Roku's Transition Is Paying Off in a Big Way

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The transition from hardware developer to platform provider is not as easy as Roku (NASDAQ: ROKU) is making it look. The content aggregator and maker of streaming TV set-top boxes turned in another quarterly earnings report that looked effortless, and Roku is so confident in its ability to continue doing so, it hardly bothers trying to make a profit from the device side of its business anymore.

Other tech companies -- like GoPro and Snap -- that have attempted the same maneuver and stumbled hard can only look on in envy. TiVo said it would stop selling hardware altogether last year.

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Padding its lead

Roku hinted back in January that its fourth-quarter earnings were going to come in strong, and the end result didn't disappoint. While device sales jumped 21% from the year-ago period, platform revenue surged 77%. And Roku now expects it will cross $1 billion in revenue this year, with two-thirds of it coming from the platform side of the business.

It ended 2018 with over 27 million active accounts, having added 8 million last year alone, which led to the number of streaming hours rising 9.2 billion year over year to 24 billion.

Roku has a powerful business model that offers plenty of room for further growth. Smart TVs are starting to adopt operating systems much the way smartphones did, and Roku has an advantage because unlike other players that are trying to retrofit their systems to work with televisions, Roku's OS was purpose-built for them.

A platform to grow on

TV advertising is a huge opportunity, estimated by some to be as much as $70 billion. The revenue that Roku earns from its platform business is primarily advertising, so the greater the number of people watching, the greater its reach, and the more lucrative its ad market.

And it can capture a growing portion of the ad pie because its advertiser-supported Roku Channel -- which complements the advertiser-friendly technology built into its OS -- has quickly become one of the top channels on Roku devices, based on hours streamed. Because Roku owns and operates the channel, it allows the company to control both the ads and presentation of content to best effect while monetizing a growing proportion of its ad inventory.

One of the benefits of that control is that Roku demands the right to sell 30% of partners' ad inventory if their shows are available on Roku devices, meaning it is making extra money off of its partners' content. The partners don't mind, either, because of the effectiveness of showing ads to Roku viewers. A large percentage of the important 18-to-34-year-old demographic can only be reached through the Roku Channel, according to Nielsen data.

Just getting started

Even though Netflix has been around for over 20 years, streaming TV is still in its early days of growth. And smart TVs, while assuming a larger proportion of the sets in homes, still have a long way to go before they're the predominant device for watching video. eMarketer estimates just over 37% of U.S. households had a smart TV in 2018, and while that's up about 17% from the prior year, it means there's still a great divide to narrow before smart TVs are in half of all households.

And Roku is leading the way. Some 35% of connected TV owners use a Roku device to access programming, which makes it the most popular brand among streaming devices, even ahead of Amazon.com (NASDAQ: AMZN).

That's led Roku to adopt something of a razor-and-blade model with its devices, virtually giving them away to lure consumers in. Fourth-quarter gross margins on players were just 2.4%, a 75% decline from the year-ago period. Margins for its platform business, on the other hand, stand at around 75%.

Going for global domination

What could have been a risky strategy for Roku -- giving up the security of device sales to instead focus on the platform side of its business -- turned out to be the foresight to see that profitability would be difficult to maintain by remaining just a device maker. Now it is paying off in a big way, even though Roku's competitors are larger, more established -- and in some cases better financed.

Having successfully made the leap, it looks poised to capture even more market share, and that's before it even looks at international markets. Roku is currently available in 20 countries and is looking to increase its presence in new markets. The opportunity will really pay off as it begins adding local content to attract international viewers.

Shares of Roku have surged 160% above the lows they hit in December, but they look like they can stream higher still.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Rich Duprey has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon and Netflix. The Motley Fool recommends GoPro. The Motley Fool has a disclosure policy.