Is Rovi Going To Pop Again?

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 |  About: Rovi Corporation (ROVI), Includes: MITSY, NFLX
by: Mike Arnold

Since Rovi (NASDAQ:ROVI) announced on March 7, 2012, it settled its patent dispute with Hulu, Inc, the value of Rovi's equity is up some 15%, or $270 million, and is now valued at some $2.1 billion.

Meanwhile, Rovi has actively settled other patent disputes of late, including entering into license agreements with LG Electronics, Mitsubishi (OTCPK:MITSY) and Vizio, all of whom were respondents in a Section 337 investigation conducted by the United States International Trade Commission ("ITC"). A Section 337 investigation involves claims regarding intellectual property infringement rights, including patents and trademarks of imported goods.

The Section 337 investigation initiated by Rovi alleges that the respondents (LG Electronics, Mitsubishi, Vizio, Netflix and Roku) unlawfully imported into the U.S. certain products containing interactive program guide ("IPG") technology and related features, including televisions and media players, that infringe one or more claims of U.S. Patent Nos. 6,701,523 (the '523 patent), 6,898,762 (the '762 patent), 7,065,709 (the '709 patent), 7,103,906 (the '906 patent), 7,225,455 (the '455 patent), 7,493,643 (the '643 patent), and 8,112,776 (the '776 patent) (collectively, the "asserted patents").

Two respondents remain party to the Section 337 investigation being conducted by the ITC: Netflix (NASDAQ:NFLX) and Roku, Inc.

Many investors and consumers are likely unaware (like I was) that Netflix intended to get into the set top box business at one time. It developed a product known as "Product Griffin," and weeks before it was set to be unveiled, CEO Reed Hastings decided to spin off the technology rather than get into the hardware business. It is reported that Mr. Hastings thought it would be viewed by the marketplace as a competitive attack to the media distribution and content market, instead Mr. Hastings decided to take the stance that Netflix should be available on all platforms rather than solely through Griffin. Hence, the technology was spun off to Roku, Inc.

Netflix and Roku are now the two remaining respondents to the 337 investigation with respect to the certain patents covering certain IPG technology. At least one of the disputed patents was covered in the Hulu complaint (the '906 patent), which resulted in a settlement agreement.

If the market valued the Hulu patent settlement agreement at 10% of Rovi's market capitalization, then a Netflix deal could have a major impact on Rovi's share price. Why? Because the paid subscriber counts are far different, with Hulu reportedly having 3 million US paid subscribers at the end of 2012 and Netflix covering 27 million US paid subscribers.

Of course, part of the 10% increase in Rovi's share price as a result of the Hulu deal could have been due to analysts increasing their probabilities that Netflix and Roku would settle too. Let's assume the market is inefficient and did not price in the greater likelihood of a Netflix deal.

All things being equal (except for the paid base subscriber count, 3 million for Hulu and 27 million for Netflix), including a similar royalty rate, term of the license and expected subscriber growth rates, the value of a Netflix deal could be worth substantially more than the Hulu deal. Of course, all things are not equal, and Netflix may be able to negotiate a better deal than Hulu based on a "volume discount" on the royalty rate, and the expected future paid subscriber growth rates for Hulu and Netflix will surely be different.

Valuing a running royalty rate license agreement is relatively simple. Like with anything in valuation though, the devil is, as always, in the details. To value a running royalty deal, an analyst would likely begin with the base subscriber count, project expected subscribers based on available market data (and input from management or third party experts), apply the established royalty rate on expected net sales, and discount the expected royalty cash flows to present value using an appropriate discount rate. Typically the discount rate would be the weighted average cost of capital ("WACC") of the licensee, providing an indication of the riskiness of such royalty cash flows to the licensor.

Based on recent settlement evidence covering the respondents in the Section 337 investigation and concurrent Hulu matter, it appears more likely than not that Netflix and Roku will ultimately enter into a license agreement with Rovi covering certain portions of its IPG technology.

If, or when that happens, expect Rovi to pop. And because royalties shift income from the licensee to the licensor, effectively a zero sum game, expect Netflix's margins and share price to be pressured.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.