Why Roku Isn't Sweating Declining Device Revenue

Roku might be known for its streaming sticks and players, but it's clear in looking at the company's recently released financials that it's shifting away from a hardware-focused business model.

It sounds strange, but it might be the company's best shot at surviving the crowded streaming space and building a solid long-term business.

Hardware vs. software

Roku breaks its business down into two segments, player and platform revenue.

You can think of the player revenue as its hardware business, the sales of physical streaming devices like the Roku Express and Roku Premiere. In the first half of 2017, that segment made up 59% of the company's top line.

The rest of the Roku's revenue comes from the platform side of its business, which is fueled by what people do once they actually have their Roku device set up. The platform revenue is largely made up of advertisements that the service serves up and subscription share revenue from content providers that partner with Roku.

The times they are a changin'

Roku has historically been a hardware-driven company, but that's begun to change in the past few quarters.

In dollar terms, the company's device segment seems to be struggling -- player revenue was down 2% year-over-year for the first half of 2017 -- but it's important to understand the inputs and management's vision for the business.

The company has focused on the low-end of the streaming device market, aiming to get as many Rokus as possible into living rooms.

Short-term, that strategy is impacting the revenue contribution of the player segment -- recently the 37% increase in devices sold wasn't enough to offset the 29% decline in average selling prices -- but long-term the company hopes that the larger installed base will create an even bigger opportunity for the higher-margin platform segment.

Like most software businesses, Roku's platform segment enjoys lofty margins because it's an incredibly scalable system once it's been built out. The device world requires raw materials for every single product, so while fixed costs like machinery might scale, the gross margins will always been capped by inputs like components, wiring, and plastic that go into each unit.

As Roku's becomes increasingly platform-oriented, the company's overall margin should continue to trend up, meaning more of each dollar of revenue will flow down to the company's bottom line.

The long game

Beyond the bump to Roku's numbers, management's emphasis on the platform is important because it puts the company on track to remain relevant long-term. Recently, the market has seen several high flying consumer tech names go public, only to languish as the markets for their devices matured and other entrants came into their spaces.

Companies like Fitbit (NYSE: FIT) and GoPro (NASDAQ: GPRO) were hardware-first, then tried to create a compelling software business to add value for end users and keep their products sticky. In both cases the efforts to build out an ecosystem haven't really caught on, and the companies have been staring at struggling device sales.

Roku has a chance at escaping the same fate, for two reasons:

1. The platform approach aligns naturally with the "guide" experience consumers are accustomed to with their existing cable boxes, dramatically increasing the likelihood they'll actually use it.
2. Management made the platform business a priority pretty early on, beginning the early efforts years ago and making it central to how users interact with the actual hardware.

For as farsighted as management's been, the company still faces an uphill battle. They're a pure-play business in a space where pretty much every major tech company has a product -- so they'll be going up against larger R&D budgets and more robust ecosystems.

To compete in that environment, the company needs an offering that keeps current users happy and can win over new tech adopters, plus a business that creates enough cash to support innovation.

It's a tall order, but Roku's focus on its platform business puts them on the right path.

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Dylan Lewis has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Fitbit and GoPro. The Motley Fool has a disclosure policy.