ROKU | THE COUNTDOWN BEGINS | MOVING TO THE BENCH

overview

Roku (ROKU) reported 3Q21 earnings last night. The headline revenue number of $680M was light relative to $682M consensus (in-line with management's guide), but if you look underneath platform revenue beat – $583M vs $560M consensus - with hardware/player revenue of $97M missing the mark of $121M. Player sales were down 26% YoY as we compared against a tough COVID demand comp last year. Of course, it would be great to beat on both, but platform is far more critical to the long thesis since it is a 65% gross margin business and 86% of revenue (compared to player revenue gross margin of -15% in 3Q21).

On the platform side, revenue growth was 82.5% YoY in 3Q21, a deceleration compared to 118% in 2Q21 (easy comparison). However, the 2-year growth rate accelerated 200bps to 80% YoY - impressive considering the business is 3x the size it was in 3Q19. ARPU on TTM hit $40, up 49% YoY, and we still think there is room to go to $100. Meanwhile, platform gross profit growth was an impressive 95% YoY, with margins of 65% coming in ahead of the consensus of 60% (High margin M&E growth continues to outpace overall platform growth - despite weaker OTT/sub-trends in Q3). And overall gross margins came in at 53.5% vs. management’s guidance of 47% or 650bps.

In terms of accounts and streaming hours, numbers were light - but better than feared. Roku added 1.3M net new active accounts to 56.4M, which was below the consensus of 1.6M – but better than the 1.0M whisper floated throughout the quarter. Still, not good enough to offset concerns over competition (Amazon/Google) and lower than what we were modeling. Active account growth slowed to 23% YoY in 3Q21 (2-year 32%).  Supply chain problems with TV OEM partners are having a negative impact, and TV sales are also down below 3Q19 levels. Management called out high pricing as one reason for the decline in demand - definitely a factor, but also reflects a hangover in demand after folks rushed out and bought TVs last year. Again, nothing we didn’t already know. However, we don't expect trends to turn until 1H22 before reflecting positively into 2H22 (Click Here for TV Supply Chain Call).

The biggest issue is around the guide for Q4, which came in below consensus for revenue and margins - 37% revenue growth and 26% gross profit. It implies a sharp revenue and gross profit deceleration compared to 3Q21 of 51% YoY and 69% YoY, respectively. The margin guide for 43% suggests either a much higher mix of player revenue (on much lower GM % QoQ) and/or a material slowdown in platform revenue growth and/or a decline in platform gross margins to an all-time low. For added context, management's gross margin guidance of $385M is only a +6% QoQ increase compared to the average Q4/Q3 growth since 4Q16 of 48%. And frankly, we can't get there assuming everything is status-quo. A possible explanation could be if one of their big media partners significantly reduced M&E spend or if Roku plans on having a 606 writedown/reversal in 4Q21 (both would be a big margin headwind). Alternatively, we suppose player gross margin could continue to decline in Q4 to -30% or worse (compared to -15% in 3Q21), but that seems a bit extreme. 

Management called out a tough comp due to HBO Max and Discovery+ launch in Q4 last year (even though Discovery+ had its initial debut in the U.S. on 1/4/2021 and the HBO Max deal wasn't reached until the middle of December 2020). They also mentioned a slowdown in advertising spend from Auto and CPG categories negatively impacted by supply-chain issues. However, remember management also called out difficult comparisons due to the launch of Disney+ in 4Q19, Dataxu acquisition, and an uncertain COVID environment when they contemplated their 4Q20 guidance last year - which they beat significantly.

It is possible that WarnerMedia and Discovery are slowing marketing/distribution spend in anticipation of the merger 1H22 as they contemplate what the new go-to-market strategy will be for their streaming services. However, we then have to factor in other offsets. For example, the secular shift to CTV where Roku doubled advertising $ coming out of this year's upfronts, the contribution from smaller advertisers (Shopify beta program oversubscribed), and strength in categories NOT impacted by supply chain such as financial services. It will be important to look at the RPO number in the 10-Q when it comes out later this week.

Additionally, on a YoY basis, the most significant step up in the platform revenue growth rate happened in 3Q20, where growth accelerated to 78% from 46% coming out of the pandemic. The 4Q20 platform revenue growth rate was 81.5% - so it is not like we are staring at a more difficult YoY comparison in Q4 compared to Q3. And then on player sales, while they were down 26% YoY on an unusually tough comparison, they were still up 19% compared to 3Q19 - and we expect them to be flat to up slightly again in 4Q21 relative to 4Q19 levels. 

Bottom line... if we are right and history is of any guide, Roku will beat their guidance when they report 4Q21 earnings in February 2022 (Revenue growth closer to 45% and GM 48-50%). The platform business continues to do exceptionally well. While active account growth has been disappointing, we believe it has more to do with industry factors than a problem with Roku specifically. Meanwhile, we are in the very early innings of Roku's international launch, which will become a more meaningful driver of account growth 2022+. That said, we are mindful of more difficult growth comparisons on platform revenue/gross margin 1H22 and realize that active accounts probably won't turn the corner until late Q1/early Q2 2022.

And between now and 4Q21 earnings, we have the 12/9 distribution deadline with Google for YouTube on new Roku devices (Click Here for our more detailed thoughts). As we wrote in our Position Monitor note earlier in the week, we believe this will be an overhang on the stock regardless of fundamentals (the reason why we moved Roku to the bottom of the active long list). If a deal is reached, it likely won't happen until the 11th hour. And because the disagreement is not over financial terms and YouTube is not an emerging service, we don't have the conviction that a deal gets done (like we did with PeacockTV and HBO Max). With 3Q21 earnings behind us, we expect investor attention and narrative to become increasingly dominated by YouTube. 

If Roku loses YouTube, we believe it will be a negative catalyst for the stock relative to today's price. And for this reason, primarily, we are moving Roku to the bench. We will revisit Roku as an active long once we have more clarity on distribution for YouTube, we get closer to 4Q21 earnings and/or have a better line of sight in the turn in account growth. 

earnings takeaways

• Headline number $680M soft relative to $682M expectations
• Platform revenue beat, $583M vs $560M expectations <- Platform matters more; we were at $585M
• Player revenue came in at $97.4M (down 26% YoY on difficult comparison / should have been a known); below consensus of $121M.
• Gross profit in aggregated increased 69% to $364, or 53.5% gross margin vs. 47% guide implied at mid-point
• Overall gross profit beat relative to $328M consensus and our $345M
• Platform gross profit $378.5M up 94% YoY <- Very strong - 606 Impact this q?
• Platform gross margin 65% 3Q21 vs. consensus 60.3% (in-line with 65% in 2Q21 and 3Q20 of 65%).
• Player gross profit -$15M or negative 15% <- Company communicated negative player margin previously
• Adjusted EBITDA $130.1M (19.1% margin) versus $71.M consensus, and our $128.6M
• Active Accounts 1.3M, definitely a bit lighter but not as bad as feared (1.0M)
• Active account growth 22.6% YoY 3Q21, versus 28.1% 2Q21
• Streaming hours increased 21.6% YoY, accel from 19.2% YoY 2Q21; albeit 18B was a bit light relative to consensus of 18.7B <- Management says outperforming industry per Nielsen data in Q3
• Streaming hours per active account -2.9% YoY; improvement compared to -9.22% YoY 2Q21; and 6% above 3Q19; up 0.9% QoQ

Q4 Guide

• Total net revenue $885 - $900M (consensus $945M)
• Gross profit guide $380 - $390M (consensus $426M)
• Implied gross margin % guide 43% versus 53.5% 3Q21 
• For context, they guided 3Q21 to 47% gross margin and ended up coming in at 53.5%; historically, beat their gross margin guidance by 600bps YTD
• Adjusted EBITDA $65 - $75M (consensus $71M)
• Guided Q3 $60-70M and put up $130.1M

• Calling out supply chain challenges
• Mid-point revenue of Q4 +37% YoY; Gross profit +26% YoY
• Context on the guide…
• Q3 earnings last year they guided to mid-40% revenue growth, that came in at 58% YoY
• Q3 earnings last year they guided platform gross margins mid-50% to 60% range, that came in  at 67%

Account Growth

• "We believe the slowdown in active account growth rate this quarter was, in large part, attributable to global supply chain disruptions that have impacted the U.S. TV Market."
• Overall U.S. TV Sales in Q3 fell below pre-COVID 2019 levels; Roku TV OEM partners were hit particularly hard with inventory challenges, which negatively impacted their unit sales figures and market share in Q3.
• Roku player unit sales were down YoY, but above pre-COVID 3Q19 levels.

Product Launches

• Roku Streaming Stick 4k, and the Roku Streaming Stick 4K+ product launch, including the Roku Voice Remote Pro
• Launched new brand campaign in October to support these new products into holiday season
• Roku OS 10.5 launch
• Expanded in Germany, with more than 2,000 channels
• New line-up of SEMP TCL Roku TV models for Brazil, and will bring TCL Roku TV models to the country this year.
• Expanding TV footprint in Latin America to Chile and Peru later this year

Monetization

• "Significant contributions from both content distribution and advertising activities. Despite some macro challenges that impacted advertising partners in certain industries."

Content Distribution

• Media & Entertainment promotional spending continued to grow "significantly faster than the overall platform."
• In Q3, channels outside the top ten increased their share of total streaming hours by nearly five percentage points <- Audience fragmentation

The Roku Channel Growth

• 200+ content partners
• Added 17 linear channels to more than 200 channels
• First feature-length film, 'Zoey's Extraordinary Christmas'
• Premiered 23 new Roku Original titles
• Great streaming hours of This Old House on TRC by nearly 50% since acquisition

Ad Business Strength

• In Q3 ratings for adults 18-49 on traditional TV fell 19% YoY, creating supply shortages and increasing ad prices
• Top 10 cable TV advertisers doubled spend on the Roku platform YoY
• Total monetized video ad impressions nearly doubled YoY
  
• Expanding to SMBs/DTC
• Lovevery, a DTC brand, used OneView to reach potential purchasers of products for infants and toddlers… cross-screen campaign drove a 72% lift in website visits, 105% lift in subscriptions and 170% lift in purchases.
• Spending by smaller advertisers (outside the Ad Age top 200) continued to significantly outpace the overall growth in spending on Roku
• TV Streaming impressions delivered through OneView more than doubled YoY in Q3
• Introduced new tool for Shopify merchants in Q3 <- Oversubscribed

Call Notes

• Player revenue unit sales were down 26% YoY
• Favorable mix toward higher-margin M&E spend by content publishers in Q3
• Product availability could hurt spending by certain verticals (e.g., Auto)
• Q4 Growth Guidance
• Tough comps for last year, especially on the platform side delivered exceptional performance in 4Q20 on the content distribution side; "you had a couple of marquee services that were building up in terms of HBO Max and Discovery+ launching" <- Discovery+ didn't launch until January 2021 (possible there was some early spend recognized ahead of actual launch); Management, called out tough comps from Disney too last year and they compared against it in 4Q20
• Components of Q4 Revenue Guide
• Supply chain disruption impacted a lot of industries, impacting U.S. TV sales market is down 31% YoY and in part, because pricing is up 42% YoY; U.S. TV market is down compared to 3Q19
• Roku player and Roku units are down YoY based on extraordinary demand spike in 3Q20, but player revenue and player unit are still above 3Q19 levels.
• **Management did not answer questions directly or provide color on revenue mix assumptions Q4 (frustrating...)
• Supply-chain issue impact
• Autos and some CPG impact, but a lot of other categories not impacted like Financial Services
• Amazon agreement
• Not up for renewal or distribution agreement at this time
• Active Account Growth
• The majority of the active account base is still in the U.S.; Intl has been growing faster than the U.S.
• Factors Impacting TV Sales
• The main component of the price is shipping costs and TV costs…
• Inventory was down, and that was driven particularly with China TV OEMs were particularly bad, and it was impossible or very expensive to ship the product
• Panel/chip shortages also impacted, the brand you sell under doesn't compare to the price
• You have companies like Vizio that have model where they source products from mfg overseas and they transfer that product from a retailer (we are happy with how we run our RokuTV program and work with many top brands, we work the entire TV ecosystem).
• Media/Entertainment
• Category continues to perform very well
• Business continues to grow and the tool/service will become a great asset for the business going forward (even though growth is going to normalize)
• Deceleration in monetized video ad impressions?
• Video ad business has roughly doubled, wasn't substantial decel; we are coming up against a couple of quarters that is a difficult comp relatively speaking.
• Other categories we are seeing robust growth categories like financial services that are not impacted by supply chain, we are seeing growth in performance categories.
• Shopify Partnership
• We have a beta program working with them… program was oversubscribed on the first day.
• CTV/SMB Taking Share from Social
• In some cases they are being priced out of those other platforms; we are brand new to the category, and offer an opportunity to have a branding impact and optimize outcomes and 15, 30-second spot; we are the new kid on the block, we are still early in the business, there are SMBs and DTC brands nationally.

Andrew Freedman, CFA
Managing Director
@HedgeyeComm