Motley Fool Hidden Gems Investing - Alphabet, Visa, Roku

Episode Date: October 26, 2022

Google's parent company disappointed Wall Street, but share buybacks continue. (0:21) Bill Mann discusses: - Alphabet being a strong business, despite recent downturns - Spinning off YouTube being an idea that doesn't make sense - Visa wrapping up the fiscal year in strong fashion - CEO Al Kelly being among those who do not expect a recession in 2023 (10:56)  Shares of Roku have fallen more than 75% year to date. Ryan Henderson and Jose Najarro engage in a bull vs. bear debate over the digital media player company. Companies discussed: GOOG, GOOGL, V, MA, ROKU, NFLX Host: Chris Hill Guest: Bill Mann, Ryan Henderson, Jose Najarro Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Hey Ontario! Come on down to BetMGM Casino and check out our newest exclusive, The Price is Right Fortune Pick. Don't miss out! Play exciting casino games based on the iconic game show, only at BetMGM. Access to The Price is Right Fortune Pick is only available at BetMGM Casino. BetMGM and GameSense remind you to play responsibly. 19 plus to wager. Ontario only. Please play responsibly. If you have questions or concerns about your gambling or someone close to you, please contact ConnexOntario at 1-866-531-2600 to speak to an advisor free of charge. BetMGM operates pursuant to an operating agreement with iGamingOntario. We've got Alphabet and Visa going in opposite directions,

and we've got a Bull vs. Bear debate over Roku. Motley Fool Money starts now. I'm Chris Hill. Joining me today, Motley Fool Senior Analyst Bill Mann. Thanks for being here. We've been banished to another part of the office. I like to think we haven't been banished. We chose this of our own accord. Let's start with Alphabet because it is really the dominant story in the market today. Third quarter profits and revenue were lower than expected. The only silver lining appears to be Google Cloud,

but Search, YouTube, everything else came in lower, and shares of Alphabet down 7% this morning. Which doesn't sound like all that much, but just to put things into perspective, that's something on the order of $20 billion, just poof. I'll be honest, Chris, it wasn't a terrible quarter from Google. I think because we think of this company as being the best business model ever created, that we sometimes give it credit for somehow having sorted out business cycles. This is the first quarter that they have ever had in which their advertising revenues dropped a little bit. They missed badly on the bottom line. They hired 13,000 new employees, which you have to wonder what those 13,000 employees were doing. But

the numbers from Google are still, they just seem like a cheat code. $69 billion in revenues for the quarter. Thank you for reminding everyone of that. Because there is a tendency, because of the size of the company, because of its importance, there is a tendency on days like this to overreact a little bit. This is not a business in trouble. There are questions about this business, and you pointed to one of them, which is, you know, for all the talk that Pichai has been doing about headcount, and he has been doing a lot of it, you know, even with this most recent quarter talking about how they are slowing the rate of hiring, they're still hiring, they're still adding. And I think there are questions

that really go to what you put your finger on there in terms of, what are all these people doing? Also, this was another quarter. I don't know what the answer is with YouTube. When I say that, what I mean is, for a long time, there have been people who have been saying they should spin it off, and there are other people making arguments, no, they need to keep it in-house, and here's why. I don't know what the answer is. I do know that this was one of those quarters that gave some ammunition to the people arguing that YouTube needs to be spun off. I actually think that that argument is crazy. I think that Google, I can't call it Alphabet, I'm sorry. I know they want us to call it Alphabet. I don't know what would be solved

by spinning it out, other than Google, which is already a cash flow machine, would monetize YouTube just a little bit. Google's issue is not that they're having any trouble at all generating cash flow. Now, I look at where they were this quarter versus the same quarter last year, an unbelievable deceleration in revenue growth from 41% to 6%. And it doesn't look like they have cost control. And I think at least partially that is the huge number of employees who are coming in. Now, I think that you have to give every company, even really big ones, a little bit of grace when there is a shift in external factors. you know they can't they can't turn on a dime so perhaps they were hiring for a 41 world and they

got a six percent world but it absolutely is something that they can they should and they will get to the bottom of i don't i don't know that i don't know that going to financial solutions like spinning off uh youtube makes any sense any more than just lock it down and figure out who needs to do what and what is profitable, what has potential, and then everything else ought not be done. If you are looking for a bullish sign with this business, I think you can point to the fact that Ruth Porat is still the CFO and they continue to buy back stock. Yeah, they do continue to buy back stock. Now, I don't give Google Alphabet full credit for buying back stock, because they do put out plenty of incentive stock options for employees.

So, we as shareholders don't get full value for it, but we don't get none. And in a world where they are generating as much cash as they do, they do have to do something with it. I would prefer a dividend. I think that Ruth Porat will get to the bottom of what's going on with Google. They did not become incompetent all of a sudden, and there are parts of their business that are still growing like wildfire in a very profitable way. Visa, on the other hand, wrapped up its fiscal year in style. Fourth quarter profits and revenue came in higher than expected. Their payment volume was up. They hiked their dividend. then they greenlit a $12 billion share buyback plan. Unlike Alphabet, shares of Visa are

up 6% today. Yeah. Visa hasn't gotten the memo that we're supposed to be going into a recession. Do they not read the papers? Not only have they not gotten that memo, but CEO Al Kelly said when they were doing their planning for 2023, they didn't factor in a recession. They basically said, we're not expecting it, and we are not planning for it. You know, Chris, when you think about a company like Visa, and I think about this a lot, and people have asked us what types of companies are inflation-resistant, Visa and MasterCard may be as inflation-resistant as any company that I know of, because they have something that's called a take rate, and it's about eight basis

points on the size of a transaction. So, the transaction size is what matters to Visa. So, if there is inflation, they are generating a larger cash return on the transaction than they would have a year ago, simply because that same transaction is slightly more expensive. So, yeah, I could see Visa not being particularly sensitive to an inflationary environment. Now, this is not to argue that they are completely resistant to it, because if there is inflation and if there is a recession, then transaction volume is going to drop. But this is a company that is still the circulatory system of global commerce. Zooming out from Visa, now we can put Visa in the camp of big, important companies

that are saying, no, we're not seeing a recession. There is another side where there are big, important companies and their executives who are talking about like, no, we are seeing it, we are planning for it. What's an investor to do in these situations? Because that was my first thought when I saw the comments from Al Kelly. I thought, well, okay, I guess we can put Visa on that side of the ledger of companies saying, no, there's not going to be a recession. We're not planning for it. These are serious people, Bill. You and I were talking earlier this morning, And I said, look, you can always find people who are willing to go on financial television every three weeks and say the sky is falling. You can always find people who are just permabulls,

everything is great all the time, no matter what. Jamie Dimon is not one of those people. He is not one of those people. Al Kelly is not one of those people. As you think through the question of, are we in a recession? Are we going to be in one? What do the comments from Al Kelly do to your thinking? This may seem like the dumbest thing that you've heard today. And we hang out a lot, so that probably is saying something. But do we have to have an opinion on this? I don't really know that the average investor or the average American, if you will, is particularly good at predicting recessions or predicting growth cycles. And if Al Kelly and Jamie Dimon are on opposite ends of the spectrum here, then what chance do we have?

So, when you're making investing decisions, I really actually do think that the best way to go about it, is not particularly worry about whether we are going into a recessionary environment, an inflationary environment, and simply assume that if it happens, like every other recession, we will come out on the other side. Bill Mann, always great talking to you. Thanks for being here. Thanks, Chris. When you're not listening to this podcast, chances are you spend at least part of your week watching streaming video. If you're like a lot of people, you're streaming your favorite shows through a Roku device. Ricky Mulvey has a bull versus bear debate on the digital

media player business currently facing a tough advertising landscape. Welcome to Bear vs. Bull. We find a company, get some analysts, flip a coin to see which side they'll take. Today, the company is Roku. They sell digital media players for streaming. It's also an advertising business. It's also apparently a smart home camera business. I've been struggling, down 80% this year. On the bull side, we have Ryan Henderson. Ryan, good to see you. Good to see you too, Ricky. I'm looking forward to this. Likewise. And taking the bear case is Jose Naharro. Jose, thanks for joining us today. Thank you for having me, Ricky, and I'm super excited for today's episode. All right. That is enough setup. Let's get it started.

Ryan, you've got the bull case. Five minutes is yours. All right. So, the Roku bull thesis essentially rests on its position in the CTV space, which is a really promising industry. They've got a lot of tailwinds behind them. Especially in the U.S. and Canada and North America broadly, more and more people continue to switch to streaming. I believe right now, it just crossed 50% in the U.S. The trend is quite clear that it's probably going to go towards 100% over time. Roku is the leading connected TV platform in the U.S. and Canada by quite a wide margin. I think they're seeing great adoption in Mexico as well. The U.S. and Canada make up the majority of their active accounts. Over the last decade, everyone seems to be,

especially in North America, as I mentioned, shifting away from linear TVs to streaming. Roku has really captured the audience. Since the third quarter of 2016, Roku's total number of active accounts has gone from 11.3 million to 63.1 million. Additionally, Roku has seen an increase in usage among those accounts. I believe five years ago, roughly, they were streaming about two and a half hours a day, the average account. Today, it's about three and a half, so about an hour more a day than five years ago. You've got the combination there of increasing number of users and then increased engagement. They've also shown an ability to better monetize those users as well. Roku's average revenue per user is up 4X from

what it was in Q3 of 2016. Between the growing user base, the increased engagement, and their improved ability to monetize the users, Roku's platform revenue, which now comprises the majority of its top line, has increased nearly 20X in the last five years. Clearly, they have been right there to benefit from this trend. However, they haven't quite seen the operating leverage or inflection in profitability that most investors probably would have expected because the cost increases that they've seen on the hardware side. As a lot of people know, they're basically selling their players at a loss. They are selling them at a loss, negative gross margins, because they believe the lifetime value of those users is going to exceed the losses on that initial sale of the

hardware. I think they're right. Ultimately, what Roku's returns, I believe, are going to come down to is not only how the industry evolves, but how much money gets poured into streaming. It's clear that companies are pouring more and more of their investment dollars, a lot of these content companies, into the streaming world. Netflix even highlighted this on their last quarter release. They said, our competitors are investing heavily to drive subscribers and engagement, but building a large, successful streaming business is hard. We estimate that they're all losing money with combined 2022 operating losses well over $10 billion versus Netflix's $5 billion to $6 billion annual operating profit. This isn't meant to be a

Netflix pitch, but as that money gets invested into content for streaming, Roku benefits in a ton of ways. First off, and this one's probably pretty obvious, the more content that's available to consumers, the more time they'll likely spend on the platform. That means more room for ads, more time for Roku to monetize those users. Secondly, the two leading services in terms of streaming market share are Netflix and YouTube. From what I understand, Roku's original contracts with Netflix and YouTube don't really generate that much revenue because Netflix and YouTube had all the negotiating leverage. You needed them on the platform. They generate a negligible amount of revenue from their two leading streaming services. However, as the industry gets more

competitive and more content comes out from the players of HBO, Paramount, other providers, other suppliers of content. The negotiating power for Netflix and YouTube gets muted, and Roku can finally get better contracts with those. I think you're probably going to see that when Netflix rolls out its ad-supported channel. The other two I'll mention, advertisers are slow to switch. Right now, I believe at the end of last year, 45% of adults in the U.S. ages 18 to 49 were choosing streaming. Only 18% of advertisers' TV ad budgets were on streaming. There is a disconnect there, I believe advertisers will switch over time. Last one, Roku makes money when someone subscribes to a service through their platform. As things

get more competitive, I see churn increasing. People will end and restart their subscription more often as there's more alternatives. They'll be likely generating greater referral revenue from that. Right now, to boil it down, Roku generates about $3 billion in annual revenue. At their peak, they were generating about 17% EBITDA margins. If they can get back to those levels, and I think they can, they'd be generating about $500 million in annual EBITDA. That assumes no growth from today. Really, they don't have to do anything to grow. There's going to be some natural adoption just because everyone's shifting to streaming. That's real conservative. Their current enterprise value is $5.6 billion. If you think they can get

$500 million in annual EBITDA. You're paying roughly 11X theoretical profits. I think that's a really fair price to pay for what seems to be this perfect blend between hardware and software, and the world where a lot of people are shifting to. Ryan Henderson, thank you for the bull case. Up next, we have Jose Naharro with The Bear Case. Thank you, Ricky. I do want to say, for The Bear Case, the first thing is, the company's trying to hit numerous markets at once. The hardware, the platform, and the original content and all these markets have numerous headwinds affecting the company right now and for a growing company like roku it can cause much stress to management which can lead

to long-term mistakes especially if management focuses too much on short-term shareholder pleasing moves for example if we take a closer look at the share of the original content this takes time to build and it's not something that's gonna provide results it might actually just flop and it's also very expensive to do on the platform side at the moment there are numerous headwinds in the advertisement side that we're seeing globally that can obviously impact the overall numbers for Roku on the revenue side. Finally, the hardware side is prone to inflation, cost of goods increase, and also consumer spending is in question right now, which would cause a decrease in adoption of connected TV. The hardware market is also one with very low margin and the company

continues to double down with recent addition to things like soundbars and other audio solutions. Same with the international market, growth is heavily dependent on connected TVs, but network infrastructure might not be set up properly in certain international countries or the consumer demand is not there. Outside of that, the company is seeing a huge balloon in expenses. For example, sales and marketing increased 97% year-over-year in the most recent quarter. Research and development also increased 74% year-over-year and have caused income loss from from operations in the last two quarters the final thing i do want to mention is even though we

are seeing a kind of a back to trend into streaming streaming hours are decreasing sequentially in the most recent quarter was one of the first few quarters the company saw a decrease in streaming hours and this is something investors should keep an eye on so like i mentioned even though some might say that hey hitting all these markets at once might be a very bullish case i think sometimes hitting all these markets at the same time can kind of overwhelm management. And if they make a wrong move, it can overall slip up how the company does at the end. Jose Naharro, thank you for the bear thesis. Big move to acquire the Quibi library. But anyway, you can decide who made the better argument for today's bear versus bull on Roku at Motley Fool Money on Twitter.

Today's lucky winner will receive a working Netflix login. The Lewis family has an empty profile remaining on their family's Netflix account. They're willing to share their login info with today's Bear vs. Bull champion. Enjoy Netflix original movies, reality TV shows, and a dwindling selection of licensed content. It's an entertainment paradise. But wait, there's more. The Lewis family tends to use the same password for all the websites they visit, and this login probably works on Disney Plus and HBO Max. Give it a go on Hulu. You might pleasantly surprised. All of this could be yours if you win, bear versus bull. As always, people on the program may have interest in the stocks they talk about,

and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening. We'll see you tomorrow. Thank you.