Roku’s China Problem Could Net You Big Profits

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Fast growth can sometimes come with large hiccups. For tech company Roku, its largest hiccup could come very soon.

Roku, in case you haven’t been part of the 16 million households in just the U.S. to cut your cable, is a company that sells streaming platforms. It doesn’t really stream its own content, at least not as a significant portion of its business. It instead offers a sort of TV operating system.

The company has designed a user interface its customers use to connect their Netflix, Hulu and Amazon accounts all in one place. With the likes of Apple’s and Disney’s coming online soon, you can see how this type of product would be useful.

The way the company makes money is twofold. First, it sells a little stick you can plug directly into your HDMI port on your television that puts this operating system at your fingertips. From there, it also sells advertising to those streaming and media companies. After all, Roku acts as a sort of marketplace, where Netflix and Amazon can compete for your views.

This business model is growing sharply. As of its most recent earnings, the company saw a 40% growth rate for its number of users.

In addition to this core business, it is also a big-time maker of TVs with its software pre-installed. Here, the story doesn’t look so good.

We’ll get to why its hardware business could become a weight in the second half of this year. But first, you should really see the whole picture the company is showing the rest of investors.

During its most recent quarter, the company basically missed its earnings target. But investors didn’t care. Every other number was exceptional.

Number of users, ad sales, overall revenue, 2019 guidance and more were all through the roof. Shares exploded the morning after this report, jumping from about $65 to more than $80.

And that is only what’s happened this month. Since late December, investors can’t get enough of this play:

Screen Shot 2019-05-17 at 1.03.20 PM

As you can see, shares of ROKU are up more than 215% just since Christmas Eve, this past year. And while much of that price appreciation and growth is certainly warranted, Roku isn’t a flawless company.

The idea behind all of that is the as-yet unrealized potential. With more and more cable-cutters and additional streaming services, Roku’s advertising side has a virtually unlimited upside. Its advertising business can scale up without caution, as these services battle for each and every viewer they can find. Roku can provide those new eyes.

Right now, ads make up two-thirds of its total revenue. And that’s good… because its other business isn’t as sharp.

You see, the other one-third is hardware. Both its sticks that offer its service and the TVs that come with it already installed are made in China. You didn’t think this story would somehow not involve the trade problems with China, did you?

That’s right, insiders at the company have already noted publicly that they fear what the trade war is going to do to this side of the business. On the stick side, its products are targeted by the current tariffs. On the TV side, the increased tariffs Trump recently signed will be an even tougher blow.

It’s not only increased tariffs and lower margin the company fears, however. Recently, Roku received another gut punch from its Chinese manufacturers.

Electronics maker TCL announced at the end of last year that it is selling off most of its business to focus on semiconductors and next-gen display technology. One of its cut operations is television manufacturing… specifically, the manufacturing of Roku TVs.

This major partner made up about half of Roku’s TV supply. With higher tariffs and increased tensions, now is a poor time to try and make up that lack. The company would only be locking in terrible prices with an inability to properly forecast future costs.

Of course, as noted, the hardware side of Roku is limited. Just one-third of its business relies on its actual physical products. Advertising is the more important growth factor. But if fewer potential customers can access those ads because of manufacturing problems, that could have an exponential impact.

None of this is to say Roku is in trouble. The company is indeed growing and doing just about everything right. It has already received agreements from Apple and Disney to add those services to its platform going forward. And it’s not like the company isn’t able to make changes to its supply chain. But it does appear certain that its stock is due for a breather.

While a correction or even a slight retraction is possible here, we wouldn’t bet on that either. There’s another way to play this inevitable slowdown in share price appreciation.

A Strategy For Roku’s Slow Down

A bear call spread is a type of options trade that involves selling a call option on a stock you believe will either fall or sit still and buying a second call option to limit your risk if it doesn’t.

This is a rather conservative way to play falling stocks. But it is perfect for those that might not fall at all. With Roku, it’s tough to say if its Chinese manufacturing mess will actually cause a decline. But it’s safe to say that it will prevent the growth its been having to continue in the short term.

The beauty of this strategy is that shares don’t have to move an inch for you to maximize your profit. Plus, you start with that money in your account… making this a net credit trade.

You can see how this works here:

OIC Profile

Source: The Options Industry Council

As you can see, your profit is capped to how much you receive when opening the trade. But the risk is quite limited too.

Let’s look at a specific trade to see how this might pan out…

A Specific Trade on ROKU

Right now, a trader could sell a July 19 $90 call on ROKU for $5.90 per share and buy a July 19 $95 call for $4.05 per share for a net credit of $1.85 per share. On 100 shares each, that’s a payment of $185 that goes directly into the trader’s account right at the beginning of this deal.

That too, however, is the most he’d make on this trade. But keeping that $185 is far easier than trying to make it by actively betting against Roku.

You see, for this trade to work out – and let the trader keep every cent of that $185 – shares of ROKU would have to just not move. They don’t have to go down at all. In fact, the trader keeps his maximum profit as long as shares don’t rise above $90.

Right now, they are trading at $85.75. So, they’d still have to run a bit for any of this to be at risk. Speaking of risk, that too is known right up front.

To find it, take the difference in strike prices ($95 – $90 = $5), and subtract the premium received ($5 – $1.85 = $3.15). On 100 shares, that’s total risk of $315. For the trader to lose that full amount, however, shares would have to skyrocket a full $10 to more than $95 each.

With so much weighing down the company’s hardware business – and therefore its all-important number of new users – that’s unlikely in this short period of time.

This trade offers a great way to play Roku’s slowdown. Shares don’t have to crash to profit. They just have to take a much-needed break from their rallying. And that seems extraordinarily likely right now.

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