- In 2015, the four large U.S. video companies Comcast (CMCSA), DirecTV (DTV), Dish (DISH)/EchoStar (SATS), Time Warner Cable (TWC) all have to renegotiate IP-licensing contracts with Rovi (ROVI).
- Due to some weird accounting treatment (details below), two of these companies currently do NOT generate any revenue for ROVI. The payments they will have to start making in 2015 will provide a step-function increase of $100 million to $200 million per year in revenue and an incremental $0.90 to $1.50 in EPS!
- The other two companies are paying well-below-market rates, as they last agreed to terms ~10 years ago. A 75% increase in rates (a fair estimate; details below) would yield an additional incremental $70 million in annual revenue and an additional incremental $0.60 in EPS
- Taken together -- ROVI could layer on more than $250 million in incremental annual revenue, capable of increasing revenue from an estimated $1,90 in FY13 to more than $4.00 in 2015/2016+
- I believe investors will shift their focus from 2014 estimates to 2015 estimates in the next 6 months, and the large step-function increase in revenue/EPS is likely to drive a 50%-plus price increase in ROVI shares
- Disclaimer: This article only focuses on the 2015 renegotiation catalyst. It does not factor in the headwinds some units are facing (i.e. DivX, CE licensing), or other potential growth catalysts Rovi has (advertising, Total Guide for Service Providers, online video companies like Netflix (NFLX)). Those are different factors with a wide range of outcomes -- and they require a different analysis.
Brief Overview of Rovi's Business Model
Rovi has many different businesses, which gives it a relatively complex revenue model. There are four different revenue reporting segments, and each operates with a different revenue model and has different growth drivers/pressures. A quick overview of each is detailed below. The vertical the 2015 catalyst will occur in is the largest/core vertical: Service Providers.
1) Consumer Electronics: Delivery/Display (~12% of total revenue). This vertical mainly licenses DivX video encoding/decoding tech to consumer electronics manufacturers; licenses are either one-time, per-unit licenses, or large annual fees.
2) Consumer Electronics: Discovery (~23% of total revenue). This vertical mainly licenses ROVI's electronic program guide and guide-advertising patents to consumer electronics manufacturer; licenses are either one-time, per-unit licenses, or large annual fees.
3) Service Providers (~55% of total revenue). This vertical mainly licenses ROVI's electronic program guide patents/software and guide-advertising patents to video service providers (i.e. cable TV and satellite TV companies); licenses are largely a per-subscriber, per-month fee.
Note: an electronic program guide is that "what's on TV" application you see every time you press the "guide" button on your remote control. That's what Rovi provides...
4) Other/Data Licensing (~10% of total revenue). This vertical licenses ROVI's entertainment data to hundreds of companies; revenues are usually flat annual fees.
Service Provider Vertical -- Some History and Why Its a Big Future Catalyst for Rovi
The service provider vertical is the core of Rovi's business. It generates the majority of the company's revenue and is the most consistent growth driver. About 2/3rds of the revenue in Service provider is from licensing customers to Rovi's 5000+ global patent portfolio (mainly focused on electronic program guides). The remaining 1/3 of the revenue come from a "bundled" license where customers get both a license to Rovi's patent portfolio and Rovi's electronic program guide software product.
The majority of Rovi's customers have licensing contracts that last 2-3 years. When these contracts are renegotiated, Rovi typically gets 10% to 20% higher licensing rates upon renewal.
What is unique however is that the four large TV service companies in the U.S. [Comcast, DirecTV, Dish/Echostar, and Time Warner Cable] all signed up for ~10-year contracts, lasting from 2005 - 2015. These four players combine to provide TV services to 2/3rds of the U.S.
This dynamic is setting up Rovi for two very big opportunities:
Big Opportunity #1 (Very High Probability). Patents can be licensed in many ways. When Comcast and Dish/Echostar agreed to license Rovi's patent portfolio, they each decided to pay a very large up-front fee instead of paying a fee annually; a fairly normal thing to do in the patent-licensing world.
The accounting treatment for a company when doing this would be to create a reserve account on your balance sheet ("pre-paid revenue"), and then you recognize an equal portion of that revenue every year (i.e. you amortize the pre-paid revenue account).
But things get really complicated when acquisitions happen! Rovi was built through acquisition, most notably in late-2007 they acquired Gemstar/TV-guide -- the company with all of the electronic program guide patents that provide the Service Provider revenue (and the company that did the 10-year, paid-up-front licenses to Comcast and Dish/Echostar). In an acquisition, these pre-paid patent licenses stop being amortized/recognized-as-revenue every year.
What that means: The revenue Rovi recognizes right now is artificially low, because they are not showing any revenue from either Comcast or Dish/Echostar! The chart below details roughly how the revenue looks for the group of these big 4 in 2013:
The Opportunity. Both the Comcast and Dish/Echostar licenses expire in 2015, and they will need to renegotiate a new license to Rovi's patent portfolio. At a minimum, these two companies will need to pay the low-end rate for patent licenses, which is around $0.25 per month, or $3.00 per year. Financially, that means Rovi will have a step-function increase in revenue in 2015/2016+ of at least around $110 million dollars. And since this is licensing revenue (that requires no operating expenses), the after-tax EPS impact would be an incremental $0.89, a boost of nearly 50% from the estimated 2013 EPS!
Big Opportunity #2 (Strong Probability). As noted above, excluding the big-4 in the U.S., Rovi typically licenses cable-TV companies to a 2-3 year deal and increases the rate 10% to 20% upon renewal.
Given the 10-year license, the rates for the big-4 have not increased since 2005, but the average household cable bill is up more than 75% since that time. This is a big opportunity for Rovi because they have a history of raising rates, and the rates for these big-4 will not have increased in a decade!
As detailed in the chart below, if Rovi was able to increase the licensing rate it receives from these big-4 by 75% (i.e. roughly how much cable bills have increased), the revenue and EPS impact would be massive!
The annual fee per big-4 customer would increase from $3 per year to $5.25 per year. Layer in Comcast and Dish/Echostar also having to pay licensing fees every year (opportunity #1) -- and the incremental revenue ROVI would see per year would be more than $250 million! Moreover, because this revenue has no operating-expenses associated with it, the incremental EPS impact would be more than $2.00 per share, an increase of more than 100% from Rovi's estimated 2013 EPS!
Recommendation: Get Long ROVI Shares Now. 2015 sounds like it is far away, but smart investors pay a lot of attention to "forward" revenue and earnings. 2014 is only a few months away, and the smart investors will start to dig a lot deeper into 2015 (and to some extent 2016+) revenue and EPS estimates. The potential step-function increase in revenue and EPS I detailed above is extremely compelling -- and will likely create upward pressure on shares as investors establish or add to positions to take advantage of the approaching step-function increase.