Roku: One Stop Streaming Shop - [Business Breakdowns, EP.116]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Jesse Poogee and today we are breaking down Roku. With all the hype about social media on smartphones, it's easy to forget that the average American still spends over five hours a day watching TV. And while the streaming war has got the most headline attention, the battle for the user interface of smart TVs also has billions of dollars at stake. Here, Roku has emerged as an unlikely frontrunner ahead of Samsung, Google, Amazon, and other giants. To break down Roku, I am joined by Joe Frankenfield, Portfolio Manager at Saga Partners.

1:21We cover Roku's history, dive into its income statement, unpack why it's the leading smart TV platform in the U .S., and what the future holds. Please enjoy this business breakdown of Roku. All right, Joe, welcome to Business Breakdowns. Thanks for having me. Excited to talk about Roku. Let's jump right in. So for those who don't know, tell us what is Roku and give us a sense for their scale, size, and business model. Roku is a platform that distributes TV content over the internet. It's the operating system and the user interface of a smart TV. And so they're really the distributor in the internet age for television content.

1:58They're the largest TV operating system in the United States. They have over 70 million active accounts. And if you compare that to the traditional paid TV distributors, whether that's cable or satellite, that is larger than Comcast, Charter, DirecTV, DISH combined. So they're a very large distributor of TV and the new age of television with the internet. So Conviva is a company that tracks the different TV operating systems and the other competitors of Roku. And they estimate Roku has about 40 % to 45 % of market share of streaming hours in the United States. And that's larger than the next three or four TV operating systems combined.

2:38So there's Fire TV, which has maybe 15 % to 20 % of viewing hours in the US. There's Samsung's Tizen that has about 10%. LG and Apple TV have low single digits. And really, Google TV, which a lot of people are scared of. And when Roku's competing against Google, they're really low single digit type of market share and viewing hours. What scale is the business at in terms of revenue and EBITDA? And how has it grown in the last few years? They've had strong growth. Their total 2022 revenue was $3 .1 billion. They had $1 .4 billion in gross profits, and they had EBITDA losses in 2022. And the way that they think about their business is they have a device segment, and then they have a platform segment.

3:17The device segment is trying to sell the little TV sticks that people buy and plug into the back of their TV. And they really try to target breakeven to even losses on a gross profit margin basis. The platform segment is where they monetize the active accounts. That's been the growth that you've seen in the revenue over the last five or six years. You can describe it as a distributor and almost a new cable, which I want to go into later. But just for the time being, what's the history of Roku, major milestones, and even maybe to the extent you can speak to the evolution of streaming as I assume that they're interrelated, interwoven.

3:51I'd love to hear how did this all come to be? It's probably good to start with the story of Anthony Wood because he's the current CEO and the founder of Roku. And he's been in the TV space over the last 20 or 30 years and really into the software and hardware computing space. In high school, he programmed computer games back in the 1980s. He started a software hardware company in college and ran that after college, sold that. And then really where you get closer to the Roku store is he's the inventor of the digital video recorder, the DVR. And he started a company called Replay TV in the late 90s.

4:28And that was a big innovation for television where you could record television and not to see it in real times. Unfortunately, he lost out to TiVo in a marketing battle and ended up selling Replay TV in 2001. So then after that, he still wasn't done working. He probably had enough money at the time to retire, but he wanted to see what could be the next step for television. And he knew that internet was going to change the way that media was going to get distributed. So he started Roku in 2002. And that was before they started selling the dongles or TV sticks on the back of your TV. but he wanted to create products that would stream content.

5:08So they had a music streaming player and they had another thing that I think posted images and pictures on the TV. But during that time, he saw what the internet was doing to publishing, what the internet was doing to music. And he reached out and met with Reed Hastings at Netflix to talk about the different dynamics that were changing in the TV industry. And at that time, Netflix was still just mailing DVDs by mail. They haven't made the transition into streaming television. Inevitably, he said to Reed, and Reed understood this was that we're going to have to change our business and we're going to have to be a streaming company.

5:44And so Netflix did start their streaming product in 2007. And at that time, you could only watch Netflix over the internet on your personal computer. And at that time, Reed was interested in growing their own Netflix player to help make it easier for people to watch Netflix on their big screen in their living room. And so he hired Anthony Wood to come to Netflix in 2007 and build that out. They were building that during 2007. And in December of 2007, they were weeks away from launching this product. And Reed just pulled the plug on it. And so they had the advertising, They had the distribution.

6:23They had the product ready to go. And so they spun out the Netflix player into Roku. So Anthony would, and I forgot to mention at this time, Anthony was still running Roku at the time. So he had this company on the side while he was at Netflix. So that was spun out in 2008. And that's really when Roku was starting to sell these, it was called the Netflix player the first year. And then they changed it to the Roku player in 2009. And so in 2009, was it a dongle or what did they actually roll out? was a piece of software? Yeah, it was like a hockey puck. Probably was a dongle or at least would become a dongle next year.

6:57Netflix was 100 % of the content that Roku had in 2008. It was called the Netflix player by Roku. But soon after, they started an app store so that other content suppliers could then go on to the Roku. And so it wasn't a big surprise to Anthony Wood. And this was actually what he wanted when he was first talking with Reed Hastings was to work with Netflix and Roku to build this. Well, now he could do this in Roku. But it was obvious there was a conflict of interest between Netflix, who is trying to be a supplier of TV content, and what this device would be, which would be a distributor of it. So the reason why Reed pulled the plug on it was supposedly he spoke with Steve Jobs at Apple, and Steve Jobs was not interested in having Netflix on the Apple TV, which was one of the few smart TV type devices at the time.

7:43And Reed realized this was going to be difficult to really get Netflix on all the different devices. And really Roku wanted to be an aggregator of all the suppliers. So it makes sense that they split up and was spun out. Netflix had invested, I think, maybe $5 million into Roku and then also had maybe a quarter of the equity at the time. But Netflix shortly after sold their equity as to not be seen as having a conflict of interest. It was software powering the various pieces of it. How did the content landscape evolve maybe during the five or 10 years that came after it became a device? Not specific numbers, but Hulu and all these other services, how did they start to evolve?

8:19Because aren't they critical to make Roku as a device actually valuable? Yeah, definitely. During that time, so Netflix came out around 2007 and Hulu was around the same time and HBO came out around the same time. Really what Hulu was, was a joint venture between the legacy cable companies to test the waters into how they would want to transition into the internet age, but it wasn't all in. So it was a joint venture between ABC, Fox, and CBS. As you transition from, let's say, 2007, 2010 to 2015, you see that the legacy suppliers of TV content started testing the waters, but it really wasn't until the last five or six, probably even less than five years where they went all in and realized this is where we need to be going forward in the future.

9:04Because the cable business was a very profitable business was a bundle of bundles of bundles. The broadcasters also had mutual ownership with the cable networks who in certain cases had local TV broadcasters. And also Comcast is a great example as they also had the cable lines that go into people's homes. And so there was a lot of mutual interest in maintaining that bundle. And there wasn't a lot of economics to move over into the internet because the way that you monetize TV was either through advertising or through subscriptions. the cable operators that went into the home would sell your cable bill $100 a month.

9:41And then the cable channels networks would also have advertising on top of that. But there was not that type of monetization in the internet. So Netflix went full on subscription SVOD, subscription video on demand. And that worked really well because to convince advertisers to move over, you need eyeballs. And so first you have to get the eyeballs, then the advertisers will move over, which is where we are today. I want to go deep in a second, but before, how do consumers make a decision around this? It sounds like there's Roku, there's Apple TV, there's Fire, Samsung's have something in them.

10:12How do consumers make that choice and how does Roku play to try to become the choice provider? Early on, there were two main things why Roku was successful in winning over consumers. It was relatively affordable and cheap. It was cheaper than competitors at the time. They did that because Purpose built operating systems. They built their programming language from the ground up for television, as opposed to Google TV or Amazon Fire, which is actually a forked version of Android. It was built for mobile phones. And so mobile phones require a lot more RAM, a lot more memory. They're built on HTML5 programming, which means they need a web browser, which you don't necessarily need for television.

10:51So it takes more expensive, more powerful chips for their competitors. So Roku had a cost advantage from early on. The other thing is that it was very simple to use. They tried to make it very similar to iPhone, where it's very app -first based, as opposed to content -first, because content can get very muddled and confusing for the consumer. But really, they had Netflix, they have Hulu, they have YouTube, they have those things and very easy to click into those apps. And they kept it a very simple user interface. So that helped with the consumer adoption. Now that we look at the playing field today, that alone is not really going to stay a strong differentiator.

11:28And today, Roku has a big advantage where they're the largest one. They have 70 million active accounts, the largest share, at least within the US. And so that's a big advantage just from a network effect where content wants to be where the consumers are, consumers want to be where the content is, or there's that two -sided network effect. That's a good question that most people ask is, why does someone prefer Roku over Samsung's Tizen operating system? The data that we have so far shows a lot too. So Samsung has maybe 30 % or just under 30 % market share of TVs in the United States, but they only have 10 % of streaming market share.

12:07So just taking that, two out of three people that buy a Samsung are now either buying Amazon Fire Stick or a Roku stick to then go over the Samsung because the operating systems historically have not been very good and to this day arguably are still not as good. At least two out of three consumers that buy Samsung agree with that. The other thing that's interesting is that you look at the overall market, TV space is very price sensitive. A couple of dollars goes a long way if you're trying to get that Black Friday deal at Walmart and you're negotiating with Walmart for the dollar cheaper type of TV.

12:41Let's go into the P &L of Roku in a little bit more detail. So earlier you mentioned, obviously, they're selling the dongles at breakeven, then they make a lot of their money from subscription. I think there's advertising is a big part of the business too. So maybe walk us through the major pieces of revenue, major parts of gross profit, and then how you think they're driving growth in those segments. Like I said earlier, their revenues last year were $3 .1 billion. And that's broken up into their two main segments, which is devices and the platform segment. The device segment, which had maybe around $400 million last year, had losses.

13:14And so historically, they try to have it be around break even on a gross profit margin basis. COVID caused a lot of supply chain disruptions where they subsidized those inflationary costs that they experienced at a negative gross profit margin last year. The platform segment, which is where they're monetizing their active accounts, it was around $2 .8 billion, just under $3 billion. So it makes up the majority of their business, which was not always the case. Now they're able to monetize the viewing hours on their TV better. So on a gross profit margin basis, the platform segment is above 60, around 60%, but it's trended down over the last decade or so, or last five to 10 years.

13:54And the reason behind that is you can think of how they monetize it is, is take their advertising. It can either be first party or third party advertising. So Roku will take a piece of the advertising that goes over their platform. So if you're Fox and you have nine minutes of advertising going over Roku, Roku will take three minutes of that and they will sell that and Fox will sell six minutes on their own. So that's first party. And if it's first party, it's a really high margin. It can be 80, 85 % type of first party advertising type of margins. If it's third party, which means that Roku is selling on behalf of its content partners.

14:31So let's say Fox says, I'll give you the nine minutes of advertising and then you sell it and then I'll take a cut. And that's closer to like a 50 -50 % type of margins. And that's been an increasing part of their business over time, especially as the Roku channel has grown in viewing hours. Because in the Roku channel, they manage all the inventory and then they have more of a revenue share agreement. And similar, they also have revenue share for the subscriptions. So if you're spending $10 for a subscription, Roku might get $2 of that. Or if they do the subscriptions in the Roku channel, Roku will recognize the $10 as revenue and then forward on the $8 in COGS and they'll have a $2.

15:07So it's just an accounting. So it's almost like three businesses. It sounds like they're selling you hardware, which is basically free break -even. They don't make any money on that. There's this $2 they get. Whether or not it passes through them or not, they're getting $2 per sub. and then there's this advertising business which has both first and third -party ad sales. Yeah. And I would even just say that their device business isn't a profit center at all. It never will be. It never is what they want to make money from. But the way they monetize their platform can evolve. There is different ways they go about that.

15:42And that's advertising, whether that's within the content they watch or it's on the user interface, which is their M &E type of advertising first party too. And suppliers will say, I want to push this Disney film and it'll be on the user interface. And then there's buttons on the remote control. Then there's also just discovery. If you need to discover content in search, it's similar to having those end caps in retail. Or search ads, which we see everywhere now these days. Exactly. I mean, if the business of Roku is the Apple iOS, it's the Android OS, they are the retailer of television. So if you want to get prioritization or priority in your content, then you will pay for that.

16:23And whether that's through advertising or through being easily available through search or things like that. So when you think about the business's maybe gross profit or contribution, obviously the device provides zero, but it's critical to get people on there. How does the advertising versus the subscription compare in terms of size? Which one's bigger? Advertising is bigger. They haven't disclosed what the makeup of it is recently, but a couple years ago, they said that two -thirds of their platform revenues were advertising. One -third was subscription or on -demand. Advertising part of the business has grown faster, so I imagine that's higher today.

16:57They are largely an advertising business. People look at cable providers. They're often talking about number of subscribers, ARPUs, those kinds of things. Is that the way investors look at Roku? Is that the way you would look at is how many users they have, how much are they making per user? Is there some other mental model you use for the business? That's right. Yeah. It's how many active accounts do they have? What is the ARPU per those accounts? And then you can go through the different line items of costs, but their ARPU is trying to grow the revenue generation of those active accounts over time.

17:28That makes sense. So now they have the gross profit. What's below gross profit in terms of the major cost centers and what's important, what's not important below that gross profit line? Yeah. Historically, the management has targeted EBITDA break -even. They've always wanted to invest all the gross profits they have because this is a huge space where they're just trying to take advantage. It's in land grab mode right now. They're trying to grow active accounts. So they're reinvesting as much as possible and as much as reasonable. How do they reinvest it? Most of their SG &A are people. I think they said maybe three quarters of the SG &A are the people.

18:02It's the people that are engineering, the software engineers, which is in research and development. And then there's the sales and marketing. And those are the two big line items out of the three because the third one is administrative. R &D makes sense to me and the administrative. And then I assume they have a big sales force for selling ads to advertisers. How do they acquire customers? The old cable guys had customer acquisition costs and recurring revenue. Is that how you look at their business or is their marketing and the way they acquire customers different? They're infamous for not advertising Roku.

18:31So you won't see a Roku commercial saying, buy this device. Where they do put their advertising dollars or their marketing dollars is in the retailers getting the end caps because that costs money to do that. Or the team that builds out their displays and retailers, integrations they have with TV OEMs. So that's where they spend the money, but also with their sales team to get those direct advertising dollars or supporting their advertising technology platform. So that's where those dollars go to. From a customer acquisition cost standpoint, Anthony Wood would say they used to have a $0 customer CAC, but now it's negative.

19:07So let's say last year when they had a decent negative gross profit margin, it was like $10 per acquired user last year. But then you can bake into the marketing expenses and see how much it took to acquire those customers. But the sales and marketing, arguably a good chunk of that is fixed just to support their sales team, to get advertisers. And probably like a chunk is to grow out that team as they go internationally or try to expand into different areas. The question maybe that's coming up for me most is why have they won? Is it just price? Do you think the first mover in price, is that the two things?

19:38Or why do you think they're by far the market leader? The simple answer is that Roku has executed really well. I mentioned that Roku has a cost advantage and it's really easy to use, which drove early customer adoption. Roku did benefit from being early, but they actually weren't the first mover. The first mover was Apple TV, which launched in early 2007. The reason why Apple TV struggled was that they had a higher price point. They were about $300 at a time, and they eliminated the number of apps that were on their device. And then Roku launched about a year or so later, and they were maybe $100 at the time and were really good at getting all the available content on Roku and being very easy to use, which drove early customer adoption.

20:26A couple of years after that is when Google and Amazon entered the streaming device space. So Google came in with a Chromecast and they didn't have as much success because there was much more of a mobile focused device where they didn't come with the remote control and you really had to control how you access content through your phone, which customers didn't really like as much. Amazon came with their Fire TV stick and they did have a lot of success. They had a low price point. They were well integrated in the Amazon ecosystem. And so they did win a lot of adoption. And if you fast forward 10 years from there to the present, the streaming device space is split between Roku and Amazon Fire with each having about 40 % market share in the US.

21:11And then the remaining 20 % of the market share is really split between many different players. What's happening now is that the TV operating system is being integrated into the actual hardware of the TV. So while streaming devices initially enable TVs to connect to the internet, TV operating system battle is moving on to being in the TV itself. And similar to how phones became smartphones, TVs are becoming smart TVs. Really, they're computers. All TVs are coming with built in operating systems that run third party software. And there is the debate of whether the operating system dynamics are moving towards consolidation or fragmentation.

21:54But if you look at the history of computing, the natural economics of operating system is to move to a standard, to move to a few key winners. When IBM was selling their mainframe 360, they provided the operating system, which was a standard across all of the computers, which were largely IBMs. And then as computing became faster and cheaper and moved into the personal computer space, IBM decided to license the operating system from Microsoft in the 1980s. And then the other hardware manufacturers, OEMs, decided to license from Microsoft as well. And Microsoft became the standard. And IBM realized the power of owning the personal computer operating system.

22:33And they entered the space in the early 90s. It was already too late. Microsoft Windows already had the most adoption, the most applications. It didn't matter that IBM had greater scale and multiples of the R &D dollars compared to Microsoft. It's just that Microsoft was now the standard. The same dynamic happened with mobile phones where Nokia and BlackBerry had the largest market share in the early 2000s, and they had their own operating systems. But then eventually, Google came out with Android operating system, which was adopted by all the other smaller mobile phone OEMs. And those mobile phone OEMs stole market share, and they became the standard.

23:12And so the same dynamic is happening with TVs today, where TV OEMs, they have to decide, do they want to build their own OS, homegrown one, or do they want to license one from a Roku, Google TV, or Amazon Fire? What we have seen is the smaller TV OEMs that have licensed their OS from, let's say, a Roku have gained market share at the expense of the larger TV OEMs who have decided to not license them. So for example, TCL and Hisense went from essentially no market share in the US in 2017 to over 20 % by 2021. That's after they decided to license their OS from Roku. Vizio went from 30 % market share in 2017 to, I think it was the low teens by 2021.

23:57So that's the trends to date. And the question is, why is Roku being successful in their licensing of the OS as opposed to Google TV and Amazon Fire TV? Google was first to market. They started licensing their Google TV in 2010. When Roku started licensing in 2014 and Amazon more recently in 2017, Google has faced some hiccups with bugs and shifts in focus between focusing on Android TV or Google TV. And while the Google TV device market share isn't really available, Google TV streaming hour market share is only around 4 % in the US, which is pretty comparable to PlayStation and Xbox, which don't really have the best user interfaces and aren't really as focused done in the operating system.

24:42Amazon has also faced headwinds in licensing their Fire OS, which is largely due to Google. Amazon's Fire operating system is a forked version of Android's OS, and Google restricts major TV OEMs from licensing any forked version of Android, which includes Amazon. The TV OEMs have been hesitant to license from Amazon. And then the second major reason why Amazon has faced some headwinds is that major retailers who sell a large share of TVs in the US, largely like Walmart and Target, they view Amazon as their direct competitor. They're less inclined to sell Amazon TVs as opposed to Roku TVs, which makes TVOEMs hesitant to wanting to license from Amazon.