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Roku Plunges: 3 Reasons to Buy, 4 Reasons to Sell

Leo Sun, The Motley Fool

Shares of Roku (NASDAQ: ROKU), one of the hottest tech IPOs of 2017, plunged more than 20% on Feb. 21 after the streaming solutions provider reported its fourth-quarter earnings. That decline was surprising, since Roku easily beat analyst estimates on the top and bottom lines. 

Should investors buy this dip, or should they wait for the stock -- which remains more than 180% above its IPO price of $14 -- to pull back even more? Let's look at three reasons to buy Roku, and four reasons to sell it.

A woman controls a smart TV with a remote.

Image source: Getty Images.

Three reasons to buy Roku

  1. Roku's platform revenue rose 129% annually to $85.4 million and accounted for 45% of its top line. That growth offset the weaker sales of its streaming devices, and lifted its total revenue by 28% annually to $188.3 million, which beat analyst estimates by nearly $6 million.

    Roku attributes the growth of its platform, which runs on its own devices and third-party smart TVs, to strong demand for content partnerships, licensing fees, and ads. Roku claims that "more than half of the Ad Age's top 200" companies now advertise on its platform. It also noted that its average deal size was increasing as it attracted more advertisers.

  2. The higher gross margin of Roku's platform business, which hit 74.6% during the quarter, offset the much lower gross margin of 9.5% for its player (set-top box and streaming device) business. Roku's total gross margin expanded from 30% in the prior-year quarter to 39%.

    As a result, its adjusted EBITDA more than doubled to $14.4 million, beating estimates by nearly $2 million. Its diluted net income of $0.06 per share, which was weighed down by a $2.3 million debt charge, still marked a big improvement from $0.00 a year earlier while topping Wall Street's estimates by $0.16.

  3. Roku's total active accounts grew 44% annually to 19.3 million during the quarter, as its total streaming hours surged 55% to 4.3 billion. Its average revenue per user also rose 48% to $13.78 on a trailing 12-month basis.

    Most of its accounts growth was fueled by robust sales of Roku TVs, which are manufactured by a wide range of partners, instead of sales of first-party streaming devices.

Four reasons to sell Roku

  1. A major concern is that Roku's platform business can't grow fast enough to offset the ongoing declines of its player business. Roku's player revenue fell 7% annually during the quarter, but still accounted for 55% of its top line.

  2. The platform unit's gross margin of 9.5% also represents a steep drop from 14.3% a year earlier. That decline can be attributed to rivals like Amazon.comAlphabet's Google, and Apple flooding the market with competing devices.

    Last August, Parks Associates reported that Roku controlled 37% of the streaming device market in the U.S., while Amazon, Google, and Apple held shares of 24%, 18%, and 15%, respectively. All three of those companies can also afford to take losses on their streaming devices to expand their ecosystems -- a luxury Roku can't afford. 

    Amazon and Google are particularly formidable rivals, since their Fire TV and Chromecast devices target lower-end users. That's why Roku started selling the Roku Express, a $30 device that could cannibalize its pricier set-top boxes.

  3. Roku's guidance for 20% to 30% annual revenue growth in the first quarter also missed the consensus estimate of 32% growth. The midpoint of Roku's guidance, at 25%, would also represent a slowdown from its 40% growth in the third quarter and 28% growth in the fourth quarter.

  4. That "slowdown" wouldn't be worrisome if Roku traded at lower valuations. But with a market cap of $4 billion (after its post-earnings drop), Roku still trades at about eight times its 2017 sales, versus the industry average of two for pay-TV solutions providers.

My take: Avoid Roku (for now)

It seemed like a good idea to sell Roku at the beginning of the year, due to its weak profitability, high valuation, and narrow competitive moat. While the situation is improving, as Roku's platform business boosts its profits and widens its moat, but its weaknesses outweigh its strengths.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, and Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.