku.
Roku’s share internationally is much smaller and the growth potential is higher, with price being a more important factor in some emerging economies. A study from Bank of America’s Initiation Report from 2019 showed that Roku enabled TVs still only account for 20% of the global TV market, up from 18% 2 years prior.
On the platform side, the opportunity in AVOD is much larger than most people think. The linear TV advertising market hovers near $70 billion annually. While streaming accounts for 29% of TV viewing, according to Magna Global, it only captures 3% of the advertising dollars spent or over $2B. Other estimates point to a $5B annual AVOD market. Either way, it’s still early innings for this market.
We’ve seen this play out before in desktop and mobile Internet advertising. Consumer behavior shifts first and then the ad dollars follow in subsequent years. The ad dollars actually become more efficient as marketers move from traditional to online advertising due to the increase in accuracy of aggregate and individual user data available to the advertisers. We expect ad dollars from linear TV market shift to AVOD and total ad dollars actually to be lower at equilibrium.
While we don’t know what the final outcome will look like, cord cutting continues to accelerate. Cord cutter households have reached 17% of the U.S. population or 21.9 million households in 2019. According to eMarketer, this percentage should increase to 34.9 million households by 2023, or 27% of the U.S. population.
The Roku Channel is also a large reinvestment opportunity. Since its launch in 2017, the Roku Channel has outgrown the overall platform in the number of streaming hours and popularity. The ad load remains a half of linear TV for a better user experience while offering much better data for advertisers. Streaming hours continue to grow at a pace over 100% year over year.
The Roku Channel has a chance to become the aggregation platform for streaming content across paid and ad supported networks. There are, however, many roadblocks to this becoming a reality. The first is that the large content creators are trying to establish their own relationships with the end consumer. To do this they are better served by keeping all customers within their own streaming ecosystem. For example, AT&T is trying to remove HBO content from aggregation platforms such as the Roku Channel and Prime Video. They would rather have customers come directly to HBO Max. The issue is that customer growth may be slower if HBO Max isn’t available on an aggregation platform. According to Variety, Amazon has been reported to have 5 million HBO subscribers through Prime Video.
International is also a large opportunity for Roku. Using Netflix as a guide, International has the potential to become much larger than the U.S. When Netflix first launched in international markets with scale, critics were certain that ARPU would be low and/or subs would be difficult to acquire. However, international Netflix memberships surpassed domestic memberships in 2017 and never looked back, while maintaining ARPU that is only 30% below that of domestic. By 2019, Netflix international memberships reached 106 million while domestic memberships reached 61 million.
We estimate that Roku’s intrinsic value growth, while lumpy, can average above 20% for the medium term. We arrive at that estimate by assuming a 55% reinvestment rate and 35% return on capital for the medium term. Returns for certain projects are better than others and many projects won’t contribute to returns for many years, which will lead to volatility of incremental capital returns.
What else is important?
ARPU potential
Netflix, while an SVOD model, is the closest company we have to Roku’s potential growth in AVOD due to its pure play in streaming and the success Netflix has had internationally. The two companies exhibit many similarities in that the user experience is top notch, they both benefit from cord cutting tailwinds and their management teams are laser focused on achieving scale in each of their domains. Interestingly, both companies compete with Amazon and have been successful to date.
Using the Roku’s calculation for annual ARPU, Netflix’s domestic ARPU was $153 and international ARPU was $110 in 2019. That compares to Roku’s ARPU of $23 at the end of FY19, or 85% and 79% lower than that of Netflix. Even if we assume that Netflix never raises prices again, we don’t think that Roku ARPU will reach that of Netflix any time soon. Assuming a steady decelerating growth for both Active accounts and ARPU until 2023, we see Active accounts having the potential to reach almost 100 million and annual ARPU reaching almost $50. This would imply that Platform revenues reach $4.5 billion, which would imply 6.5% share of the global TV advertising market assuming that the $70B remains steady.
We also point out that ARPU growth for Roku will lag Active Account growth because ARPU depends on advertising dollar monetization and the gradual shift of advertising dollars from linear to AVOD. This will happen but only after AVOD viewership has grown and relevant data has been established. A subscription model on the other hand is very straight forward. Netflix charges $12.99/month for the Standard option in the U.S. Every incremental subscriber leads to a bump of $12.99/month, whether it’s this month or a year from now (assuming no price increases). However an AVOD model grows in value as both the number of users and the number of advertisers grow within the Roku ecosystem.
When it’s all said and done, Netflix’s ARPU has a much higher ceiling than that of Roku. Eventually, Netflix will go from growth mode to profit harvesting, which implies price increases are down the pike. It makes perfect sense if you think about it. Pay TV through a cable provider costs $40-$70/month in the U.S. while Netflix monthly ARPU is just over $13/month. While Netflix is just one “channel”, the amount spent on original content each year will prove to justify price increases.
Amazon as a threat
While Roku has done well, Amazon’s growth in SVOD and AVOD streaming has been impressive. Amazon has grown its platform business in a similar fashion to Roku by offering its FireTV sticks and players at a low cost, hoping to lock in the customer into the FireTV OS ecosystem and make money through its ancillary services like Prime Video. Furthermore, Amazon has been aggressively growing its premium subscription business through its Prime Video channel (similar to Roku Channel) and advertising through its IMDb Channel. Amazon’s other revenues have grown to $14B, most of which is advertising, in FY19.
Amazon also has a substantial lead in smart home devices with its Alexa home OS being able to control more than 100,000 devices in 2020. With the ease of use and ubiquity of the smart home speaker, Amazon has the potential to create a better user experience for the Smart TV. Similar to Netflix, Roku still has a good opportunity to compete against Amazon through singular focus and nimbleness. But we must not discount Amazon’s impact into Roku’s growth trajectory in the space. Amazon’s video offerings will enable them to become one of the largest players in AVOD, if the company can execute.
Optionality
As the business currently stands, Roku has many areas to reinvest its cash flows at high rates of return. We view the Roku Channel having the highest chance of upside optionality. While Roku isn’t in the best power position with content suppliers just yet, the Roku Channel has the potential to be a Trojan horse in AVOD and SVOD.
As it stands today, there is no application that can show consumers every bit of content that is available to them. Even though the Roku home screen makes it easy for consumers to switch between many different channels, it’s the consumer’s job to find out where they can watch certain shows. Is Breaking Bad available to watch on Netflix or is it Hulu? And maybe it differs depending on country or region.
The Roku Channel has the potential to become the one platform that consumers can use to access their favorite pieces of content. The company does need to convince premium content providers that this method is better economically than keeping the consumer within their own ecosystems. That’s a tall order, but with more Active Accounts that access the Roku Channel, power shifts from the content providers to the platform.
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