Motley Fool Hidden Gems Investing - Should Netflix Buy Roku?

Episode Date: June 8, 2022

Is Roku really preparing for a takeover bid from Netflix? (0:25) Asit Sharma discusses: - Whether acquiring Roku solves Netflix impending ad challenges - Why Roku's stock is still pricy after its recent fall - DocuSign's expanded partnership with Microsoft - If this paves the way for an eventual acquisition (13:21) Deidre Woollard talks with Jason Hall about why he's so bullish about homebuilders and the tailwinds driving his thesis. Stocks discussed: ROKU, NFLX, DOCU, MSFT, ADBE, CRM Host: Chris Hill Guests: Asit Sharma, Deidre Woollard, Jason Hall Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. We've got a partnership, a potential acquisition, and the bull case for homebuilders. Motley Fool Money starts now. I'm Chris Hill, joined by Motley Fool Senior Analyst, Asit Sharma. Thanks for being here. Chris, thanks for having me. We're going to start with one of my favorite mills, and that's the rumor mill. Shares of Roku are up more than 10% this morning after a Business Insider report that says Roku employees are discussing inside their headquarters a potential takeover bid from Netflix. Let's just put this in the category of smoke. This is a not insignificant amount of smoke, especially

when you consider the stock movement of Roku, remains to be seen if this is going to lead to fire, and by that I mean an actual takeover bid by Netflix. But when you saw this news, what was your reaction? Chris, I wasn't too surprised by this. If you'd asked me this a year ago, I would have said, nah, Reed Hastings, the CEO of Netflix has always been about the streaming. He's had so many opportunities to get into the device world, just shown zero interest. But look, Netflix is at a crossroads. They've built this amazing content powerhouse. At the same time, they're struggling with new paid subscribers. That's come to a screeching halt. Of course, there are some factors behind

They have seen a drop-off in Russia, of course. And we've got people who found out they like the outdoors after COVID, so they want to spend a little less time on Netflix. But Netflix does have a longer-term growth problem because the competition has become so fierce between Disney and other platforms. So, this is a chance potentially to get into one part of the market, which lots of investors have asked them about over the years. Why not get into advertising? They could potentially acquire Roku and be able to study. As they pull in that advertising platform, they could study a lot about competitors and where consumers are watching ads. They have an instant access to ad revenue, but also for the day they introduce it on the Netflix platform

itself. They can be smart about it. I'm not terribly surprised now given where we are. If you look at it from Roku's side, they're struggling too because they are partly a device player. They're having all kinds of problems with supply chain. Device sales are falling off. They can't meet demand in some cases. Nonetheless, Roku is growing its base. They have huge subscriber numbers. They're doing very well in their business with advertisers who spend a million plus a year. They retain somewhere upwards of 95%, 96% of those customers. There are some interesting ways this deal makes sense in a way it didn't make sense a year or two or three years ago. I mentioned the stock movement of

Roku this morning. This is bouncing off of a little bit of a bottom here. Even with the movement today, shares up more than 10%. Shares of Roku are still down somewhere in the neighborhood of 70% from their high. It's a $14 billion company. Whenever we talk about Netflix, at some point, we get around to how much they are spending on content every year. This would be a not insignificant chunk of money that Netflix would have to put forward to acquire Roku. Maybe they just do it with stock instead. But I would be remiss if I didn't mention the shares of Netflix are up 3%. I'm wondering if this is Wall Street's way of just encouraging Netflix like, if you guys aren't thinking about this, maybe you should. Which leads

me to this question. We know an ad-supported model is coming on Netflix. Does this in one fell swoop solve that challenge for Netflix? It doesn't solve the problem for Netflix, but it does get them a long way towards having the answer to the problem. If you take a look at Roku's growth, the device portion of their business has been less and less relevant. Even before the pandemic, it was slowing down relative to their platform growth, which includes all that advertising revenue. They've mastered the art Roku has of understanding when and where to place ads. They work very closely with their advertisers. They have a lot of data and metrics behind advertising efficacy. Netflix can really pull that out. It's not

going to solve their problems overnight because part of the issue for Netflix isn't going to be solved by going overnight to an ad-supported model. They're still going to have to figure out what's the right amount to spend on content and where. For a while, Netflix didn't care what size checks it wrote for content development, and now they're having to manage that business more carefully. We've seen them not renew some titles that we thought would be renewed, and also they seem to be a little more stingy, and I like this, with their dollar in terms of hiring and what they're paying employees. There are a number of problems that Netflix faces, none of them unsolvable. But yeah, this gets them much of the way there.

We'll just keep watching. We'll see if we get more smoke later in the week and possibly later in the month. Let's move on to DocuSign. DocuSign reports after the closing bell on Thursday, but shares are moving up a little bit today after the company announced an expanded partnership with Microsoft, basically integrating DocuSign's technology into Microsoft's software applications. I'm sure Microsoft, given the size of the company, got terms that they liked with this deal. But for DocuSign, it's probably good to have a partner of that size. I think it is. It's good news for DocuSign. They have had a partnership with Microsoft that's been leading up to what looks like a more formal relationship now. It's pretty much

the second phase. You test the waters with each other. Microsoft likes what it can get out of DocuSign, which makes them more able to compete with platforms like Adobe, which, of course, has its own e-signature product. What's interesting about this from DocuSign's perspective is that they've always seen their total addressable market as being split down the middle between the e-signature business, which is an easy sell for them, and their agreement cloud business. The agreement cloud is a platform that DocuSign built from scratch to try to make something very important. That is the process of signing an agreement, then following the terms of that agreement, re-upping if you need to after several years. They want to make that as important as HR

or enterprise resource planning to corporations. This is something the market has been excited about for a while, but in recent quarters, DocuSign just hasn't been able to get the momentum out of selling the agreement cloud to corporate customers that many observers and investors thought they would. The stock has suffered. DocuSign got this huge pull forward during the pandemic. They were one of the stocks that I put in a rarefied air. I think they were up like 400% from 2019 levels. Then boom, COVID and the pandemic normalized a bit, and then you had this effect where investors were wondering, are they really going to be able to grow this agreement cloud business the way we thought they were?

helps a little bit in that direction, this agreement, because it gives them a broad reach, it gives them a lot of credibility to other enterprises. So, maybe investors who walked away from DocuSign and left it like 70% plus off its all-time highs, take another look this morning. How pricey is this stock? Because as you said, you can look at this and say, well, look, This is a business, I think anyone who's ever used DocuSign, particularly if you've used it more than once, you see the attraction, and it seems like one of those businesses that is here to stay. The stock down more than 60% over the past year. They had that pull forward early in the pandemic. It has come back from that. When you look at the stock right now heading into earnings,

does it seem pricey to you? Well, DocuSign is interesting because it's a company which looks a little light on the income statement. But if you flip over to the cash flow statement, you see that there's a lot of stock-based compensation in there. They're giving a lot of stock to employees. So I evaluate them on their cash flow. In their last 12 months, this company had about $440 million worth of free cash flow. It's a really strong cash flow generator. But on that basis, it is still pricey. This company trades at roughly 40 times its free cash flow. It's not cheap. Even after all this decline, it's not a cheap stock. But at the same time, this reflects the fact that many investors still see the

potential for just a high rate of growth, and if they ever do get traction selling the agreement cloud to enterprises, they could sustain that growth at a very fast rate for years to come. There's a lot of potential still embedded in this stock. Just the valuation got crazy last year, year before, and now it's come back to something that's more of a proposition, it's going to be centered around its earnings. Over time, we'll see that stock-based compensation decrease a bit, we'll see more earnings hit the bottom line, and about the cash flow growth. I think this is a company that, even though it looks like it's battered and it still looks expensive, is worth taking a look at. I could see it doing pretty well

from these levels. Not to say that it couldn't take another dip, but it's not as dire as the stock chart might indicate. Do you think there's any chance that Microsoft is taking a closer look at DocuSign? Do you think that there's any chance this expanded partnership is prelude to Nadella and his team saying, we like how this is going. company that is not afraid of big acquisitions, and a year or two down the line, Microsoft acquires DocuSign? I think that they would be wise to at least glance at that future. The reason is that the agreement cloud gives Microsoft the ability to compete with a number of players in different fields. It helps them compete

with Adobe. It also helps them have almost a salesforce.com element in their Microsoft Teams offerings. This product is going to be embedded in Microsoft Teams, which is becoming just a nice behemoth competitor for any company, small or large, that needs to have employees collaborate. With this, you up the ability of small teams that collaborate to sell product. make it easier on sales teams for companies to close deals. It's just a fun piece to think about integrating into Teams and across some of the other Microsoft offerings. It makes a lot of sense. It's not a bad fit. You're so right. Microsoft has unlimited resources in terms of market capitalization if they want to do a stock deal. Speaking of having

deep pocketbook and writing a check, I mean, penny change, pocket change for Microsoft. They would be remiss not to at least envision a future where they just snap the company up outright. Asit Sharma, great talking to you. Thanks for being here. Thanks so much, Chris. Today, we're kicking off part one of a two-part conversation. Motley Fool contributor Jason Hall recently made the comment that when it comes to industries he's feeling bullish about, homebuilders are one of his highest conviction ideas right now. So Deidre Willard caught up with Jason to talk about the tailwinds driving his thesis and how homebuilders could fare

against rising interest rates. Hello, I'm Deidre Willard, and I'm here with Motley Fool contributor, Jason Hall. Jason and I have spent a lot of time thinking about homebuilders, talking about them back and forth on Twitter. I'm excited to talk to you today. Welcome, Jason. Yeah, I'm excited. As you know from a recent tweet storm of mine, this is a really compelling area for me right now. Yeah, totally. Let's start with the basics on it. You and I have talked about this. We just need more housing in this country, but we don't build enough of it, and we've got this big problem. What are the fundamentals underneath all of that?

This is a problem that's really, I guess you could say, a dozen years in the making, certainly a decade in the making. Coming into the global financial crisis, we've got to go back to the beginning here. 2006-2007 period, there had been a multi-year housing boom. Homebuilders were making hay. Everybody was buying a house. Everybody was buying a second house. A lot of people were buying a third house. It just became like in the popular consciousness, there was this sentiment that owning homes was this guaranteed way to get rich, right? So the movie, The Big Short has been very popular. Of course, the book I think is even better in more depth. If you haven't seen the movie or read the book, I encourage you to do both.

At any rate, we ended up with just all of this excess housing, and much of it was paid for with sustainable financing. A seemingly innocuous and unrelated series of events ended up causing, or maybe being caused by, this tsunami of defaults that took down the global financial market. right? It just was, um, record foreclosures. And then we have the worst economic crisis in eight decades that occurred, right? So this, this happens. And then all of there's all of this, what's the aftermath, right? There's the financial aftermath of so many people that were affected, um, investors and banks and, and all of, all of that. But there was all this excess inventory

sitting on bank balance sheets, um, that had to be sold through in so many markets before homebuilders could even think about starting to recover. We have this multi-year period with all this excess inventory. Nobody was building new houses because there were too many already. It was too much supply. At the 2006 peak, just to put the homebuilding industry in perspective, new housing starts were just under 2.3 million. That's multifamily and single family, both. It was just under $2.3 million. By early 2008, a year and a half later, it was barely $1 million. By 2009, it was less than a half a million. It's this massive, massive crash. Now, during the same period, existing homes for sale peaked at over 4 million units.

And we're still above $3 million in 2009. A lot of that is people that are still making the payment that are trying to sell that house that they can no longer afford, plus all of that excess inventory that had already been foreclosed, was flooding the market and builders couldn't build. There was no need to build. To put that into another metric to help understand the overall health of supply and demand, existing home supply was still more than six months in 2012. So six months is an important benchmark that's considered plenty of supply. Here's the thing. Again, this was a terrible environment for home builders for multiple years. Basically, everybody had to downsize significantly. Housing starts, I mentioned that half a million unit, but I want to put it in

more context. So in 2009 is when it fell below 1 million units. It did not pass 1 million units for six years, right? So we spent six years with a build rate that was far lower than our historical average. Now, again, a lot of that was all of that excess inventory from the years leading up to the housing crisis, the global financial crisis that had to be sold through, Right. So, but as a result, the home builders that, that survived, that came through this, they pivoted, right. They, they shrank and they focused on luxury homes. They focused on custom homes because that's where there was still an opportunity, right. That's a place you could still build, but most had shrunk significantly. And this is a labor intensive industry. So as a result,

many skilled workers, a lot were older, right. A lot just retired and a lot moved on to other industries. And over that period and continuing through now, really, we haven't seen a lot of young adults that have entered into the skilled trade profession, uh, professions at anything like the rate of, um, demand for those professions. And that's really been the story for much of the past decade, you know, overlapping, overlapping with that builder collapse. You put all that together. And what you have today is because of the necessity is to stop building. And then the change in the business model for a lot of builders, the lack of skilled labor and the slow build in demand. Now we just don't have anywhere near enough houses. The past 10 years, we've built

the last 12 years, really going back over the past five decades, plus we've built fewer houses than any other comparable period of time. Absolutely. Because we've got another situation too, which is, you mentioned briefly there, inventory on existing homes running around two, two and a half months. It's been below that six-month benchmark that you mentioned for just about a decade. And so, we don't have enough homes. Part of this is we sort of thought that people would age and move, and they didn't, and people are aging in place. You've got the biggest generation of people, millennials, hitting home buying age with no homes to buy. And that's another factor as well. But something interesting is happening with new home sales. And

new home sales, they represent on average around 10% of the market in total. But last month's new home sales, the number for April, it was down by almost 27% year over year, down 16% month over month. I'm thinking that was interest rate sticker shock. You and I talked about it a little bit before, but what are you thinking about that going forward? And all these home builders that are starting to feel really optimistic, their sentiment, according to the index every month, is just starting to waver a little bit. Is this temporary? Yeah, I think so. And it's one of those things where, number one, we see this happen when interest rates rise, right? Because the Fed usually kind of telegraphs, we're going to be raising rates, right? They kind of make noise

that it's going to happen. And we'll see a surge in interest and activity before that. And then when it happens, there's a pause. There's a pause in activity as buyers readjust to the new rate. But I think the thing that's important in this case, this is rate shock. Because we saw rates nearly double from last summer through this spring. The 30-year mortgage rate, less than 3% in a lot of cases to now 5%, right? It's an enormous change. At the same time, prices continued to rise. So, right, the net effect of housing, the cost to the buyer surged, right? So, there's that. But I think we also have to remember, in these cases, it's rarely just one thing. And one of the things that's happened over the past

couple of years, you and I've talked about it numerous times is how quickly demand for housing just shot up. And we have seen the persistent decline in existing homes for sale. So home builders have just blasted through their inventory of prepped land. A good home builder can build a house in a month, right? They can, they can get a house up quickly, but you can't do that if you don't have land that has streets, and sewers, and telecommunications, and water, and all of that infrastructure. That takes like a year, right? So, we're at this position now where there's a lot of builders that would love to be building more homes, but they can't because they're waiting on the land prep process to play out so then they can actually complete houses.

So, I think we're seeing a little bit of that normal pause. The effect of two years of hyper-aggressive consumption of that land that was ready, right? The absorptions are just incredible and the communities that have been built. And we're just having to kind of take a little bit of a pause. I do think it's going to be temporary. And I do think maybe we will see a little bit of a moderation in prices, but I don't think we're going to see prices decline. Yeah, I think that's true. At one point last year, the median existing home sale price and the new home existing home sale price were pretty close together. Now, median existing home price is around $391,000. Median new home is around $450,000. So, they're separated again. But I kind

of want to talk to you also about where these companies are building. I think that's really fascinating. We've talked before, and other Fools have talked about, Sunbelt migration. This is this massive trend sped up during COVID, but really this decades-long trend. I was looking at Redfin report that came out this week, where are home builders building? And it's all that. It's Austin, it's Raleigh, North Carolina, and the Research Triangle. It's Jacksonville, Florida, Nashville, Phoenix. Some of these names, though, are the names of places that were a problem during the great financial crisis and some of the places that really got hit hard, it's starting to worry me a little bit. Are you thinking about that, too? Is there any potential for overbuilding?

Yeah. I think anybody that tells you that there's not a risk of overbuild is either lying to you because they're trying to sell you something, or they've just never been through a housing cycle. It's been more than 10 years, and there's a lot of people that didn't go through that in the past. There's always a risk of overbuilding. So, I think about those markets, and I think a good proxy for really understanding where the inventory situation is, is looking at the rents. And look at how much rents have increased in a lot of those markets. And a lot of those same markets, we're seeing rents continue to increase at double-digit rates. And what does that tell you? There ain't enough housing, right? And I think that does create some margin of safety

for builders who are focusing on those markets, because those are definitely the markets that we also talk about as ones that are the most interesting for home builders that are looking to grow. All right. Well, that's all the time we have for now, but I want to continue this conversation, so let's pick it up next time. Tomorrow, we're going to bring you part two of that conversation. 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.