1 Big Reason Roku's Stock Dropped Immediately After Earnings, and 2 Reasons It's a Long-Term Buy

When streaming media giant Roku (ROKU 0.92%) delivered its third-quarter results on Nov. 2, the report looked good on the surface. It beat on the top and bottom lines. Yet the stock opened the next day’s trading session down 18%.

There was one big reason the stock dropped after the report, but I see two reasons why it’s still a long-term buy.

Why Roku dropped after the earnings report

Roku generates most of its revenue through its connected TV (CTV) ad platform, which assists brands and marketers in buying ad slots from networks and other content distributors.

Advertisers can purchase ad space on CTV in two ways. The first is to buy ads at annual events called the upfronts where media companies and distributors negotiate with advertisers to buy specific ad slots at certain prices for entire seasons. These events generate commitments that guarantee the platforms displaying the ads a certain amount of revenue throughout the year. For instance, management closed $1 billion worth of upfront deals earlier this year for The Roku Channel’s 2022-2023 TV season.

The second way publishers sell advertising is through the scatter market, which handles all unsold inventory left after the upfront ad sales. Roku generates revenue by assisting advertisers in making CTV ad buys on the scatter market through its automated ad platform. But the downside of the scatter market is that advertisers can turn off those ad campaigns more or less instantly if they see a need.

Considering that many experts predict the U.S. will enter a recession in 2023 and that consumer demand will decline, many advertisers are canceling their ad campaigns, resulting in a weak scatter market.

Image source: Roku.

Roku management believes that ad demand in the fourth quarter will be worse than it was in the third quarter. The company is already seeing signs that telecom, insurance, and even toy companies are cutting their ad budgets for the holiday season — traditionally a strong time of year for advertising. As a result, the company projects that its platform revenue — which primarily comes from CTV advertising — will be down sequentially in the fourth quarter. That’s terrible news for Roku in the short term.

However, if you are a long-term investor, there are two reasons you should consider buying the stock.

Reason No. 1 to buy: Growing membership and engagement

Roku’s strategy is to continue growing its number of active user accounts by selling its streaming hardware at prices that are not profitable. In line with that loss-leader strategy, it decreased the average selling price of its Roku players by 6% year over year in the third quarter. That helped Roku maintain player unit sales at levels above where they were pre-COVID, and promoted its active account growth.

Management defines active accounts as those that have streamed content on the platform within the last 30 days of a quarter. In the third quarter, active accounts grew by 16% year over year to 65.4 million. It also added a net of 2.3 million active accounts on a sequential basis, outpacing its 2019 and 2021 rates.

Another important measurement of engagement is the total number of streaming hours. The more content viewers watch, the more ads they see, and ultimately, the more revenue Roku generates. Roku platform viewers streamed 21.9 billion hours in the third quarter, an increase of 1.1 billion hours sequentially and up 21% year over year. Moreover, engagement with The Roku Channel increased by 90% year over year.

Although Roku’s ability to monetize viewers through ad sales has been temporarily reduced, its strategy of prioritizing active account growth and enhanced engagement is positioning it for robust revenue growth once the ad market recovers.

Reason No. 2 to buy: Charlie Collier

On Sept. 22, Roku announced it had hired an industry heavyweight to head its global media division: Charlie Collier. Collier has been the CEO of Fox Entertainment and the president of AMC Networks (AMCX 2.33%) — and he’s just the type of heavy hitter that Roku needs. He has over 25 years in the TV industry, running ad sales organizations and leading entire media businesses, including programming, operations, strategy, and digital. He has broad respect in the TV industry, and his hire signals that management is fully committed to improving The Roku Channel’s original content. And Collier’s strong relationship with the largest advertisers and agency-holding companies should give a boost to Roku’s advertising sales efforts.

If his stint at Roku proves as effective as his runs at Fox and AMC, Collier should help boost Roku’s revenue as the company comes out of this industry downturn.

Should you buy Roku?

Roku trades at a price-to-sales ratio of 2.4, well below its median ratio of 10.5 across the past 10 years, so most investors would consider the stock undervalued. In my view, Roku is a solid buy over the next three to five years for long-term investors willing to accept that in the near term, volatility and further stock declines may prevail as traders bid the stock down in light of weak economic conditions.

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