Here’s the entire text of the prepared remarks from TiVo’s (ticker: TIVO) Q3 2006 conference call. The Q&A is here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.
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Marilyn Lattin, Head of Investor Relations
Tom Rogers, Chief Executive Officer
Dave Courtney, Chief Financial Officer
Stuart West, VP-Finance
Richard Baldry, First Albany Capital, Analyst
Daniel Ernst, Hudson Square Research, Analyst
Tony Wibel, Citigroup, Analyst
Lee Westerfield, Harris Nesbitt, Analyst
Todd Mitchell, Kaufman Brothers, Analyst
April Horace, Hoefer & Arnett, Analyst
Alan Gould, Natexis Bleichroeder, Analyst
Brian Coyne, Friedman, Billings, Ramsey, Analyst
David Miller, Sanders, Morris, Harris, Analyst
Chris Rowen, Robinson Humphrey, Analyst
Good day, everyone. Welcome to the TiVo Third Quarter Fiscal 2006 Earnings Conference Call. This conference is being recorded.
I will now turn the call over to miss Marilyn Lattin. Please go ahead.
Marilyn Lattin, Head of Investor Relations
Thank you, operator. Good afternoon everyone. I'm Marilyn Lattin, TiVo's Head of Investor Relations. With me today are Tom Rogers, President and Chief Executive Officer; Dave Courtney, Executive Vice President and Chief Financial Officer; and Stuart West, Vice President of Finance. We are here today to discuss TiVo's financial results for the period ending October 31, 2005 which is the third quarter of our fiscal year 2006. The prepared remarks will last about 30-minutes and then we will leave another 30-minutes for a question and answer session. About an hour ago we distributed a press release detailing these financial results. We also posted on our website several visuals that may make this discussion easier to follow. Within a few hours we will release a recording of this call both in a streaming, online format and through a downloadable MP3 podcast. You can access all these materials through our investor relations website at www.tivo.com/ir.
Before we begin and as is noted in slide 2, I would like to remind you that our discussion today will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that relates to TiVo's future financial results, partnership products and other factors that may effect future earnings or financial results. You can identify these statements by the use of terminology such as guidance, believe, expect, will, or similar forward-looking terms. You should not rely on these forward-looking statements as they involve risks and uncertainties and may cause actual results to vary materially from the forward-looking statements. We describe these risks in TiVo's recent SEC filings including our annual report on Form 10-K and our quarterly report on Form 10-Q. I'd also like too note that any forward-looking statements made on this call reflect analysis as of today and that we have no plans or obligations to update them.
Please now turn to slide 3 and I would now like to turn the call over to Tom Rogers. Tom?
Tom Rogers, Chief Executive Officer
Thanks very much. Good afternoon, everybody. Thanks for joining us today to discuss TiVo's third quarter earnings. Last quarter, which was my first earnings call as CEO, we discussed our strategy of driving scale in our distribution base, reinvigorating our sales and marketing efforts and developing partnerships and alliances that would lead to greater brand awareness and an even more cemented future for TiVo. Today I will focus my remarks on three principal areas. First, sales, marketing, and distribution, second, a related subject, differentiation of our product offering, and third, our continued efforts to develop partnerships to drive brand value and clearly anchor TiVo in the future TV landscape.
Let me start by addressing some of the top line highlights for the quarter. Please see slide 4 for some accompanying notes here. We added 434,000 subscriptions this quarter, ending with over 4 million subs, which is 74% growth over last year. Our scale in terms of overall subscriptions, in equivalent to about the fifth largest MSO cable operator in the country. As to stand-alone subscriptions on a gross adds basis we were up 19% for the second quarter with 92,000 new gross adds, which was 27,000 below last year's third quarter. Given the substantially increased competition from cable and a unique situation from direct TV coupled with a marketing and advertising program that started halfway into the quarter this year, these were reasonable results for the period.
Just a note on DirecTV--they launched a $30 million ad campaign which moved a lot of TiVo boxes. In fact, our DirecTV net adds were 379,000. The DirecTV program, which basically offered a free box with rebate, had some impact on our stand-alone retail unit sales. In fact, DirecTV actually added more TiVo subs than they did a year ago. It's interesting to note that this year, they were giving the DVR to consumers for free with rebate versus a $49 price last year. Additionally, cable DVR offerings were more widely available this last quarter than the equivalent quarter last year. Dave will take you through our net subscription adds and related churn in a little bit.
Now, on to the first area of focus for my remarks, our activities around sales, marketing and distribution. The question we hear most often is, how are you going to grow the subscription base of TiVo in this competitive environment? Our focus in this area during the third quarter was on education and learning around this question. Both about our target audiences and how best to serve their needs and about how to communicate the compelling aspects of the TiVo service. Our primary mission was to solve for the question of what is the optimal way to market TiVo. So we can have the greatest confidence in knowing what it will cost to attract subs and better evaluate the resources it will take to drive distribution substantially higher.
Here are some early observations on high level issues relating to this question. Critical to our thinking is how we are now viewing the television market. We understand that one size doesn't fit all in terms of how people watch television or as importantly, how they bring it into their homes. The television marketplace is incredibly diverse and one needs to take that diversity into account to market effectively. One of the ways we have begun to segment the market is by how consumers bring TV into their homes. We've initially identified three specific segments. The basic cable analog market, the digital market and the high-end market. There are more specific ways to cut this, but this provides an overview of how we are looking at it right now.
I'm going to focus on the basic cable analog opportunities now and digital opportunities a little further on in the discussion when I lay out our cable partnerships. The high-end opportunities will relate more to our products being introduced next year for which we are now developing new and different marketing initiatives to penetrate the home theater media room focused consumer.
Looking at slide 5, you can see the basic analog market is approximately 36 million homes. By some measures it may be even higher. What is critical about this consumer is that because they are analog homes, they by definition do not have digital boxes, which are a necessity if one is going to get a cable DVR. Yet if a basic analog sub wants a DVR and plans to remain an analog sub, they have one solution, TiVo. We think that is a truly unique opportunity to serve 36 to 40 million homes where the TiVo service is the only real answer for that subscriber.
The question one might ask is, is that basic analog subscriber interested in a subscription TV product like TiVo? The answer is clearly yes. Today about 30% of our stand-alone box subs are analog subs. And in the most recent months, due in part to our more focused marketing efforts, just under half of our new stand-alone subs are basic analog customers where as just over a third are digital cable customers. A year ago those proportions were reversed. Thus we can see we have a product that can be marketed to this segment. Moreover, our testing has shown that markets with a high ratio of analog subs to digital subs do respond at significantly higher rates to advertising for TiVo.
Our cable relationship with the national cable television cooperative which we announced last quarter is an example of our strategy to find other creative means to market to analog subscribers. By enlisting small cable operators who will simply not have digital DVRs. So offering TiVo to their subscribers provides an answer. We are spending time trying to educate small cable operators on how to participate in this solution to their subscriber needs. We have found that the analog cable segment responds well to TiVo, not only because it's a better product but because it's more acceptable in terms of price. Analog cable plus TiVo is cheaper than upgrading to digital cable, renting a cable DVR, and paying cable DVR monthly fees.
Now that I've laid out some strategic thoughts on sales and marketing I want to walk you through some of our early observations on tactical issues. We put a good deal of effort into trying to understand the messaging, pricing, packaging, media mix, and effectiveness of different marketing and advertising programs. We are highly focused on trying to quantitatively assess the best combination of those variables to yield the lowest possible SAC for driving distribution going forward.
In terms of media effectiveness, a few key learnings. First, we are seeing online programs be by far our most efficient customer acquisition tool. We are now testing just how much volume can potentially be driven from ramping up the level of spend in this media given its efficiency. Second, while it's still early in our testing, we are finding that explaining the product in greater depth clearly increases the level of response. Consumers have generally heard of TiVo but do not always understand why they should subscribe. Our direct response television efforts have shown the longer the explanation, the greater the response. Two minute ads are more effective than one minute ads, 30-minute infomercials are the most effective of all. Third, we have seen when we work with retailers who put together good in store offers and we support it with targeted marketing programs we can drive a significant response.
In terms of resistance points, many consumers view an upfront box purchase as well as a need to subscribe to the service as a hurdle to signing up. In other words, they respond to our direct response ads but many resist becoming customers when they fully understand there's a $49 upfront price and then a monthly fee as well. Therefore, we have begun to test alternatives that potentially could yield a higher net present value per sub depending on the term of subs acquired on that basis. We are testing a higher monthly fee with no upfront costs compared to the 12.95 with the upfront box fee which is currently in place. Now this is extremely interesting. Early results have indicated that we're getting far better conversion on this approach versus an upfront box fee with a lower monthly charge attached. In other words, the monthly only fee approach and no box fee at all is testing better. We will continue to test various combinations of price and commitment durations.
I can give you some further context for these learnings with a brief comment on our approach to acquisition spending during the quarter. We spent about two-thirds less on advertising media during the past quarter than we did the past year. It was prudent for us to focus on subscription acquisition spending that was based on price reductions where cost related directly to unit sales. In other words, success-based spending. The modest level of advertising spending helped advance our effort to understand the impact of different pricing alternatives in the market and drove some demand while reflecting our disciplined approach to deploying marketing dollars effectively. By keeping our advertising costs lower, our losses came in well below the range we guided for. The third quarter losses include the impact of the $150 rebate available for all units sold to retailers during the third quarter, even though many of those units will not be activated until the fourth quarter.
Another important change we have already made surrounds service commitments. Most of the monthly subs we added this quarter committed to at least one year of occurring fees and agreed to a $150 penalty for early cancellation. This is real progress against a backdrop of pure month-to-month signups until now. The change addresses one of the major windows of churn, the first year, and will drive more long-term value out of each subscription. I consider this one of the more important developments of the quarter.
Before I move on from sales, marketing, and distribution, let me touch briefly on the digital opportunities, the second of the two areas I spoke about on how people bring TV into their homes. While a significant number of digital subs opt for a TiVo box instead of a cable DVR, we believe when it comes to the digital subscriber our best opportunities are very much tied to continuing to put forward integrated boxes based on cable partnerships. We continue our discussions with other major cable operators who view DirecTV's plans to move away from TiVo and market an alternative DVR as a major opportunity for their own digital cable sub acquisition efforts.
We get a few questions regarding our Comcast relationship, and I don't think most fully understand certain unique elements of the Comcast approach to TiVo distribution. What makes this TiVo business model with Comcast truly different from our other approaches to date is that we are working with them on software only. This doesn't include any separate stand-alone TiVo Comcast hardware. The end result is that the TiVo service will be an option for any Comcast cable customer with the Motorola box that has DVR capability. The reality is that if a Comcast subscriber wants TiVo, Comcast simply sends the software upgrade to their digital receiver and it is TiVo ready. Comcast customers can become TiVo subscribers overnight. Last week I spoke to Steve Burke, Comcast President who continues to reiterate that TiVo remains a very high priority for Comcast and that we're making the kind of progress he wants to see. We remain on track for rollout the latter part of next year.
The second area of my remarks today is product differentiation. See slide 6 for some notes on this front. Many of you have asked me, can TiVo successfully market itself as a premium DVR in light of the increased offerings of generic DVRs? The answer lies in continuing to offer a clear set of major features which are truly differentiated from the other DVRs in the market. Over the next 4 to 6 months, we will be announcing a number of new features which will even more clearly set TiVo apart and convincingly demonstrate we are in no way being commoditized. These are the kind of features that the salesperson on the floor of Best Buy, for instance, will be able to tick off that will go to the heart of how people watch TV.
Our engineering capability runs very deep. Yesterday we announced an example of a truly distinctive DVR feature that our technical depth gives us real advantage in bringing to market next year. Along with several major advertising agencies we announced plans to provide consumers with the ability to search for television ads based on products they want to seek out. For the first time, this will allow a viewer who, for instance, may be in the market for a car, to call up all the ads that are pertaining to SUVs on his television screen. So instead of consumers having no idea when a television ad for a particular product may appear because of their random attachment to a TV show, the viewer can pursue an ad he wants to see when he wants to see it, just as a viewer can do with any television program through TiVo. This begins to introduce the Internet advertising notion of paid search to television. And advertisers paying for priority status in any search, somewhat like what Google and Yahoo! offer by way of pay per click advertising on the Internet.
Another distinguishing feature of TiVo is that it allows people to enjoy their television programming on the run. The TiVoToGo mobility clearly sets us apart from generic players. We announced last week further feature differentiation on this front that will allow seamless downloads of TiVo reported programs to both the video iPod and the Sony PSP, giving an even broader array of consumers the ability to take their television programs with them. Since commercials will be downloaded with the programming, it also preserves for advertisers who support the development of these programs the ability to continue to relate to viewers who wish to see their programming in this format. We have made sure this will be done in a secure means with trackable water marking technology.
The third topic I want to cover in my remarks today is our efforts to drive partnership and affiliations with major companies which demonstrate the increasing support TiVo has from others to be a key part of the future TV landscape. See slide 7 here. Partnerships and affiliations with various kinds of media and new media companies are also important to TiVo as they can drive substantial marketing by third parties of TiVo. Earlier this month, we announced a collaboration with Yahoo! that allows Yahoo! TV users to request using TiVo scheduling technology, recordings of their favorite TV shows on their TiVo device from anywhere they access Yahoo!. It will also provide certain content from TiVo such as personal photos from the my photo section of Yahoo! to be displayed on my TV. It will also involve substantial marketing of the TiVo service at the Yahoo! site. We continue to work on additional alliances and partnerships that we expect to unveil over the next 4 to 6 months.
One further announcement that we made today which also goes to the issue of the importance of the role of TiVo in the future of television relates to international expansion. DVRs are beginning to gain visibility as a consumer electronics offering in various international markets. As some of you may recall, with the help of outside investors we formed a joint venture called TGC, which is headed by a former senior TiVo employee. TGC., in which TiVo has a minority interest, was formed in part to offer the TiVo experience to consumers in greater China. TiVo has no cash obligations to fund the venture. Part of its mission is to penetrate certain Asian markets with TiVo units.
The first foray is into Taiwan which is the most highly-cabled market in Asia at well over 80% consisting almost entirely of analog basic subs. A TiVo product will be launched in retail and will be the first DVR made available to the Taiwanese market. A major announcement will be made in early December in Taiwan introducing it to the consumer market. Through TGC and other efforts we continue to focus on the potential for international expansion of the TiVo brand.
I will now turn the call over to Dave for a review of our financial performance.
Dave Courtney, Chief Financial Officer
Thanks, Tom. As you're just heard, Q3 was a quarter in which we implemented a number of actions and programs designed to support our long-term goal of driving increased scale in our subscription base. From a financial perspective, Q3 was a quarter where we were very focused on executing our game plan. We grew revenues dramatically year-over-year. At the same time, our net loss came in significantly better than guidance, indicating that we are managing our expenses well within the bounds that we've set.
As you'll note from the agenda on slide 8, I'd like to cover three areas in my comments. First, operational metrics such as net subscription adds and SAC that are helpful in measuring our progress. Second, financial highlights from both our income statement and balance sheet, and third, our financial guidance for Q4.
I'll begin with our operational metrics provided in our earnings press release which are also highlighted on slide 9. Of the 434,000 total net subscriptions added this quarter, 55,000 were TiVo-owned net subscriptions. This TiVo-owned subtotal is up 38% compared to the second quarter of this year. Churn was 37,000 units out of our total installed base of approximately 1.25 million TiVo owned subs at the beginning of the quarter or approximately 1% per month. Although this overall churn rate is low, some of the reasons for the modest increase in the third quarter included some subscribers going to DirecTV for an effectively free multituner TiVo and other subscribers going to cable for high definition multituner DVRs with lower monthly fees. These are current competitive disadvantages which we plan to address as part of our efforts to differentiate our product offering.
Our subscription acquisition cost per gross add or SAC was $308 in the third quarter of the year compared to $275 last year. While our marketing and advertising expenses were down considerably from last year's spend, our SAC increase was driven by a more aggressive rebate program, a $150 rebate which was coupled with a commitment to the TiVo service for one year. It is important to understand that we see seasonal variations in SAC due to the significant impact of the timing of expenses. In a preholiday quarter such as Q3, we ship a significant number of DVRs into the retail distribution channel in preparation for high activation volume during Q4's holiday period. Accordingly we incur significant rebate expense and negative hardware margins in Q3, resulting in relatively large SAC in Q3 without the commensurate number of activations simply due to timing. In a quarter like Q4, this situation is reversed as we activate significantly larger numbers of subscriptions yet ship fewer DVRs into the retail channel and incur less rebate expense and less negative hardware margin. As a result. Q4 SAC is expected to be significantly lower than in Q3.
A second point I'd like to make on SAC is that we generally believe it is better to evaluate SAC over a longer time period such as a full year. If you take a look at slide 10, you can see our quarterly SAC represented by the bars and our rolling 12 month SAC costs represented by the line. Over the past 12 months, our SAC has averaged $178, which we feel is more representative of a full seasonal cycle. We take a conservative approach to the measurement of SAC. Our SAC calculation encompasses all of our sales and marketing cost, not just the variable components. Variable costs include rebates, revenue share and other payments to the channel minus any hardware gross margin. On top of these variable costs we also include fixed costs such as salaries and semifixed costs such as advertising and market development programs. As a result our SAC metric is much more than just the pure variable costs of acquiring an incremental subscription.
The second major area I'd like to cover are Q3's financial highlights from our earnings press release which are also summarized on slide 11. Service and technology revenues for the quarter increased 52.2% to 43.2 million compared with 28.4 million for the same period last year. This was at the high-end of our guidance for the period. Hardware revenue from the sales of TiVo DVRs were $24.7 million in the third quarter compared with 27.9 million last year. We believe this sales volume has positioned us appropriately in the retail channel in anticipation of the holiday season. Gross margin was 16.4 million up 14.5 million from only 1.9 million last year. This is largely due to the growth in our subscription revenue base which does not require us to scale our costs of revenue proportionately. This highlights one of the key benefits of scale in our subscription business.
Operating expenses were $31.4 million up 13% from last year. This was principally attributable to a significant increase in our legal expenses in connection with ongoing patent litigation. We reported a net loss of $14.2 million and a net loss per share of $0.17, a significant improvement compared to a net loss of 26.4 million or $0.33 a share fort third quarter of last year. As I mentioned earlier, this net loss is significantly better than our guidance.
Our balance sheet continues to be in very good shape. We ended the quarter with approximately $90 million of cash, cash equivalents and short-term investments. We feel very comfortable with this cash balance in light of our anticipated cash needs going forward. Our inventory balance at quarter's end was $21.2 million compared to $36.4 million last year. We are comfortable with the lower inventory number for two reasons. We sold more product into the channel and we were more efficient in our ordering processes from our contract manufacturers. As I mentioned earlier, we believe our products are well positioned at retail for the upcoming holiday season.
Now finally, I'll give you our financial guidance from our earnings press release which is also summarized on slide 12. As we indicated on last quarter's earnings call, we expect to have fewer gross subscriptions added in the fourth quarter than in last year's fourth quarter and we believe we have sufficient inventories on hand to meet expected demand. For the fourth quarter of fiscal year 2006 we expect service and technology revenues in the range of 43.5 million to $45.5 million and a net loss of 17 million to $22 million.
Now we'll open the call up for questions. Operator?
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