Roku (NASDAQ:ROKU), the market-leading TV operating system provider in the U.S., has seen its stock rise by a staggering 163% this year, aided by the improving sentiment toward tech stocks. The company seems well-positioned for profitable long-term growth. Still, investors will have to be wary of Roku’s valuation, which seems to accurately reflect the company’s growth potential. I am neutral on Roku stock based on valuation concerns, but I believe it’s an attractive bet for long-term investors at the right price.
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Roku’s Ad Business Will be a Growth Driver
Many streaming companies, including market leaders such as Netflix (NASDAQ:NFLX), are shifting toward an ad-based streaming future today. Roku embraced ad-supported streaming many years ago, but investors and analysts were reluctant to believe in the sustainability of this business model, given that streaming market leaders followed a contrasting strategy with a focus on selling paid subscriptions.
With streaming market dynamics trending in favor of ad-supported streaming today, Roku will be able to compete with market leaders on a more level playing field. This is a positive development for Roku and its shareholders.
The global advertising market is coming back to life after a period of lackluster growth on the back of high interest rates and inflation, and Roku is poised to benefit from this expected recovery of ad spending. The World Advertising Research Center projects global ad spending to grow 4.4% this year, followed by a more robust 8.2% in 2024 as recession fears subside, coinciding with a potential rate cut by the Federal Reserve to boost economic growth.
The long-term appeal of Roku stems from the expectation that the cord-cutting movement will eventually shift nearly all TV advertising spending to streaming platforms. This is a realistic expectation, as ad dollars will eventually follow viewers. According to data from Statista, U.S. pay TV penetration has fallen from a high of 88% in 2010 to 64% in 2023, which highlights the impact of the cord-cutting movement.
In 2023, U.S. TV ad spending is expected to hit $66.3 billion, making up almost 18% of total media ad spending. Video streaming companies will eventually eat into this $60 billion market, and Roku, as a well-established streaming company with 76 million active accounts as of Q3, is well-positioned to capture a meaningful share of this market.
Roku’s International Expansion Efforts
Roku is expanding internationally, and the favorable outlook for ad-supported streaming positions the company well to penetrate populous, developing regions of the world such as South Asia and Latin America. According to company filings, Roku reaches approximately half of the total U.S. broadband customers today, but the company is still at an infant stage in key global markets. Encouragingly, Roku is making solid progress in penetrating key markets.
In the third quarter, Roku TV OS emerged as the best-selling TV OS in Mexico, a strategically important market with a long runway for growth amid the rise of a middle-income society. In Mexico, Roku has partnered with Phillips and Sharp to design new Roku TV models, which is a step in the right direction to grow Roku TV sales in the coming years. The company recently formed a partnership with Caixun to drive Roku TV sales in Chile, another fast-growing streaming market.
Roku’s expansion plans in Europe are gaining traction, with the company now partnering with JVC, Polaroid, and Sharp to design Roku TV models in the United Kingdom.
A Scalable Strategy That Promotes Earnings Growth
For a business to earn economic profits over a long period, a scalable strategy is a must. The first component of Roku’s strategy is to attract new users with its flagship Roku Channel, Roku streaming players, the all-new Roku Smart TV, and other TVs that run Roku OS.
The second step is to increase engagement by offering both free and premium content on the Roku Channel and providing a seamless experience to Roku OS customers to stream thousands of free and premium channels and streaming services. The third step is monetization.
In the U.S., the company has already become the number one TV OS and has achieved a similar feat in Mexico as well. This is a clear indication of the scalability of Roku’s business strategy, which bodes well for the company at a time when it is looking for global expansion. During the third quarter, Roku turned free cash flow positive, which gives a strong platform for the company to aggressively expand internationally.
Is Roku a Buy, According to Wall Street Analysts?
On November 27, Cannonball Research upgraded Roku to a Buy rating on the basis that the company will benefit from the improving market trends in the advertising sector. The firm’s updated price target of $116 suggests Roku stock still has upside from the current market price.
A couple of weeks ago, DA Davidson claimed that Roku is an attractive takeover target due to its leading position as a smart TV OS provider. According to the investment firm, such a deal could value the company at $13.7 billion. Since then, Roku stock has accumulated more gains, valuing the company at just over $14.6 billion today.
Overall, ROKU stock comes in as a Moderate Buy based on 10 Buys, 13 Holds, and two Sells assigned in the past three months. The average ROKU stock price target is $86.52, which implies downside risk of 18.95%.
Although Roku is proving to be a wonderful business, its valuation seems to accurately reflect the growth opportunities that lie ahead of the company. Investors may have to wait for a better opportunity to invest in the company when the risk-reward profile tilts the odds in favor of long-term investors.
The Takeaway
Roku has a long runway to grow. The company’s foray into smart TV manufacturing will be a revenue driver, and its focus on monetizing platform users will help the company grow sustainably in the foreseeable future. However, its growth is likely priced in at the moment, proven by the average price target for the stock implying downside potential. Investing in Roku at a lower, reasonable valuation is likely to help investors unlock alpha returns in the long term.
