Author
Joel Espelien
Date
September 5, 2017

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Welcome back from Labor Day. An interesting story as the summer of 2017 comes to an end. Roku filed for an initial public offering (IPO) on September 1, shining an interesting light on a long running story in the streaming video space.

What does the Company’s S-1 filing tell us about both Roku and the future of TV?

A few thoughts….

1. Hardware Is Not A Business
Roku was founded in 2002 and first shipped a streaming box (i.e., an iSTB) in 2008. In the early years, Roku attempted to compete purely as a hardware play. It was all about the box. But even Roku knew this wasn’t a viable long-term business, as it concedes in its most recent S-1.

We are strategically decreasing our streaming player average selling prices, or ASP, to expand our active accounts, which will also reduce our player gross margin. As a result, our player revenue may not increase as rapidly as it has historically or at all, and, unless we are able to adequately increase our platform revenue and grow our active accounts, we may be unable to grow gross profit and our business will be harmed. We expect to continue to make tradeoffs away from player gross profit in favor of platform gross profit to grow active accounts more rapidly and increase monetization.

In plain English, this means that Roku now (finally) admits that selling boxes is not a sustainable business model and it now intends to sell them at (or below) cost in an attempt to grow the user base.

This is both correct and also a problem. It is correct insofar as it is better than the former alternative of trying to monetize a completely commoditized product. It remains a problem in that Roku will incur real costs to design, manufacture, ship, and provide ongoing updates to its boxes (although BOM cost is nowhere mentioned in the S-1). This is true even in the case where Roku licenses its Roku-OS software to third-party smart TV makers. This means that Roku’s CAC (customer acquisition cost) must include both its actual marketing costs as well as any losses that it incurs in attempting to subsidize the boxes. Given the capacity (and willingness) of Roku’s competitors (in particular the Big 4: Amazon, Apple, Google, and Microsoft) to endlessly subsidize their own streaming boxes, this could be a tough row to hoe going forward.

Monetizing Third-Party Content Is Sort Of A Business
Roku is now thinking in terms of active users and ARPU (annual revenue per user). The company current has roughly 15 million monthly active users who collectively streamed 6.7 billion hours of video in first six months of 2017. The company generated $81 million dollars in revenue from these users over that period via ads, app placement, and the like, amounting to $11.22 in annualized revenue (roughly $0.93 per month) per active user.

These certainly look like fairly healthy numbers and Roku deserves a great deal of credit for sticking with it and building a loyal user base that clearly consumes a lot of video on the platform.

Before anyone gets too excited, however, let’s put those numbers in perspective. As TDG has reported in many of our syndicated reports, total US video viewing is more than 100 billion minutes per day. Translating the math, this equates to more than 300 billion viewing hours every six months. In other words, Roku’s share of the total US video viewing market in the first half of 2017 was roughly 2%. Just as importantly, $81 million dollars spread over 6.7 billion hours means that Roku is making just over one cent per hour of video viewed on the Roku platform. How is this possible? Why so low?

The answer is obviously that Roku still faces enormous obstacles when it comes to monetization. The most popular channel (by far) on Roku is Netflix, which by the company’s own estimation comprises one third of all viewing on Roku devices (i.e., more than two billion of the 6.7 billion hours). Unfortunately, Roku’s revenue from Netflix viewers is –- wait for it –- zero. This is true not just for Netflix, but for all of the SVOD apps on Roku that account for 3.8 billion viewing hours.

In fact, given the importance of Netflix to the Roku platform (and the fact that Netflix users have a zillion other devices on which to access the service, including pretty much every single smart TV ever made), it seems like Roku needs Netflix more than Netflix needs Roku. And Roku’s current app distribution deal with Netflix expires in the next 12 months. Could Netflix actually demand payment from Roku (i.e., a negative revenue share) to keep its app on the Roku platform? It’s possible, and a lot more likely than Roku ever receiving a dime from its Los Gatos neighbor.

This still leaves 2.9 billion hours of video for Roku to monetize. Still pretty great, right? Well, sort of. The problem is this little bitty app called ‘YouTube’ is the single most popular AVOD app on Roku (and likely by a large margin), from which Roku receives no revenue.

Assuming YouTube (and other AVOD apps for which Roku receives no payment) account for another two billion viewing hours, which seems like a pretty safe assumption given YouTube’s continued dominance of that segment, this leaves less than a billion viewing hours for Roku to monetize. Using the same $81 million referenced above, this amounts to about $0.09/hour in revenue for AVOD video on the platform -— an excellent example of what Jeff Zucker of NBC famously meant when he commented that the industry is trading “analog dollars for digital pennies.”

The bottom line: Roku monetizes a very small portion of the video viewing on its platform, and a good chunk of that is remnant inventory that the AVOD provider couldn’t sell itself. Only the smallest (and weakest) AVOD providers are letting Roku serve as their main ad platform, which will never generate much in the way of revenue.

Like Everyone Else, Roku Probably Needs To Become A Premium Content Brand Going Forward
So what should Roku do? The answer seems obvious, at least in theory. There’s only one type of content that reliably monetizes, and that’s high-quality originals. Just ask Netflix, HBO, Hulu, and others now competing in this space. Roku is never going to get anywhere living off of the scraps of the streaming video industry. Roku should invest in original content, promote that content heavily to its 15 million active users, monetize said content via both ads and subscriptions (i.e., freemium), and let the chips fall where they may. If it worked, Roku would suddenly have a real reason for viewers to pick its platform over others, an additional way to grow viewing hours, and (most importantly) a way to finally monetize all of these eyeballs it has worked so long and hard to attract.

In practice, however, original content is a very expensive game. Remember, Apple just allocated $1 billion to original content for 2018, and that’s just as an experiment. Even as a public company it’s not clear Roku has a strong enough balance sheet to play this game.

Conclusion
Streaming video is a tough, tough business. To date, a small group of companies (comprised of Netflix, the Big-4, Facebook, the big mobile operators, and the strongest content companies) make essentially all of the money. Everyone else is just fighting to tread water.

Roku is a tough, scrappy company that has shown admirable persistence even if it has never quite figured out a business model. We wish them well.

Stick with TDG and stay ahead of the curve.

Joel is a Senior Advisor for TDG and serves as an advisor and Board Member to the video ecosystem and technology companies. He lives near Seattle, WA.

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