Roku (NASDAQ: ROKU) was the top tech IPO of 2017, soaring 270% from its IPO price of $14 in September to nearly $52 at the end of the year. But 2018 has been tougher: the stock tumbled more than 10% during the first trading week of the year.
Continue Reading Below
At first glance, Roku's growth figures look great. Its revenue rose 25% in fiscal 2016, then grew another 29% in the first nine months of 2017. The midpoint of its fourth-quarter guidance implies that its full-year revenues will rise 27%.
But take a closer look at Roku's business and you'll notice that it has quite a few flaws. Let's take a look at the three most glaring ones, and why they indicate that investors should take some profits at these levels.
1. Its lack of profitability
Roku's revenue growth is impressive, but it's still deeply unprofitable. It reported a net loss of $70.5 million during the first nine months of 2017, compared to a loss of $46 million a year ago.
However, its $46.2 million loss during the third quarter was mostly caused by a $37.7 million charge from an increase in its preferred stock warrant liability. If we exclude that charge, Roku's net loss narrowed year-over-year. Roku posted an adjusted EBITDA of negative $17.7 million during the first nine months of the year, compared to negative $36.5 million a year earlier.
Continue Reading Below
Those improvements are encouraging, but Roku's operating expenses still rose 26% annually during the first nine months. Those expenses will likely keep rising over the next few quarters as the company pivots and invests more heavily in its higher-growth Platform business.
2. Its valuation
Since Roku is unprofitable, we need to value its stock with its price-to-sales ratio. Its current P/S ratio of 10 is much higher than the average P/S ratio of 2 for pay TV providers.
The bulls may argue that Roku shouldn't be valued like a traditional pay TV company, and should be compared to high-growth streaming players like Netflix (NASDAQ: NFLX) instead. Yet Netflix, which is expected to post 32% sales growth this year, trades at just 8 times sales.
Therefore, Roku was a compelling buy at its IPO price, but the stock now has much too much growth baked into its price.
3. A tough balancing act
Roku generates revenue from two main businesses: its Player unit, which includes its set-top boxes and dongles, and its Platform unit, which includes the software it runs on its own hardware and third-party smart TVs.
Roku is the top streaming device maker in the US according to research firm Parks Associates. It controlled 37% of that market at the beginning of 2017, putting it ahead of Amazon's Fire TV (24%), Alphabet's (NASDAQ: GOOG) (NASDAQ: GOOGL) Google Chromecast (18%), and Apple (NASDAQ: AAPL) TV (15%).
However, the competition is heating up as all three tech giants launch newer devices and expand their streaming media ecosystems.
Amazon is tethering users to its Prime ecosystem, Google is strengthening the ties between Android devices and Chromecast dongles, and Apple is using its box as a launchpad for original content.
Last quarter Roku's Player revenue rose 4% annually and 25% sequentially, and accounted for 54% of its top line. Its Platform revenues rose 137% annually and 25% sequentially. The newer Platform business mainly generates revenue from advertising and content partnerships, and relies on its app -- which can be installed on other devices and smart TVs -- instead of first-party devices.
The bulls believe that Roku's platform revenues will keep climbing and offset the stalled growth of its players. However, the Platform business' sequential sales growth merely matches the Player business' sequential growth -- indicating that it isn't a silver bullet for all of Roku's long-term problems.
The key takeaways
There's still a lot to like about Roku. Its active accounts rose 48% annually to 16.7 million last quarter, its streaming hours jumped 58% to 3.8 billion, and its average revenue per user (ARPU) grew 37%. Its gross margin also hit 40%, up from 29% a year earlier.
However, Roku's lack of profits makes it a risky play in a frothy market, its valuation is too high, it faces stiff competition, and the growth of its Platform business might not offset its gradual declines in Player revenues. Therefore, I'd either sell or avoid Roku at these levels, but I'm willing to revisit the stock at lower prices.
10 stocks we like better than Roku, Inc
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*
David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Roku, Inc wasn't one of them! That's right -- they think these 10 stocks are even better buys.
Click here to learn about these picks!
*Stock Advisor returns as of January 2, 2018
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Leo Sun has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Apple, and Netflix. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.