Bull vs. Bear: Roku

In this podcast, Motley Fool senior analyst Bill Mann discusses:

• Alphabet being a strong business, despite recent downturns.
• Spinning off YouTube being an idea that doesn't make sense.
• Visa wrapping up the fiscal year in strong fashion.
• Visa CEO Al Kelly being among those who do not expect a recession in 2023.

Shares of Roku have fallen more than 75% year to date. Motley Fool contributors Ryan Henderson and Jose Najarro engage in a bull vs. bear debate over the digital media player company.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Oct. 26, 2022.

Chris Hill: We've got Alphabet and Visa going in opposite directions and we've got a bull versus bear debate over Roku. Motley Fool Money starts now. I'm Chris Hill joining me today, Motley Fool Senior Analyst, Bill Mann. Thanks for being here.

Bill Mann: We've been banished to another part of the office.

Chris Hill: I like to think we haven't been banished we chose this of our own accord. Let's start with Alphabet because it is really the dominant story in the market today, third-quarter profits in revenue were lower-than-expected. The only silver lining appears to be Google Cloud, but Search, YouTube, everything else came in lower, and shares of Alphabet down seven percent this morning.

Bill Mann: Which doesn't sound like all that much. But just to put things into perspective, that's something on the order of $20 billion, just poof. I'll be honest, Chris, it wasn't a terrible quarter from Google, I think because we think of this company as being the best business model ever created that we sometimes give it credit for somehow having sorted out business cycles. This is the first quarter that they have ever had in which they're advertising revenues dropped a little bit. They missed badly on the bottom line, they hired 13,000 new employees, which you have to wonder what those 13,000 employees were doing. But the numbers from Google, they just seem like a cheat code, $69 billion in revenues for the quarter.

Chris Hill: Thank you for reminding everyone of that because there is a tendency because of the size of the company, because of its importance, there is a tendency on days like this to overreact a little bit. This is not a business in trouble. There are questions about this business and you pointed to one of them, which is for all the talk that Pichai has been doing about headcount and he has been doing a lot of it, even with this most recent quarter talking about how they are slowing the rate of hiring, they're still hiring, they're still adding and I think there are questions that really go to what you put your finger on there in terms of what are all these people doing? Also, this was another quarter. I don't know what the answer is with YouTube and when I say that, what I mean is, for a long time there have been people who have been saying they should spin it off and there are other people making arguments, "No, they need to keep it in-house and here's why." I don't know what the answer is. I do know that this was one of those quarters that gave some ammunition to the people arguing that YouTube needs to be spun off.

Bill Mann: I actually think that that argument is crazy. I think that Google, I can't call it Alphabet, I'm sorry, I know they want us to call it Alphabet, I don't know what would be solved by spinning it out other than Google, which is already a cash flow machine, would monetize YouTube just a little bit. Google's issue is not that they're having any trouble at all generating cash flow. Now, I look at where they were this quarter versus the same quarter last year an unbelievable deceleration in revenue growth from 41 percent to six percent and it doesn't look like they have cost control and I think at least partially that is the huge number of employees who are coming in. Now, I think that you have to give every company even really big ones a little bit of grace when there is a shift in external factors. They can't turn on a dime, so perhaps they were hiring for a 41 percent world and they got a six percent world. But it absolutely is something that they can, they should, and they will get to the bottom of. I don't know that going to financial solutions like spinning off YouTube makes any sense any more than just lock it down and figure out who needs to do what and what is profitable, what has potential, and then everything else ought not be done.

Chris Hill: If you are looking for a bullish sign with this business, I think you can point to the fact that Ruth Porat is still the CFO and they continue to buy back stock.

Bill Mann: Yeah. They do continue to buyback stock. Now, I don't give Google, Alphabet full credit for buying back stock because they do put out plenty of incentive stock options for employees. We as shareholders, don't get full value for it, but we don't get none. In a world where they are generating as much cash as they do, they do have to do something with it. I would prefer a dividend. I think that Ruth Porat will get to the bottom of what's going on with Google. They did not become incompetent all of the sudden and there are parts of their business that are still growing like wildfire in a very profitable way.

Chris Hill: Visa, on the other hand, wrapped up its fiscal year in style, fourth-quarter profits in revenue came in higher than expected. Their payment volume was up, they hiked their dividend, they green led a $12 billion share buyback plan, and unlike Alphabet shares of Visa up six percent today.

Bill Mann: Visa hasn't gotten the memo that we're supposed to be going into a recession. Do they not read the papers?

Chris Hill: Not only have they not gotten that memo, but CEO Al Kelly said when they were doing they're planning for 2023, they didn't factor in a recession. They basically said, "We're not expecting it and we're not planning for it."

Bill Mann: You know Chris when you think about a company like Visa and I think about this a lot and people have asked us what types of companies are inflation-resistant, Visa and MasterCard may be as inflation resistant as any company that I know of. Because they have something that's called a take rate and it's about eight basis points on the size of a transaction. The transaction size is what matters to Visa. If there is inflation, they are generating a larger cash return on the transaction than they would have a year ago, simply because that same transaction is slightly more expensive. Yeah, I could see Visa not being particularly sensitive to an inflationary environment. Now, this is not to argue that they are completely resistant to it because if there is inflation and if there is recession then transaction volume is going to drop. But this is a company that is still the circulatory system of global commerce.

Chris Hill: Zooming out from Visa, now we can put Visa in the camp of big important companies that are saying, "No, we're not seeing a recession." There is another side where there are big important companies and their executives who are talking about, "No, we are seeing it, we are planning for it," but what's an investor to do in these situations? Because that was my first thought when I saw the comments from Al Kelly, I thought, "Well, OK. I guess we can put Visa on that side of the ledger of companies saying, "No, there's not going to be a recession. We're not planning for it." These are serious people, Bill. 

Bill Mann: Unlike us. 

Chris Hill: Well, I mean, you and I were talking earlier this morning and I said, "Look, you can always find people who are willing to go on financial television every three weeks and say the sky is falling."

Bill Mann: Yes.

Chris Hill: You can always find people who are just permeable, everything is great all the time no matter what.

Bill Mann: Jamie Dimon is not one of those people.

Chris Hill: He is not one of those people, Al Kelly is not one of those people.

Bill Mann: Absolutely.

Chris Hill: As you think through the question of, "Are we in a recession? Are we going to be in one?" What do the comments from Al Kelly do to your thinking?

Bill Mann: This may seem like the dumbest thing that you've heard today and we hang out a lot so that probably is saying something. But do we have to have an opinion on this? I don't really know that the average investor or the average American if you will, is particularly good at predicting recessions or predicting gross cycles and if Al Kelly and Jamie Dimon are on opposite ends of the spectrum here, then what chance do we have? When you're making investing decisions, I really actually do think that the best way to go about it is not particularly worry about whether we're going into a recessionary environment, an inflationary environment, and simply assume that if it happens like every other recession, we will come out on the other side.

Chris Hill: Bill Mann, always great talking to you. Thanks for being here.

Bill Mann: Thanks, Chris.

Chris Hill: When you're not listening to this podcast, chances are you spend at least part of your week watching streaming video, and if you're like a lot of people, you're streaming your favorite shows through a Roku device. Ricky Mulvey has a bull versus bear debate on the digital media player business currently facing a tough advertising landscape. 

Ricky Mulvey: Welcome to Bear versus Bull, we find a company gets some analysts flip a coin to see which side they'll take today the company is Roku, they sell digital media players for streaming, it's also an advertising business, it's also apparently a smart home camera business, but struggling down 80 percent this year. On the bull side, we have Ryan Henderson, Ryan, good to see you.

Ryan Henderson: Good to see you too, Ricky, I'm looking forward to this.

Ricky Mulvey: Likewise and taking the bear case is Jose Najarro, Jose, thanks for joining us today.

Jose Najarro: Thank you for having me Ricky, I'm super excited for today's episode.

Ricky Mulvey: That is enough setup, let's get it started, Ryan you've got the bull case a five minutes is yours.

Ryan Henderson: The Roku bull thesis essentially rests on its position in the CTV space, which is a really promising industry, they've got a lot of tailwinds behind them and it seems, especially in the US and Canada and North America broadly, more and more people continue to switch to streaming and I believe right now, it just crossed 50 percent in the US. The trend is quite clear that it's probably on a go toward 100 percent over time and Roku is the leading connected TV platform in the US and Canada and by quite a wide margin, I think they're seeing great adoption in Mexico as well, but the US and Canada and make up the majority of their active accounts. Over the last decade, everyone seems to be especially in North America, as I mentioned, shifting away from linear TVs to streaming and Roku has really captured the audience, so since the third quarter of 2016, Roku's total number of active accounts has gone from 11.3 million to 63.1 million. Additionally, Roku has seen an increase in usage among those accounts, so I believe five years ago, roughly, they were streaming about two-and-a-half hours a day, the average account today it's about three-and-a-half, so about an hour or more a day than five years ago. You've got a combination thereof of increasing number of users and then increased engagement and they've also shown an ability to better monetize those users as well, so Roku's average revenue per user is up 4X from what it was in Q3 of 2016.

Between the growing user base, the increased engagement, and their improved ability to monetize the users Roku's platform revenue, which now comprises the majority of its top-line, has increased nearly 20X in the last five years, so clearly, it's been, they have been right there to benefit from this trend. However, they haven't quite seen the operating leverage that or inflection and profitability that most investors probably would have expected because the cost increases that they've seen on the hardware side. As a lot of people know, they're basically selling their players at a loss, they are selling them at a loss and negative gross margins because they believe the lifetime value of those users is going to exceed the losses on that initial sale of the hardware and I think they're right and ultimately, what Roku's returns, I believe we are going to come down to is not only how the industry evolves, but how much money gets poured into streaming and it's clear that companies are pouring more and more of their investment dollars.

A lot of these content companies into the streaming world, Netflix even highlighted this on their last quarter release, they said, our competitors are investing heavily to drive subscribers and engagement that building a large successful streaming business hard, we estimate that they're all losing money with combined 2022 operating losses, well over 10 billion versus Netflix is 5-6 billion annual operating profit. This isn't meant to be a Netflix pitch, but as that money gets invested into content for streaming, Roku benefits and a ton of ways, so first off, and this one is probably pretty obvious, the more content that's available to consumers, the more time they'll likely spend on the platform, that means more room for ads, more time for Roku to monetize those users. Secondly, the two leading services in terms of streaming market share or Netflix and YouTube, for what I understand, Roku's original contracts with Netflix and YouTube don't really generate that much revenue because Netflix and YouTube had all the negotiating leverage, you needed them on the platform and so they generate a negligible amount of revenue from there to leading streaming services.

However, as the industry gets more competitive and more content comes out from the players of like HBO, Paramount, other providers, other suppliers of content, the negotiating power for Netflix and YouTube gets muted and Roku can finally get better contracts with those, I think you're probably going to see that when the Netflix rolls out its ad-supported channel. The other two I mentioned, advertisers are slow to switch right now, I believe at the end of last year, 45 percent of adults in the US ages 18-49 were choosing streaming, only 18 percent of advertisers, TV ad budgets were on streaming, so there is a disconnect there I believe advertisers will switch over time. The last one, Roku makes money when someone subscribes to a service through their platform, as things get more competitive, I see churn increasing and people will end and restart their subscription more often as there's more alternatives and so, they'll be likely generating greater referral revenue from that. Right now, to boil it down, Roku generates about three billion dollars in annual revenue, at their peak, they were generated about 17 percent EBITDA margins. If they can get back to those levels, and I think they can, they'll be generating about $500 million in annual EBITDA and that assumes no growth from today. Really they don't have to do anything to grow, there's going to be some natural adoption just because everyone's shifting to streaming, so that's real conservative, their current enterprise value is 5.6 billion, so if you think they can get 500 million in annual EBITDA, you're paying roughly 11 times theoretical profits, I think that's a really fair price to pay for what seems to be this perfect blend between hardware and software and the world where a lot of people are shifting to.

Ricky Mulvey: Ryan Henderson, thank you for the bull case, up next we have Jose Najarro with the bear case.

Jose Najarro: Thank you Ricky, I do want to say for the bear case is the first thing is the company's trying to hit numerous markets at once the hardware, the platform, and the original contents and all these markets have numerous headwinds affecting the company right now. For a growing company like Roku, it can cause much stress to management, which can lead to long-term mistakes, especially if management focuses too much on short-term shareholder policing moves, for example, if we take a closer look at the share, at the original content, this takes time to build and it's not something that's going to provide results, it might actually just flop and it's also very expensive to do. On the platform side, at the moment, there are numerous headwinds in the advertisement side that we're seeing globally that can obviously impact the overall numbers for Roku on the revenue side. Finally, the hardware side is prone to inflation, cost of goods increase and also consumer spending is in question right now, which would cause a decrease in adoption of connected TV.

The hardware market is also one with very low margin, and the company continues to double down with recent addition to things like soundbars and other audio solutions. Same with the international market growth is heavily dependent on connected TVs, but Network Infrastructure might not be set up properly in certain international countries or the consumer demand is not there. Outside of that, the company is seeing a huge balloon in expenses, for example, sales and marketing increased 97 percent year-over-year in the most recent quarter, research and development also increased 74 percent year-over-year and have caused income loss from operations in the last two quarters. The final thing I do want to mention is even though we are seeing a back-to-trend into streaming, streaming hours are decreasing sequentially and the most recent quarter was one of the first few quarters the company saw a decrease in streaming hours and this is something investors should keep an eye on. Like I mentioned, even though some might say that hey, hitting all these markets at once might be a very bullish case, I think sometimes hitting all these markets at the same time can overwhelm management and if they make around both, it can overall slip up, how the company does at the end.

Ricky Mulvey: Jose Najarro, thank you for the bear thesis, big move to acquire the Quibi library. But anyway, you can decide who made the better argument for today's Bear versus Bull on Roku at Motley Fool Money on Twitter. Today's lucky winner will receive, a working Netflix login, the Louis family has an empty profile we're making on their family's Netflix account. They're willing to share their log info with today's Bear versus Bull Champion. Enjoyed Netflix original movies, reality TV shows, and a dwindling selection of licensed counter, it's an entertainment therapies, but wait, there's more, the Louis family tends to use the same password for all the websites they visited and this login probably works on Disney Plus and HBO Max. Give it to go on Hulu might be pleasantly surprised, all of this could be yours if you win Bear versus Bull. 

Chris Hill: As always, people on the program may have interest in the stocks they talk about and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening, we'll see you tomorrow.