It’s spending on growth, but that’s not working like it once was.
Shares of streaming-TV platform company Roku ( ROKU -5.56%) are down more than 80% from their all-time high. The stock continued its downward slide after the company reported second-quarter financial results on July 28. For the record, Q2 resulted in a whopping $110.5 million loss from operations.
Growth investors often dismiss operating losses, assuming the company is investing for growth. That’s true of Roku. However, there’s one detail in this operating loss that bears pointing out. And it’s not good. But first, here’s Roku’s tiny hardware headwind
For context, Roku generated Q2 revenue of $764 million, up 18% year over year. However, two primary factors robbed the company of a better bottom line. First, its gross margin fell. And second, its spending increased.
To the point on gross margin, Roku has two primary ways of generating revenue. It displays ads when people stream video content on its platform. However, it also sells hardware devices for streaming. And in this hardware revenue segment, Roku’s gross margin has absolutely plummeted.
Hardware revenue was always low-margin for Roku. But over the past five quarters, the company’s hardware gross margin was actually negative. That’s right — it costs more to make these devices than what it earns from selling them. In Q2, its gross margin for this segment was its second-worst ever, coming in at negative 24.1%.
On one hand, this is a good strategy for Roku. Long-term, the goal is to generate higher-margin ad revenue. For this, the company needs more people using the platform. Therefore, incentivizing platform adoption by lowering hardware prices makes sense. On the other hand, the negative-margin strategy needs to actually result in user growth. For Roku, active accounts in Q2 grew to 63.1 million, up 14% year over year.
Some might complain that this growth is too slow. But keep in mind that people aren’t spending on TVs right now in general — it’s not a Roku problem. For example, in Target ‘s conference call to discuss first-quarter financial results, management specifically said it had excess inventory in TVs, leading to price cuts.
Roku’s negative gross margin hardware business is a problem for current profitability. However, it’s tolerable because of ongoing platform adoption. The bigger problem with Roku’s hefty Q2 loss
As mentioned, growth companies like Roku tend to spend on growth. And that’s acceptable, provided there is indeed growth. But Roku’s spending might be wading into dangerous waters.
In Q2, Roku spent a whopping $185 million on sales and marketing. This was a 97% year-over-year increase and the biggest jump among its operating expenses. In other words, spending is skyrocketing with increasingly little to show for it. Consider this trend over the last six quarters.
Data source: Roku’s letters to shareholders. Chart by author.
Roku is spending more than ever to grow its business, but its return on investment is plummeting. This is a small detail that few investors have noticed.
In my opinion, there’s a difference between Roku’s hardware losses and its sales-and-marketing expenses. Marketing spend has only recently increased exponentially. However, there doesn’t appear to be any positive correlation with its spending and the growth it’s getting. That’s the problem. What to do with Roku stock
This little detail could be interpreted to mean that Roku is reaching a saturation point. It’s spent over $330 million on sales and marketing so far this year and has added a meager 3 million active accounts. That hardly feels sustainable.
This acknowledged, I’m reluctant to believe that 63 million active accounts is the ceiling for Roku, because I believe that everyone will stream video content in the future. Roku shared data from eMarketer which projects that legacy-TV subscribers are expected to dip below 50% for the first time next year.
Roku estimates that just 22% of TV ad budgets are spent on streaming. Once less than half of households use traditional TV subscription services, it could be a watershed moment. Logically, ad dollars will flow toward streaming like never before. And media companies will be forced to increase their streaming budgets and decrease their cable budgets in order to follow the money.
This puts Roku squarely on the right side of an important trend. I see no reason to sell the stock based on its $111 million loss from operations in Q2. Out-of-control spending can destroy shareholder value over time, and I wish management was spending more opportunistically. It’s a risk to be aware of for sure. But this criticism aside, Roku is still in a strong […]
source Roku’s $111 Million Loss: The Small Detail Only Smart Investors Saw
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