- Roku management and Roku bulls framed soft third-quarter guidance as being driven by macroeconomic factors
- Yet, declining ad spend alone doesn’t explain 84% decline from highs
- Bulls may be focusing on problems with the 2022 economy — and ignoring boom that marked 2021
Shares of Roku (NASDAQ:ROKU) have declined 84% from a record close set last July. That includes a 23% decline in trading last Friday, after Roku delivered a disappointing earnings report after the close Thursday.
It’s tempting to see the decline as a buying opportunity. Indeed, many investors already have done so: ROKU rallied on Monday and Tuesday, gaining 16% over the two days.
Those investors may well be disappointed. ROKU stock is down big — but there are a number of reasons for the sharp decline. The biggest one, however, may not be the one on which optimists — toward both ROKU and the market as a whole — are focusing.
The Post-Earnings Case For ROKU Stock
There’s no way to sugarcoat it: Roku’s earnings were disappointing. Both revenue and profit badly missed Wall Street expectations. But the bigger concern centers around the company’s guidance for the third quarter. Consensus revenue for the quarter was $902 million; Roku guided for just $700 million.
Roku management framed the issue as driven by macroeconomic concerns. In its Q2 shareholder letter, the company wrote: “consumers began to moderate discretionary spend, and advertisers significantly curtailed spend in the ad scatter market (TV ads bought during the quarter).”
From this perspective, Q2 and, more importantly, Q3 represent just a temporary problem. Consumer spending will return at some point. In the meantime, Roku will continue adding users amid the long-term shift toward streaming and away from linear television.
Indeed, after the report at least two analysts made similar arguments, projecting near-term pressure, yet long-term success, for ROKU stock.
In short, bulls would argue that this is just a bump in a long road toward a sharply higher valuation. From that perspective, the sell-off here is due largely to investors focusing too intently on the short term.
Is 2022 The Problem?
Indeed, it’s likely a similar perspective has taken hold across the market. After all, recession fears have only grown in recent weeks, yet the S&P 500 now has bounced 12% from June lows.
But for both ROKU and the market as a whole, there’s a missing element to this story: What, exactly, happened in 2021? First, the economy was roaring. U.S. gross domestic product rose 10% for the year.
For a business like Roku, the tailwinds were even larger. That macro growth meant advertisers were willing to spend to attract flush consumers. But Roku also benefited from an explosion of streaming services, many of which looked to advertise on the platform to attract their own users.
It’s worth emphasizing that Roku pointed to weakness in the scatter market. That’s precisely the market that would have benefited last year. Importantly, it’s the market where prices are the highest, as Roku’s results show. In Q2, platform gross margin (platform revenue excludes sales of Roku players) declined 880 basis points year-over-year. Q3 guidance looks even worse: Roku’s consolidated gross profit is projected to decline about 4% year-over-year.
Bulls would argue that Roku’s business, long-term, will be better than it will look in Q3. That’s probably true. But those bulls also need to remember that, long-term, the business will be worse than it looked last year. The mid-60% gross margins realized last year were not sustainable.
The Valuation Problem
Similarly, the multiple assigned ROKU stock last year was not sustainable. At the peak, ROKU’s market cap was 27x the company’s eventual 2021 platform revenue. (Players are sold at a negative gross margin, so it’s worth essentially ignoring that revenue stream, at least from a bullish perspective.)
That multiple was essentially absurd for a business with mid-60% gross margins — let alone the 56% posted in Q2. And that multiple undercuts the argument that the decline in ROKU stock is being driven by a short-term focus on the economy.
What has driven the bulk of the decline is the fact that Roku was absurdly priced a year ago. That factor can’t be ignored.
Again, the same sense seems to hold for the market as a whole — not just ROKU. In 2021, investors across the board applied unreasonable multiples to revenue and profits generated in a hugely beneficial environment.
That environment is normalizing — but that’s not the only reason why stocks have declined, or should decline. Investors in ROKU and other fallen angels who ignore both aspects of the equation do so at their peril.
Disclaimer: As of this writing, Vince Martin has no positions in any securities mentioned.