Netflix (NFLX +0.96%) started as a mail-order service for renting DVD movies, but its pivot into streaming content was the big step that made the company the top content provider it is today.
History doesn't always repeat itself, but it often rhymes. Roku (ROKU +2.43%) has built a reputation for its streaming dongles and TV software.
However, it's in the early stages of pivoting from being a neutral streaming platform to becoming its own source of original content. It's currently just one-tenth of Netflix's size, but here's why Roku could someday grow up to be as big.
Making a clear push into original programming
Media streaming is all about gaining and keeping the attention of your users. For Netflix, it's been an original content story since it moved into streaming, slowly transitioning from licensing other people's content to replacing more and more of its catalog with its own productions.
Image source: Getty Images.
Roku began as a neutral platform for streaming. Its dongles would convert TVs into smart TVs, and it partners with TV OEMs to put its operating software on them to make them streaming-capable out of the box. Roku has steadily built up its user base over time, growing from 16.7 million active accounts in the third quarter of 2017, its first quarter as a public company, to 56.4 million accounts in Q3 2021, its most recent quarter.
But Roku decided that at some point, it needs to be more than just a means for watching Netflix or Hulu. It's been steadily investing in its own original programming. this effort started with launching the Roku Channel, an ad-supported free streaming service built within the Roku platform. The early content was licensed, but Roku has now begun bolstering it with original programming. The company bought content from failed streaming service Quibi and is now producing shows and movies, and recently signed a massive 240,000-square-foot building lease in New York City for content production purposes.
Roku had to wait until the right time to attempt this. If it were to try this too soon and alienate existing streaming platforms, they might leave Roku, hurting Roku's appeal to users. However, Roku's skirmishes with companies like AT&T and Alphabet over contract negotiations have shown that it's become large enough to have leverage via its user base, and the time was right to evolve. In other words, Roku has started thinking: "These streaming companies need me, so I'm not too worried anymore about stepping on their toes."
Different approaches to generating revenue
I'll repeat it: Streaming is about maintaining engagement on the platform. But monetizing those streaming eyeballs can be done in different ways. Netflix has always been ad-free, charging its viewers for the right to access the platform.
Roku is taking a different approach, becoming an advertising business underneath its streaming service. In other words, rather than generating revenue from consumer pockets, Roku is tapping advertisers. A recent Pixelate report estimated that a whopping 45% of ads on connected TV (devices that support video streaming) went to Roku devices in the first half of 2021. The report also stated that ad spending grew 50% year over year, so Roku is capturing a large chunk of this revenue pie that keeps getting bigger.
The company's average revenue per user (ARPU) grew 49% year over year to $40.10 in Q3 2021 and the ARPU expansion is Roku's primary revenue growth driver. A company like Netflix that charges the consumer must now be conscious of competing streaming platforms, and growth is more reliant on user growth. I think that Roku's ad-tech business is a stronger model, because it seems more consumer-friendly to give users a free product like the Roku Channel with targeted ads versus charging them monthly fees.
Is Roku a buy today?
Roku's user growth has been affected by the global supply chain issues, along with a marketwide sell-off of technology and growth stocks, and Roku's fallen a long way from its previous highs. However, it's given investors a much more attractive valuation on the stock.
ROKU Revenue (TTM) data by YCharts
The price-to-sales ratio has come down from more than 30 to less than 10, about on par with its pre-pandemic valuation. Meanwhile, the company is arguably much stronger today. Revenue continues chugging higher, while the business is becoming increasingly free cash flow-positive.
Analysts are looking for 35% year-over-year revenue growth in the 2022 fiscal year, which works out to nearly $3.8 billion. With the stock's valuation at these affordable levels, I think investors could reasonably expect it to appreciate at a similar rate to how the business grows, making Roku a compelling investment idea.
