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Friday, September 17, 2021

How Roku used the Netflix playbook to beat bigger players and rule streaming video


Anthony Wood of Roku and Reed Hastings of Netflix

When Netflix founder Reed Hastings sold the streaming video box he was working on to a little-known start-up called Roku in 2008, he expected it to fail.

In an interview, Hastings stated, “There was Xbox and PlayStation and Samsung and Apple TV.” “To be honest, we didn’t think Roku stood a chance.”

Roku CEO and founder Anthony Wood pestered Hastings for months after first meeting at a conference to allow his company to create a streaming video box for Netflix. At the time, Hastings wanted Netflix to build the box in-house. So the two came to an agreement: Wood would work part-time at Netflix to create the device while remaining CEO of Roku, which had about 15 employees.

That trial lasted nine months. Hastings desired that Netflix be available on a variety of streaming devices, including Microsoft’s Xbox, Sony’s PlayStation, and Apple TV. These companies saw Netflix’s hardware as a threat to their own operations. Furthermore, people polled in focus groups expressed a desire for a box that could stream content other than Netflix.

As a result, Hastings decided to spin off the division to Roku. Wood was given an unfinished device, patents, 20 to 30 Netflix employees (more than doubling Roku’s size), and some cash. In exchange, Netflix received approximately 15% of Roku’s equity.

Netflix would later sell its Roku shares to venture capital firm Menlo Ventures in order to avoid the perception of favouring one streaming distribution manufacturer over another. Netflix reported a $1.7 million profit on a $6 million investment when it sold its stock in 2009.

If Netflix had kept its stake, it would now be worth nearly $7 billion. One of the pandemic’s big winners has been Roku. Since March 17, 2020, shares have increased by more than 480 percent, as the media world has shifted to a focus on streaming video. Roku’s market capitalization now exceeds $45 billion.

Wood has an estimated net worth of $7 billion, having owned more than 28 percent of Roku at the time of its initial public offering but now owning less than 15 percent of shares outstanding after various sales over the years.

“Obviously, in retrospect, we missed a fortune,” Hastings said.

Roku is both literally and metaphorically the offspring of Netflix. While it is not a carbon copy of its parent company, Roku stole more than just hardware from Netflix; it also stole a strand of its corporate DNA.

Wood dismisses the comparison. “Obviously, my relationship with Netflix was very important to Roku,” he said in an interview. “But I was only there for nine months.”

However, by out-competing media and technology behemoths, Roku and Netflix have grown into market-leading companies worth tens of billions of dollars. Both companies could have been acquired for a fraction of what they are worth today in their early stages. Both companies restructured their businesses to accommodate streaming video. Furthermore, both have unusual corporate cultures that can alienate employees who claim to live in fear of being fired.

Pivot, pivot, pivot

Just as Netflix began as a DVD rental service, Roku’s first forays into business bear little resemblance to how it makes money today.

Wood founded Roku in 2002 as a maker of high definition video players after graduating from Texas A&M with a degree in electrical engineering. Wood initially funded Roku with money he earned from selling other businesses, including DVR maker ReplayTV, which SonicBlue purchased for $120 million. SonicBlue is no longer in business.)

Wood then expanded his product line to include streaming audio devices to compete with Apple iPods. Unfortunately, Spotify did not yet exist.

“I was a little ahead of myself on that one,” Wood admitted.

He then added digital signs, which are common in sporting event concession areas and are even used as background monitors by CNBC. Wood eventually spun off that division into a new company called BrightSign.

Then there was the Netflix deal.

Wood saw Roku as a centralised distribution platform for digital television in the future. Although Roku appeared to be a hardware company, Wood envisioned Roku as a services company, with revenue coming from channel store fees and a share of advertising revenue from every TV app supported by the platform.

XD/S Roku

Roku’s first customer was Netflix, followed by Amazon Video on Demand and MLB TV. Roku has recently added HBO Max, NBCUniversal’s Peacock, Disney+, and a slew of other subscription streaming services, including Roku’s own The Roku Channel. Roku has become the operating system for more than 15 brands of smart TVs, embedding its software directly into consumers’ television sets, just as Wood predicted more than a decade ago.

The pandemic has accelerated Roku’s penetration of American homes. According to Parks Associates data, Roku has consistently been the leader among all streaming platforms in the United States, with more than 53 million active accounts, though Amazon is catching up. Since 2015, Roku has increased its market share from 33% to 39%. Amazon Fire TV tied Roku for first place in the first quarter of 2021, with 36 percent. Apple TV came in third with 12%, followed by Google Chromecast with 8%.

Wood attributes some of Roku’s success to Clayton Christensen’s well-known business concept of “The Innovator’s Dilemma,” in which incumbent companies were unable to focus on streaming video because they were too preoccupied with protecting their older, linear cable TV models. Christensen’s book also happens to be a favourite of Hastings’.

Wood also stated that Roku’s relatively consistent user interface and simple remote control have piqued the interest of customers who seek simplicity.

“Many companies simply don’t understand the attitude people have when they’re watching TV,” Wood explained. “People want to sit there and drink beer while watching TV.”

As Wood predicted, Roku now makes the majority of its money from services, much of which comes from selling a portion of each media company’s total streaming advertising time. According to people familiar with the matter who spoke on the condition of anonymity because the details of the deal are private, when Roku agreed to distribute Peacock, NBCUniversal’s streaming service, it took about 10% of what would have been Peacock’s ad inventory to sell for itself.

Roku is developing its own advertising technology based on its viewership data in order to better target commercials than is possible on linear television. Roku purchased Nielsen’s advanced video advertising business in March in order to begin dynamically inserting linear TV advertising, which increases the number of ads that can be shown on a given show or movie and can be used to better target ads to users.

Roku has recently developed two new content divisions. The Roku Channel licences content from other media companies and has acquired some original programming, including content from Quibi, Jeffrey Katzenberg and Meg Whitman’s short-lived streaming service. Roku sells advertisements in addition to programming. Roku is also launching an advertising brand studio to assist businesses in creating their own original content.

Roku generated approximately $510 million in revenue last year from its hardware and branded smart TVs. Platform services brought in $1.3 billion.

“We focused on the idea that all TV would be streaming,” Wood explained. “It was self-evident. I don’t understand why there were sceptics.”

A world of skepticism

Wood struggled for years to find outside funding. Roku was repeatedly told by venture capitalists that it was a hardware maker, and that hardware was a bad business. Roku’s modest headquarters in Saratoga Office Center in Saratoga, California — an unusual starting point for Silicon Valley darlings — surprised some potential early investors.

Shawn Carolan, a partner at Menlo Ventures, was the only one who seemed to believe.

Carolan told CNBC, “Silicon Valley does not like to invest in hardware companies.” This is due to the fact that hardware is frequently easily replicated and frequently costs nearly as much to manufacture and market as it does to sell. According to a person familiar with the situation, Roku’s hardware is still a zero-profit margin business.

Carolan, on the other hand, saw a clear future strategy centred on services.

Carolan said in an interview, “I remember this PowerPoint deck I presented around 2009, 2010 where I kind of laid it all out.” “We dubbed it the “popcorn strategy” because movie theatres don’t make money from movies, but rather from the popcorn they sell. How will we continue to increase service revenue incrementally?”

Wood personally funded Roku’s Series A round. As part of the 2008 box transaction, Netflix contributed $6 million for the Series B. Menlo Ventures was one of the venture capital firms involved in Roku’s Series C, which was split into two parts in 2008 and 2009. Carolan and his partners would reinvest in the Series D in 2011, the Series E in 2012, and the Series H in 2015 — the final round required before Roku’s IPO.

Menlo owned approximately 35% of all Roku shares by 2017, including the Netflix shares it purchased. Carolan served on Roku’s board of directors from 2008 to 2018.

Menlo Ventures partner Shawn Carolan

As the company grew in size, it demonstrated that it could generate revenue from its channel store, revenue shares with media companies, and advertising. Wood expected to hear from other companies interested in acquiring Roku, but only a few approached him.

According to people familiar with the situation, Roku held discussions with Intel when it was considering developing OnCue, an internet-based TV platform, in 2012. According to one of the people, Intel eventually agreed to pay $450 million for Roku, but Wood demanded $1.5 billion. According to a person familiar with the talks, Wood, who several coworkers acknowledged had a quirky personality, told an Intel executive that he asked for $1.5 billion because he wanted to open a university in Texas, and that price would cover the expense. The transaction was doomed by the large value disparity.

Amazon approached the company about a year later with an initial offer of around $300 million. Those talks became more serious, prompting Roku to lower its asking price to around $690 million, according to one of the people involved. Nonetheless, the disparity proved to be too great to close the deal.

Following that, the offers essentially ceased.

“We’ve had fewer acquisition offers than is typical for a company as successful as Roku,” Wood said, adding that he couldn’t recall specifics about the Amazon and Intel bids. “I believe it is due to a lack of understanding of the company. They didn’t for a long time.”

Waverley Capital managing partner Daniel Leff, who served on Roku’s board from 2011 to 2018, described the lack of takeover interest from major technology and media companies as “astonishing.”

“A lot of CEOs from big media companies came to Roku to figure out what it is, what streaming is, and how it is going to disrupt my business.” Leff stated. “And I can say unequivocally that not a single media executive — and they’re all very smart in their own right — believed Roku would be successful, even when it was generating hundreds of millions of dollars in revenue. Even after it was made public.”

Roku attempted to go public for the first time in 2014, but bankers told Wood that there would be no appetite for investment until services revenue reached 50% of total sales.

“They told us we couldn’t get out, or at least not at a good price, until we could prove platform revenue was real,” Carolan explained.

As a result, Roku became more serious about its platform business. When Roku released its S-1 filing — the document that all companies must publish before going public — player revenue represented 59 percent of total revenue in the first half of 2017, down 2 percent year over year, while platform revenue represented 41 percent of total revenue, up 91 percent year over year.

Roku’s initial public offering (IPO) on the Nasdaq on September 28, 2017.

Nasdaq is the source of this information.

Carolan burst into tears when Roku went public on September 28, 2017.

“I thought, wow, the world is finally seeing what my partners and I have been seeing for the last ten years,” Carolan said. “It was all very emotional. And over the last few years, it’s clear that more and more people are finally getting it.”

What’s next: Content

Wood stated that he is currently devoting much of his time to developing a strategy for The Roku Channel.

The majority of the content on Roku’s channel is licenced from other media companies and studios — and it isn’t always their best work. The 40,000 free movies and TV shows are primarily back-end library content that media companies have deemed unimportant for their own streaming ventures. When Roku is able to obtain more popular content, it is usually limited — for example, it only has one season of “The Bachelorette” (Season 13, starring Rachel Lindsay).

Roku has begun to experiment with original programming in addition to licenced content. Roku purchased more than 75 shows created by Quibi for its short-lived service earlier this year. It also acquired “This Old House,” which is currently in its 42nd season and still producing new episodes. Roku has programming for both children and adults, and it is expanding its offerings to include something for everyone in the family.

There is some evidence that the original programming is gaining traction. From May 20 to June 3, the top ten most-watched programmes on The Roku Channel were all Roku originals. According to Roku’s own data, since adding the Quibi library last month, more Roku users have seen that programming in two weeks than Quibi users in its six-month lifetime.

At this point, the strategy resembles — surprise, surprise — Netflix. In its early days, Netflix was content to licence whatever content media companies would give it. Former Time Warner CEO Jeff Bewkes famously referred to it as “The Albanian Army,” emphasising its small size at the time.

Netflix now spends $17 billion per year on content.

According to a person familiar with the situation, Roku intends to spend more than $1 billion on content next year. Wood declined to comment on the exact figure, but he did admit that the budget will grow in the coming years.

Wood also stated that The Roku Channel fosters a virtuous cycle. Roku sells advertising against each ad-supported app on its platform. Roku, with its own channel, can provide advertisers with a new way to market their brands. That’s more money that can be spent on more content, making the channel more appealing to consumers — and advertisers.

There is real money to be made in ad-supported free video. According to CEO Bob Bakish, ViacomCBS’s Pluto TV will surpass $1 billion in ad revenue next year.

Roku announced in March that it was raising $1 billion in funding, which ex-board member Leff believes will be used primarily for content. Roku, with a market capitalization greater than that of media companies such as Discovery, which is merging with WarnerMedia, and ViacomCBS, is a theoretical buyer for Lionsgate and AMC Networks, according to Michael Nathanson of MoffettNathanson.

For the time being, Wood is behaving like a CEO who wishes to remain anonymous. Wood emphasised that Roku was first and foremost a distribution platform, and then a content company. However, if content creators do not exercise caution, Roku may “eat their lunch,” just as Netflix did, according to Nathanson.

“This reminds me so much of Netflix back in the day,” Nathanson said. “When I interviewed [Netflix Co-CEO] Ted Sarandos at conferences ten years ago, he’d say, ‘Oh, we’re happy with just one or two original shows.’ Meanwhile, they’d be working their way up to better content. Companies that provide Roku content, in my opinion, are digging their own grave.”

Reed Hastings, co-founder and director of Netflix, delivers a speech on January 17, 2020, at the opening of Netflix France’s new offices in Paris.

Hastings told CNBC that he is unconcerned about Roku as a competitor because its goals as an advertising-supported service will be different from Netflix’s, which is subscription-based and does not have commercials.

“They’re not a significant threat to us,” Hastings stated.

Wood agreed with Hastings that The Roku Channel is not a rival to Netflix. Roku wants to capture a person’s attention so that it can sell advertising, but it doesn’t need to spend so much money on content to keep a person paying $5, $10, or $15 per month. The Roku Channel is available on Amazon Fire TV, Apple iOS, and Google’s Android, but the company prefers that users watch it on Roku’s platform, where it can better monetize viewership data.

“We have less expensive content than a subscription service because we don’t need it to be successful,” Wood explained. “For us, it’s about assisting users in discovering content that is relevant to them.”

Testing its leverage

Nonetheless, Roku may be able to improve the quality of licenced content in the future. Direct-to-consumer streaming apps require global distribution, and Roku has a strategy in place to enter countries all over the world. Roku is also found in roughly one-third of all smart TVs in Canada and is the second-largest smart TV operating system in Mexico. Europe, where Google’s Android TV is dominant, is its next likely expansion opportunity, according to Nathanson.

As Roku enters into new carriage agreements, it may begin to demand that each company provide better content for the Roku Channel. According to people familiar with the situation, Roku requested high-quality titles during its negotiations with WarnerMedia and NBCUniversal. For the time being, it has decided to pay for a few older, relatively unpopular series, such as NBCUniversal’s “Coach.”

On Thursday, September 12, 2013, the Roku 3 television streaming player menu is shown on a television in Los Angeles, California, United States.

Roku has become more aggressive in its carriage agreement demands in recent years, including requests for more advertising inventory, higher app store fees, and better content for The Roku Channel. As a result, reaching agreements with HBO Max and Peacock has been delayed. In April, Roku removed the YouTube TV app from its platform for new customers due to a disagreement over search results manipulation and hardware requirements. The main YouTube app is still available to everyone, but that deal expires later this year, which could put Roku’s leverage to the test.

“They have to be cautious,” Leff said. “Netflix is still one of their most important partners. They don’t want to compete with all of their content partners too hard.”

However, if media companies do not collaborate with Roku, where can they turn for distribution? Apple, Google, and Amazon remain bigger long-term threats, armed with data and cash and the ability to outspend legacy media for content if they so desire. Throughout its history, Roku has benefited from its “we’re just the little guy” attitude.

Roku’s media partners are unconcerned for the time being.

“Given their market scale, I don’t think they’re difficult to do business with,” said Steve MacDonald, A+E Networks’ president of global content licencing. “They’re very collaborative and open to sharing information about how we can better monetize our partnership. They spread the word about our content. They make excellent partners.”

That’s what the media industry used to say about Netflix.


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