With Apple Cooling and Netflix Cold, Roku Looks Unstoppable

My latest warning that Big Tech is hitting natural scaling limits hit a raw nerve with some die hard fans of Apple (NASDAQ:AAPL), especially in the wake of the most important product unveiling in years.

Apple needed the keynote announcement to be a grand slam to really shake up the global technology landscape. At best this was a base hit, just enough to keep the company in the game.

Entry-level iPhones, new cameras for slow-motion video snapshots and a new streaming video channel for yet another iteration of Apple TV: that’s how “different” they’re thinking in Cupertino this year.

Apple is no longer the innovator that rocked the world a decade ago. When the iPhone launched, this was barely a $100 billion company, smaller than Salesforce.com Inc. (NYSE:CRM), Adobe Inc. (NASDAQ:ADBE) or NVIDIA Corp. (NASDAQ:NVDA) today.

Here in the $1 trillion zone, it takes more than new cameras to move the corporate needle far or fast. You can love the products and still fail to see compelling upside remaining for the stock.

Hardware Math Is Cruel

Fans of the company balked at my characterization of Apple as a hardware company. (Click here to watch the video.)

I’m well aware that CEO Tim Cook is busy de-emphasizing hardware sales in order to squeeze as much service income from everyone who owns an iPhone or other Apple device. But that pivot isn’t going to happen overnight.

A year from now, services might contribute a solid $52 billion to the annual run rate. Anywhere else, that would be impressive. Here, however, it’s still at best 19 percent of the company’s overall revenue footprint.

Even in that optimistic scenario, the other 81 percent will come from hardware. That’s a hardware company, subject to hardware economics.

Of course Apple is special. Gross margins on that side were miraculously resilient when every other phone maker on the planet was chasing volume to the bottom, but now the cost of sales is rising.

That math is cruel. Simply to compensate for 3 percent margin compression over the past year and keep cash flow constant, Tim Cook needs to sell 3 percent more devices or cut operating costs.

He hasn’t cut costs. And he isn’t selling more devices. Product revenue is down 6 percent this year and gross income on that side of the company is down 13 percent.

I agree, services are stepping up fast and margins are improving as subscribers embrace Apple Pay, Apple Music and everything else in the App Store. For consumers, that’s great. For investors, the challenge is that it’s going to take time for that business to become the company’s center of gravity.

To make services the dominant revenue stream, Apple users need to quadruple the amount they pay the company every month or the user base needs to expand dramatically.

Service revenue is up a healthy 12 percent from last year. Extend that growth rate and we’ll quadruple the base in 2032, at which point Tim Cook or his successor will truly be running a software company.

Of course Tim Cook may not be ramping up services as fast as he can. He’ll get there faster in that scenario, but I’m waiting for the acceleration to start before I rework the models.

And of course if hardware sales keep deteriorating he’ll be running a much smaller software company before we know it. This isn’t negativity. It’s just math.

Winning the TV Wars

Math is also what drives my preference for Roku Inc. (NASDAQ:ROKU) as both the next-generation Netflix Inc. (NASDAQ:NFLX) and a reminder of what Apple was like in its glory years.

Roku isn’t yet another subscription streaming TV channel spending billions to develop enough shows to capture eyeballs from competitors. The business model here is aimed more at replacing conventional cable companies.

The technology is already on one in three smart TVs and another 30,000 standalone Roku Players are selling every day. It’s one of the true breakout consumer devices on the market right now, an echo of the iPod decades ago.

But unlike Apple, which is in the early stages of pivoting toward hardware as a marketing platform for higher-margin services, Roku is already a software company. Ads and licensing fees now account for 67 percent of all revenue.

The device is simply what it takes to get households hooked up. That’s why it only costs a fraction of the Apple TV’s $150 sticker price.

And the “software” side of Roku is already as profitable as Apple’s services and expanding 86 percent a year. It’s only partially dependent on expanding the user base. Every hour existing viewers watch TV turns into another $0.02 in revenue.

The audience, meanwhile, is growing at a rate of 30,000 a day. Each of them watch 100 hours of TV a month. Until we see these numbers hit a wall, Roku keeps growing.

Granted, Apple TV may ultimately become a threat here. Again, it’s a matter of scale.

Roku is a small company, with a run rate of $900 million a year. Even in the grim pre-iPod era when Apple was fighting for its life, it booked twice as much sales per quarter.

If the Roku franchise hits a wall, investors can jump at the first sign of competitive failure. However, in that scenario, Apple is not a buy.

Say Apple TV captures every single Roku household this year. Roku revenue drops to zero and that’s a catastrophe for them. Apple revenue bumps up a little less than 2 percent.

Maybe that’s enough to compensate for sagging iPhone sales. It’s definitely not enough to move the overall growth needle far, and then to raise the bar again next year Apple needs to sell another 30 million Apple TV units and keep every subscriber.

The risk for Roku is failure. The risk for Apple is stagnation. If investors accept that, it’s great. Tim Cook is running one of the world’s great conglomerates, paying a decent 1.4 percent yield on the $1 trillion shareholders currently have in the company.

It’s profitable. Just don’t tell me it’s a growth story. Even if Apple announced an initiative like the new Apple TV every week, it would still struggle to expand as fast as Roku right now.

It’s got to bolt on five Netflixs a year to make that happen. How much would that even cost?

I loved Apple as a shareholder and a consumer 20 years ago, when it was completely shredding whole industries. But unless Tim Cook forgot to unveil his time machine, investors can’t go back there.

Both stocks have a vital role to play. Apple is slow but isn’t going anywhere. Roku is going to remain a wild ride. Value Authority focuses on the steady performers. GameChangers is where we find the heat.

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