Shareholders are probably tired of hearing it — I’m a shareholder and I know I’m tired of it — but it still needs to be said: shares of the connected TV platform company Roku (NASDAQ:ROKU) are down almost 90% from the highs reached in 2021. It hasn’t been a fun ride in recent years and there are fundamental reasons why the stock is down.
One of Roku’s biggest problems is its gross profit — how much he earns after deducting the direct costs of his products and services. The company’s hardware devices (smart TVs and plug-in streaming devices) cost more to make than they are sold for. Furthermore, the Gross margin for its operating system software has declined steadily in recent years.
Another problem for Roku is its operating expenses, which have continued to rise. In the first quarter of 2024, the company reported total operating expenses of $460 million, up 83% from its total operating expenses in the same quarter of 2021. In comparison, its net revenue total increased by only 53% during this same period.
In summary, Roku’s gross profit margin is falling and its operating margin is also falling – it’s a truly troubling combination and it’s not surprising to see the stock falling in the dumps.
However, investors might be shocked to find that Roku’s free cash flow is at an all-time high.
Since free cash flow is up and the stock price is down, Roku’s price-to-free cash flow valuation is cheaper than it has ever been. And Roku stock isn’t just cheaper than in the past; its valuation of 20 times free cash flow is also considered quite reasonable on an absolute basis.
Here’s what investors should know about Roku’s cash flow.
Roku’s Free Cash Flow Increase Explained
Some investors prefer to monitor a company’s free cash flow relative to its bottom line because net income can include non-cash accounting items. In contrast, free cash flow represents real money flowing in and out of the business.
Roku’s free cash flow is at an all-time high, although I explained the long-term trends with deteriorating profit margins. Margins are down, but revenue has continued to rise as the company attracts new users and those users spend a lot of time streaming videos on the platform, increasing ad impressions.
More importantly, Roku has demonstrated some operational discipline recently. In the first quarter, the company’s operating expenses fell 16% year-over-year; this sharp reduction in expenses helps increase cash flow.
However, Roku management also uses stock-based compensation liberally: in other words, its employees earn Roku stock as part of their compensation. This is a non-monetary consideration, so it preserves cash flow. However, it’s still an expense, so it still impacts net income – which is why there’s such a disparity in Roku’s case.
I wouldn’t say that Roku’s use of stock-based compensation is necessarily good or bad – it simply is. And investors should be aware of this.
To summarize, Roku’s revenue is up. And while some profit margins are contracting, which is concerning, its free cash flow is increasing as the company gets some control over its expenses. While there are legitimate concerns, there are also reasons for optimism.
What’s next for Roku?
The real question is whether Roku’s free cash flow can grow any further. And I believe there is reason to think that it is possible.
In the first quarter, Roku’s average revenue per user (ARPU) was virtually unchanged from the year-ago period. But streaming hours per user have increased. This indicates that advertisers aren’t paying as much for placements in Roku’s system. But I think this problem is temporary.
I think this is temporary because Roku’s capabilities are clearly improving. It has partnerships with retailers that can directly correlate advertising with purchases. And some Roku ads can be purchased with the click of a remote, reducing friction. It may only be a matter of time before advertisers start paying for a chance to get in front of Roku’s audience of 82 million households.
If bidding for Roku’s ad space becomes more competitive, as I believe it will, then Roku will generate more revenue with the same volume of business. This would be a tremendous increase in revenue and profits. And the company’s free cash flow could thus reach new heights.
This is not a guaranteed outcome for shareholders and Roku still has a lot of work to do. But it’s certainly a possible outcome with potentially significant stock price implications, which is why I’m still holding Roku shares for now.
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Jon Quast has positions in Roku. The Motley Fool ranks and recommends Roku. The Motley Fool has a disclosure policy.
Surprise: Roku’s cash flow hits record high. Here’s what investors need to know. was originally published by The Motley Fool
