NFLX

Here's What It Really Means If Netflix Tries to Buy Roku

Streaming video service Netflix (NASDAQ: NFLX) might be trying to acquire connected-TV (CTV) platform Roku (NASDAQ: ROKU), according to rumors that have surfaced in recent weeks.

For now, it's just a rumor, but Netflix has good reason to make a deal like this happen. Video content is becoming commoditized, and Netflix's recent moves suggest it recognizes the need to pivot quickly.

Here's what's happening in CTV

Something monumental recently happened in the CTV space. According to Roku's first-quarter letter to shareholders, 65% of adults aged 18 to 49 in the U.S. were streaming video content in March, compared to just 63% in that age group watching traditional pay TV like cable and DVRs. For the first time, there were more streamers than nonstreamers.

The shift to CTV is a great secular growth trend that investors should pay attention to. But there are two kinds of streaming: paid subscriptions and ad-supported channels. And while streaming in general is the future of the industry, paid streaming services like Netflix are facing a very real headwind.

According to a recent report by market researcher Parks Associates, 32 million households in the U.S. can be described as service hoppers. They switch services frequently and resubscribe to services they had previously dropped.

This suggests there was already a limit to how much consumers would pay for streaming in aggregate. And now, discretionary income is getting squeezed further by inflation. The average consumer is spending about $180 more per month on gasoline alone this year compared to this time last year, according to Yardeni Research. Therefore, consumers must cut spending somewhere, and perhaps it's the money going to paid streaming services.

Indeed, research group OnePoll did a survey for the ad-supported streaming service Tubi. The survey found the average consumer has five streaming services but plans to drop three of them soon. Around 70% of those surveyed said changes in their personal finances were the primary reason for the change.

The challenge for Netflix

Netflix started the streaming revolution, and shareholders enjoyed life-changing returns while it was the only show in town. But with more competition, it's harder to attract subscribers. And in the most recent quarter, Netflix lost subscribers for the first time in over a decade.

You need more compelling content than the other guy if you want to gain and retain subscribers. But generating quality content comes at a price; the company already spends billions annually on original films and series. As the 800-pound gorilla in the space, Netflix has more to spend than most competitors, but it might have to spend even more to stay on top.

Spending more strains the bottom line. That's OK if a company can simultaneously raise prices, but it's fair to question how much pricing power Netflix has left to preserve margins. It can't be overlooked that the company announced price increases in January, shortly before a small decline in subscribers. For service hoppers, maybe it was time to jump Netflix's ship.

This is what happens when something gets commoditized: Pricing power decreases, and profits ultimately erode. This is the challenge Netflix is now facing.

Why I (still) love Roku stock

To reiterate, the shift to CTV is real and still happening. But it's getting harder to profit from the shift with paid services. Netflix recognizes this, which explains why it suddenly announced plans to explore an ad-supported tier for its service. While discussing financial results for the first quarter of 2022, management said it was looking to add an advertising tier within the next year or two, despite previous opposition to the idea.

Having an ad-supported tier will help it retain more subscribers and monetize the original content it's already spent billions of dollars to produce. After all, Netflix subscribers who are service hoppers are more likely to jump down to the cheaper version than cancel entirely.

But this model still requires Netflix to acquire subscribers in the first place. By contrast, Roku is able to profit from the growth of CTV by better monetizing the distribution of content rather than the content itself. There are over 61 million active Roku accounts streaming from a variety of services. And Roku is able to profit at least a bit from all of it rather than being reliant on original content.

If Netflix is seriously considering acquiring Roku, it's because distribution can be more valuable than content -- which is why I love my Roku stock.

Roku's market capitalization is about $11.2 billion as of this writing, whereas Netflix has $6 billion in cash alone, suggesting a deal is more than feasible. I think it would be a great move for Netflix's shareholders.

However, as a Roku shareholder, I hope it doesn't happen. As a stand-alone company, Roku has a tremendous runway to market-beating returns, and I hope to ride it for years.

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Jon Quast has positions in Roku. The Motley Fool has positions in and recommends Netflix and Roku. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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