Roku Is Too Pricey After 2 Quarters of Slowing Growth

Stock Market

If you are a contrarian investor, you may believe that Roku, Inc. (NASDAQ: ROKU) has underperformed the broader market in 2021  and is now an investment opportunity. In 2021, ROKU stock is down nearly 6% compared to gains of about 18% for the S&P 500.

ROKU Stock Will Continue Benefitting From the TCL Partnership

Source: Michael Vi / Shutterstock.com

Being a contrarian investor has a lot of merits. If you are on the right side and the market agrees with you, then a stellar profit could occur. The “buy low and sell high” philosophy is undoubtedly a classic.

But if you are not correct about the timing and fundamentals, and the majority of investors do not share your optimistic and bold opinion, then you might face considerable losses.

Trends in the stock market change easily and quickly. ROKU stock is facing several important challenges, and I don’t believe it is a strong contrarian play. Let me elaborate on my arguments.

ROKU Stock in the News

Ηow does Roku generate revenue? The business model relies on digital advertising, the sale of its streaming players and content distribution.

Roku has expanded its operations outside the U.S. this year. In June, it announced that TCL Electronics would launch TVs with Roku capabilities in the U.K.

Roku’s VP International Arthur van Rest said, “TCL was one of the first TV brands to embrace the Roku OS and together we have created numerous award-winning TVs with great picture quality and ease of use.”

Now, Roku is expanding into another large European market. According to Reuters, the company is planning to “launch its streaming players in Germany later this year, its second big European rollout, seeking to capitalize on a pandemic-driven shift towards watching more video on demand.”

While the European market development is positive, there is also some negative news for Roku — and it has to do with competition in the U.S. market.

Amazon (NASDAQ:AMZN) will sell a line of connected TVs to gain a larger share in this quickly-growing market. This puts it in direct competition with Roku and Alphabet Inc.’s (NASDAQ:GOOGL, NASDAQ:GOOG) Google.

The in-home entertainment market is already tough, making this is bad news for Roku. A “pricing war” could harm its profit margins and require extra capital investments.

Roku’s Latest Results Are Concerning

In its second-quarter earnings report and letter to its shareholders, the company mentioned it was pleased with its financial performance. “Roku delivered a strong second quarter, with record revenue growth that was driven by exceptional performance in platform monetization,” the letter read.

Net revenue rose 81% year-over-year (YOY) to $645 million and platform revenue grew 117% since last year to $532 million. Gross profit was $338 million, a YOY increase of 130%. Finally, average revenue per user (ARPU) rose 46% YOY to $36.46 on a trailing 12-month (TTM) basis.

Still, several other key metrics revealed an alarming trend. First, active accounts only increased by 2.8% to 55.1 million.  By contrast, active users grew by 4.7% in Q1 2021 and 11.3% in Q4 2020. Roku has seen two consecutive quarters of declining growth in active users.

Streaming hours also fell for Q2 2021, reaching only 17.4 billion hours compared to 18.3 billion hours in Q1 2021. And although total net revenue in Q2 2021 increased, the total gross margin fell to 52.4% compared to 56.9% for Q1 2021.

At the same time, total operating expenses increased and income from operations fell to $69.1 million from $75.8 million in Q1 2021.

None of these are positive factors for profitability.

On top of that, Roku predicts total gross profit for Q3 2021 of $315 million to $325 million, which is lower than the total gross profit of $338.3 million reported in Q2 2021.

The predicted total net revenue of $675 million to $685 million is also showing a slowdown in growth. The upper range, if achieved, would indicate quarterly growth of 6.2% in Q3 2021 compared 12.3% in Q2 2021. Q1 2021 quarterly revenue growth was also a loss of 11.6%.

Covid Might Not Be Roku’s Advantage Now

The surge in revenue and active users as well as the subsequent slowdown were both likely caused by the pandemic. While Covid-19 certainly had a positive impact on Roku’s growth, that may change as the virus is mitigated.

Roku published an annual survey that detailed its beliefs about the future of streaming:

“The survey found that, over the last year, the shift to TV streaming was accelerated by the pandemic with more content — including live programming and new movie releases — moving to TV streaming. The ease-of-use, cost-savings, and content quality of TV streaming was shown to have extremely broad, intergenerational appeal among American consumers.”

Roku CEO Anthony Wood said, “These results show that TV streaming has passed a tipping point.” But only time will tell if that is true.

The decline in active users, streaming hours and revenue growth are worrisome and should be monitored over the next quarters. If Roku is right about its annual survey, we should anticipate a sustainable increase in these key metrics.

ROKU Stock Is Overpriced

Roku has a return on investment capital (ROIC) trend that shows it hasn’t created value for quite some time. As of 2015, Roku has had a negative ROIC. In 2020, this number was -2.72%. According to Investopedia, “A company is thought to be creating value if its ROIC exceeds 2% and destroying value if it is less than 2%.”

Comparing some key financial ratios of ROKU stock with those of S&P 500, you can see how overvalued Roku is. For example, Morningstar reports the price-to-book ratio of Roku is 16.8x compared to 4.5x for S&P 500.

Additionally, the price-to-sales ratio of Roku is 18.6x compared to a figure of 3.2x for S&P 500. And the forward price-to-earnings ratio estimate for Roku is 196.1x compared to a figure of 22.2x for the S&P 500.

I am not impressed by Roku’s revenue growth over the past few years. This strong trend is not making money for the company, and that is concerning. Also, I see a rising trend in outstanding shares, which I expect to continue and cause a stock dilution.

Roku has a business model that is problematic to me, and therefore I cannot get excited about ROKU stock.

On the date of publication, Stavros Georgiadis, CFA  did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Stavros Georgiadis is a CFA charter holder, an Equity Research Analyst, and an Economist. He focuses on U.S. stocks and has his own stock market blog at thestockmarketontheinternet.com/. He has written in the past various articles for other publications and can be reached on Twitter and on LinkedIn

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