TiVo Settlement Ends Bull Case

| About: TiVo Inc. (TIVO)
This article is now exclusive for PRO subscribers.

"From the long side, a loss -- or even a below-expected settlement or award -- would be devastating to the stock. Based on the enterprise value of $1.5 billion, and the continued struggles in the operating business, it would appear that the market is valuing the litigation opportunities at roughly $1 billion (at the least), or nearly double the DISH settlement. Any result below that figure seems likely to knock TIVO back toward single digits."

So I wrote a week ago in discussing TiVo (NASDAQ:TIVO), the maker of set-top boxes and software for digital and video content. And, indeed, it appears the market was valuing the litigation opportunities rather highly, as TIVO shares have plummeted today upon announcing a $490 million settlement with Google (NASDAQ:GOOG), Cisco (NASDAQ:CSCO), and Time Warner Cable (NYSE:TWX). Shares trade at $11.27 as of this writing, off 17.8 percent from yesterday's close.

In last Friday's piece, I wrote that TiVo was essentially, a bad business, but a good stock, with the optionality of a large settlement, a takeover, and above-expected performance from the operating business combining to make TIVO shares a risk worth taking. In the short term, my argument was clearly wrong; with the litigation matter now closed, the question becomes, what is TIVO worth now?

In an SEC filing announcing the settlement, TiVo announced that it would receive the $490 million as a lump sum (though the recognition of the payment will be split between past damages and future licensing revenue). The company already held some $400 million in net cash as of April 30th; the litigation payment now brings its net cash to $890 million, or $7.33 per share. (It would appear that the company will be able to mitigate the tax effect of the settlement through its balance of net loss carryforwards, which stood at $394 million for federal purposes and $202 million at the state level, according to the most recent 10-K. The tax effect will likely depend on when and how revenues from the payment are recognized; as such, we will discount any tax implications for the time being.)

TiVo has roughly 121 million shares outstanding. (There are also 14.2 million shares to be added from restricted stock and options exercise, and 15.4 million from its convertible debt issued in 2011, according to the most recent 10-Q. However, with the weighted average exercise price of options at $7.42, according to the 10-K, and the stock trading right near the bonds' conversion price of $11.16, the dilutive effect of the expanded share base appears to be minimal, in the range of $50-$75 million at most.) At its current price (as of noon Eastern) of $11.27 per share, that puts its market capitalization at $1.36 billion. Less the $890 million in net cash, TiVo's enterprise value sits at roughly $470 million.

In short, accounting for dilution, TiVo's operating business needs to be worth at least half a billion dollars. The problem for TIVO shareholders is that, in fourteen years as a publicly traded company, TiVo has never turned a profit without the aid of litigation settlements. It has posted impressive subscriber growth in its MSO subscriber base (customers acquired through agreements with cable operators) but the far higher profitability of its declining "TiVo-owned" base (customers acquired directly though retail channels) has offset much of the MSO-related revenue increases, keeping the company's operating business in the red.

TiVo's quest toward GAAP profitability will receive one boost from the settlement: a massive reduction in litigation spend. Litigation spending has averaged nearly $11 million per quarter over the last four quarters, according to a trend sheet issued in conjunction with fiscal first quarter earnings last month. Net loss has averaged over $17 million quarterly (excluding litigation proceeds) over the same period, showing the impact of litigation spend in the past and the potential boost from its removal going forward. The company still must close a gap of roughly $5-10 million quarterly, depending on the reduction in litigation spend and its ability to maintain more profitable TiVo-owned subscribers, or at least stem the decline of that base.

As I explained in detail last week, it will be left to the service segment to deliver the increased revenue to move TiVo to profitability. Margins from hardware sales are razor-thin, and expected to decline, according to comments from CFO Naveen Chopra on the Q1 conference call. Technology revenues (excluding any revenue booked from the Cisco/Motorola settlement) have been boosted primarily from revenue recognized from previous litigation against AT&T (NYSE:T), Verizon (NYSE:VZ), and DISH Network (NASDAQ:DISH); those figures do not look set to rise appreciably going forward as revenue recognition from the settlements is pre-determined and will rise only modestly each year.

TiVo must cover the quarterly gap with MSO subscribers, who on a trailing twelve-month basis have provided less than $4 per quarter each in revenue. With a decline in TiVo-owned subscribers -- who contribute more than $25 in quarterly service revenue apiece -- offsetting MSO growth, TiVo, as it has in the past, still needs to create subscriber growth that would appear to approach two million customers, or nearly double its current cable customer base. The company, to its credit, has been posting net growth of 220,000-275,000 subscribers quarterly for the last two years; it will need to keep doing so to have any chance of GAAP profitability by FY15 (ending January 2015).

From there, the question becomes: what next? TiVo's "time warp" patent -- the center of its litigation efforts -- expires in 2018. The revenue effects of previous settlements collapse in fiscal 2019, going from $101 million annually to $51 million, then disappearing in FY20. The company has moved into software and audience measurement in an attempt to become a potential beneficiary -- instead of a victim -- of moves to Internet-based video delivery and the coming "convergence" of consumer content. But TiVo's long-term success is far from guaranteed, given the coming changes in the television and video business and given the fact that again, its core business has never created an operating profit.

With that operating business still valued at (at least) half a billion dollars, the market is pricing in net income of roughly $50-75 million annually by 2017 or 2018. That type of profit growth would require many more millions of MSO subscribers. From where will they come? Major U.S. operators -- save for a dormant TiVo agreement with Charter Communications (NASDAQ:CHTR) -- are either using TiVo or have settled with the company and moved to another provider. An agreement with Virgin Media (NASDAQ:VMED) has provided much of the recent subscriber growth, but as penetration rates increase, adoption rates will slow. The additions of second- and third-tier operators such as Spain's ONO, Sweden's Com Hem, and U.S. operators Mediacom (NASDAQ:MCCC) and Atlantic Broadband simply don't provide the boost that TiVo needs to swing to a consistent, substantial profit.

As such, the below-expected settlement with Motorola and Cisco is a crippling blow to the bull case for TiVo. And it's worth pointing out just how disappointing the settlement was. SA contributor Samuel Biller had estimated the value of a settlement with Motorola alone at $1.6 billion, and he wasn't the only one whose estimates came in well above the final settlement. Janney Capital analyst Tony Wible estimated Google's potential liability at $720 million, while analysts pointed out that TiVo itself had written in court filings that its claims were "likely to run into the billions of dollars." The fact that the proceeds from the Cisco/Motorola settlement came in well below the money won from DISH -- which produced a far smaller sum of potentially infringing devices -- is surprising, to say the least.

Without the potential for a blockbuster settlement, it's simply time to move on from TiVo, at least for now. In the press release announcing the settlement (linked above), the company detailed a fact that shows just how difficult it is to give TiVo's operating business any value at all. The company wrote that the $490 million settlement brings "the total from awards and settlements related to the use of certain TiVo intellectual property to roughly $1.6 billion."

And yet, the whole company is, at current levels, worth less than $1.4 billion. There's no better way to show just how futile the company's operating business has been. For years, TiVo's stock price has been based largely on its litigation efforts. With that potential gone, it's hard to see what else can hold up the share price.

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.