David will win against the Goliaths in TV streaming

Roku Inc (NASDAQ: ROKU) is the market-share leader in connected TV (CTV) with a 47% share, impressively beating second-place Amazon (85x Roku’s mkt cap) that has 40% share. Roku grew topline by 3.5x and its share price by 7.5x in the past 4 years, despite going head-to-head against mega-cap media peers (Amazon, AT&T, Comcast etc). It will continue to capture the bulk of advertising budgets moving to CTV from linear TV ($70B industry vs Roku $1B revenue) as the largest CTV platform, enjoying a long growth runway. Its chief competitive advantage is superior technology, built on a programming language designed by its founder and CEO, Anthony Wood. Investors are under-estimating the potential of Roku in extracting excellent economics as the dominant provider of OS for TVs (think Microsoft for PCs, Google for Android mobile), and over-estimating the potential of competition to overtake Roku. Roku’s track record of growth-oriented innovations and potential to eventually “tax” every channel on its platform will serve high returns to investors for the foreseeable future.

Traditional linear TV is ripe for disruption. Its distribution system (cable/satellite) is expensive and outdated. Channel bundling forces consumers to pay for content that they don’t want. The lack of a recommendation engine makes content exploration difficult, which is unimaginable to the Netflix/Hulu user served with content aligned to viewing habits. Advertising on linear TV, dependent on Nielsen data, is no longer as effective as targeted ads in the digital age popularized by Google/Facebook.

Roku has disrupted linear TV and beat streaming peers using the cheapest prices in the market, the greatest variety of content, and the most user-friendly interface. A Roku device cost less than half of an Apple TV or Google Chromecast device. Amazon Fire comes closest to matching the price of a Roku device, but does not match content variety. Unlike Apple/Google/Amazon, Roku does not sell content, and thus can offer content from all platforms. Apple TV does not allow users to rent from Google Play. Amazon Fire does not allow purchases on iTunes. Roku, as the “Switzerland” in TV streaming, can offer the greatest variety of content and attract the most users.

The most important advantage that Roku has is also the least understood. It has the most user-centric interface because it is the only OS (operating system) built for TV. OS only work when it is purpose-built. Think of Windows for PC and iOS for mobile phones. Microsoft dominated personal computers, but failed to migrate Windows to mobile phones (remember Windows phones). Apple dominated mobile phones, but could not attract a loyal following for Apple TV, which uses the same interface as iPhones. Competitors are lagging Roku chiefly because they are attempting to re-purpose OS, not designed for TV, for TV. Roku was designed from scratch for nothing but TV. The 5,000+ apps available on Roku is powered by Brightscript, the in-house programming language created singlehandedly by Roku’s founder and CEO. According to this programmer, Brightscript Components are written exclusively in C, which is an incredibly powerful, fast, efficient and portable programming language. It is also an accessible language for most programmers, underlying the potential of Roku to attract more developers and more creative content.

Roku extracts incredible economics as the dominant OS for TVs. Its high-margin (70% gross margin) and recurring revenue stream comes in the form of advertising revenues (Roku calls this platform revenues). Roku shares advertising revenue produced by AVOD (advertising video-on-demand) channels. AVOD is the fastest-growing format because it offers free content to consumers in exchange for display advertisements. The growth of AVOD (eg Tubi, Crackle) is also supported by excessive competition in the familiar SVOD format (subscription video-on-demand eg Netflix, Disney+, HBO etc). Consumers are likely to be reluctant to add new SVOD services after budgets are exhausted, implying that some SVOD players may embrace a pure AVOD or hybrid AVOD/SVOD format (similar to Hulu), and aid the growth of AVOD and ultimately Roku.

Behind Roku is Anthony Wood, an incredible founder and CEO who has the rare combination of technical prowess and business leadership. Wood reminds me of Tobias Lurie, founder and CEO of Shopify. Both started as technically proficient programmers, and created the programming languages that eventually powered their companies (Wood created Brightscript and Lutke created Liquid). Both picked up management and leadership skills after starting their companies, and retained significant ownership throughout the rapid growth of their companies. Wood had started two companies before Roku and even worked under Reed Hastings at Netflix to develop Roku. Investors should be confident of Wood’s ability to lead Roku. The early partnerships with TV manufacturers and retailers to quickly distribute the Roku OS was an effective strategy that Google is trying to replicate now (but likely can’t reach Roku’s success because of OS mismatch). The recent acquisition of Dataxu and partnership with Kroger to advance CTV advertising data analytics is ground-breaking in tech-retail collaborations, and is another proof of Wood’s innovative and effective leadership.

Valuing Roku, like its high-growth TMT peers, is not straightforward because of its heavy investments and low profitability. Because DCF works with positive cash flows, Roku should be valued as if it had achieved steady-state, characterized by normalized investments and profitability. Hence the quantitative valuation of Roku relies on a key qualitative assumption, that is Roku’s current investments are effective enough for the company to achieve steady state in the future. In this model, I assume that Roku grows topline by 30% CAGR and achieves steady-state in 8 years, and generates 30% EBITDA margin (similar to the Trade Desk, the current de facto CTV platform leader). With a terminal multiple of 17 (r=10%, g=4%), Roku is worth about $180/sh (50% upside from current price).

The price target likely underestimates the potential of Roku because of the company’s track record in innovation. It was the first to license OS to TV manufacturers, the first to initiate a major tech-retail partnership in advertising, the first to feature 100+ live channels for free in an intuitive interface, the first content-neutral platform, and the first platform (but not the first channel) to benefit from the fast-growing AVOD format. Investors should expect more growth-oriented innovations in the future. If Roku continues to strengthen its dominant position, it would become the default OS for smart TVs, and extract “taxes” in the form of advertising revenue-share similar to what Google/Apple does for mobile apps today. Every AVOD channel will have to be on Roku and pay “Roku-taxes” because its platform will be the most widely distributed. This is a capital-efficient model that will serve high returns for many years to come.