TiVo Beat Not Quite What It Seems

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

At first glance, the second quarter earnings report from TiVo (NASDAQ:TIVO) should be considered a roaring success. It should put to rest my long-running skepticism that's the company's operating business -- beyond the numerous litigation wins defending its core "time warp" patent -- would ever be profitable. And it should have created gains far higher than the roughly 5.6 percent jump seen in trading on Wednesday.

After all, the company announced -- in the very first line of its release -- that it had finally reached "sustained net income profitability." CEO Tom Rogers took a victory lap of sorts, repeatedly referring in the release and on the post-earnings conference call to the "scrutiny" faced by the company for being unprofitable for so long. (Excluding the impact of litigation settlements, TiVo has never recorded an annual profit since going public in 1999.) Meanwhile, the company's cash and investment balance -- boosted by a recent $490 million settlement with Google (NASDAQ:GOOG), Cisco (NASDAQ:CSCO), and Time Warner Cable (NYSE:TWX) -- now surpasses $1 billion, relative to a market capitalization of just over $1.4 billion.

As such, TiVo now looks like a business with an enterprise value of $400 million and what Rogers called "the foundation" to surpass $100 million in EBITDA (earnings before interest, taxes, depreciation, and amortization) next fiscal year (ending January 2015). That kind of EV/EBITDA multiple -- about 4 -- seems low, considering the company's growth. Net revenue rose by more than 50 percent year-over-year in Q2, while the company's subscriber base increased by one-third relative to the same point a year ago.

But a deeper look at TiVo's fundamentals shows that the concerns about its operating business are still valid, and that the combination of TiVo's war chest and future earnings is not quite what it appears to be. As for the latter, TiVo's balance sheet is impressive, to be sure; as of July 31st, the company had $1.03 billion in cash and cash equivalents against just $172.5 million in debt. That debt comes from a convertible bond offering issued in 2011; TiVo shares current sit modestly above the conversion price of $11.16 per share, meaning the company would, at current levels, repay the bonds in TiVo shares rather than cash when the convertibles come due in 2016.

But that convertible also represents a reasonable amount of potential dilution for current TiVo shareholders. According to the most recent 10-K, some 15.4 million shares stand to be issued upon conversion of the debt. Indeed, diluted share count rose to 138 million in Q2, putting TiVo's actual market capitalization at about $1.6 billion, and its enterprise value around $600 million.

Still, relative to the possibility (not guidance, as Rogers emphasized on the call) of $100 million in FY15 EBITDA, TiVo still looks cheap on an EV/EBITDA basis. That seems particularly true given that profitability now seems firmly established, while the company's subscriber base is growing at an exceptional clip.

But there is a very real problem with TiVo's claims of "profitability." While technically true, TiVo's seemingly newfound profits are not newfound at all; they are a direct result of the much-discussed and much-despised Google settlement that drove the stock down some 17 percent. The company is recognizing $18 million in licensing revenue quarterly from the settlement; but that money is already in the bank. As such, claiming the company has $1 billion in cash and is will be near-term profitable requires a bit of double-counting. It requires that the Google settlement count both as cash on the balance sheet right now and as revenue on the income statement in the future. Obviously, it can't be both.

What TiVo is doing is perfectly legal, and perfectly acceptable in terms of the accounting; according to CFO Naveen Chopra on the conference call, the company broke out $381 million of the $490 million settlement as future licensing revenue. That amount has thus been added to its deferred revenue liabilities on the balance sheet. The company will then draw down that amount as licensing revenue is recognized quarterly. But what investors must realize is that the settlement revenue does not change the operating business in any way, and since that money is already in the bank, the $18 million in revenue will be solely an accounting technicality; it will not flow to the cash flow statement or in any other way impact shareholders' future distributions through dividends or share repurchases.

Beyond the Google agreement, previous settlements have a similar effect in the difference between future earnings and future cash flows, though on a smaller level than that of the Google settlement. In the 10-K, TiVo broke out its annual recognition of revenue from agreements with DISH Network (NASDAQ:DISH), AT&T (NYSE:T), and Verizon (NYSE:VZ):

TiVo Settlement Revenue Recognition

from TiVo's fiscal 2013 10-K

In FY15, TiVo will now recognize some $168 million in revenue from the four settlements (including $72 million from Google, at $18MM quarterly). Yet the company is not receiving nearly that much cash. Rather, it will receive:

  • $33.3 million from DISH, one of six annual installments that total $200 million from 2012 to 2017 (side note: TiVo did receive the DISH payment before the end of Q2)
  • $26 million from AT&T, with quarterly payments of $6.5 million until Q2 2018
  • $24 million from Verizon, with quarterly payments of $6 million until Q3 2018

All told, next fiscal year, TiVo will recognize $168 million in revenue but receive $83.3 million in cash -- less than half that amount.

Again, there is nothing unethical or illegal about this; but the difference between what the company will report as earnings, and the cash that will flow into its coffers, will be substantial for the next several years. And it calls into question TiVo's bold proclamations about profitability. Rogers' citing of the "foundation" for $100 million in Adjusted EBITDA in FY15 was based on three factors: the company's likely ability to be Adjusted EBITDA profitable this fiscal year (excluding the impact of the Google settlement but including litigation costs) combined with $70 million in Google-related revenue and $30 million in reduced litigation spend.

But the deferred revenue balance needs to be accounted for. When looking at TiVo, investors can either account for the deferred revenue balance relative to the enterprise value or to its true earnings. A market capitalization of $1.6 billion - $1 billion in cash + $400 million in deferred revenue means TiVo's enterprise value under this scenario is about $1 billion, relative to Adjusted EBITDA of $100 million next year. Or, one can remove the Google revenues from EBITDA, in which case the company has an enterprise value of $600 million and forward Adjusted EBITDA of $30 million. Neither multiple is particularly compelling. Bear in mind, too, that the company excludes stock-based compensation from its Adjusted EBITDA calculations; that compensation totaled $36 million over the last twelve months.

All told, the true EBITDA from TiVo's operating business next year is still likely to be roughly modest, when discounting the Google revenue (which is purely an accounting technicality) and including the substantial stock-based compensation (the trailing twelve-month compensation represents about 26 cents per diluted share). While the company may report strong Adjusted EBITDA, and even positive GAAP net earnings, that will be based on legacy revenue that is only being recognized on an accounting basis; it seems highly unlikely that the company as a whole will generate any substantial cash for its shareholders next year, and in fact the operating business will continue to burn cash.

The reason for that is that TiVo's operating business is still not doing all that well. I have long pointed out that the company's subscriber growth simply does not translate well to the top line. The company is adding third-party (known as 'MSO') subscribers at impressive rates; nearly 1.9 million cable operator subscribers have been added in the last two years, as the total MSO base has better than tripled.

But over the same period, the company's retail subscriber base (referred to as 'TiVo-owned') has fallen nearly 16 percent. And the TiVo-owned subscribers are massively more valuable to the company than those signed up through cable and satellite operators. In Q2, according to trend sheets published by the company, average revenue per user (known as 'ARPU') for MSO subscribers was $1.15 per month; for retail subscribers, the figure was nearly 8 times higher, at $8.81.

As such, the impressive MSO growth simply cannot overcome the slow decline of retail-owned subscribers to create revenue growth from the operating business. The company guided for third quarter service and technology revenues to rise from $61 million last year to $80-82 million this year. That represents year-over-year growth of 30-35%, a seemingly impressive figure.

But all of the $19-21 million increase comes solely from the courtroom victories already won. The Google settlement adds $18 million, while the Verizon settlement accounted for $2.4 million in Q3 last year (according to the company's conference call) but should increase by roughly $4 million this year.

What this shows is very simple: TiVo's operating business -- the ongoing deployment of devices through cable and satellite operators, and the sale of those devices through retail outlets -- is not showing any real growth. The company may see some revenue growth through hardware revenues (no guidance was given for that segment), which doubled year-over-year in the most recent quarter. But gross margin in the hardware segment is in the single digits (and was traditionally negative), meaning that segment will not drive profit growth.

Once again, the problem for TiVo is simple: its operating business does not show any real value. It has historically been unprofitable, and when excluding the impact of already-disclosed and already-priced-in legal settlements, it is not creating any sort of top- or bottom-line growth. That is why the massive legal settlements have, for the most part, not moved the long-term trajectory of the stock, which has been basically range-bound between $8 and $12 for the past three years.

To change that, the company still needs massive increases in MSO revenue, or a hit with its admittedly well-reviewed new Roamio to stem or reverse the long decline in its retail subscriber base. It might find another legal target, though the guidance for substantially lower litigation spend would seem to rule out another return to the courtroom in the short term. A takeout of the company has often been the subject of speculation, but settlement agreements with long-cited acquirers Google and Microsoft (NASDAQ:MSFT) and an increase in the conversion rate of the convertibles upon a change of control would seem to be obstacles to such a deal.

And even if the company does manage to maintain its retail base or accelerate MSO subscriber growth enough to move the top and bottom lines, revenue and cash payments from its licensing settlements begin to fall away in 2017, while its key "time warp" patent expires the year after.

All told, in a real sense, TiVo is still not running a profitable operating business, no matter what the accounting numbers say. That has been the company's problem for the nearly fifteen years it has been publicly traded. Without a profitable operating business, the stock is simply not going to show any real appreciation. And, beyond the numbers, yesterday's report shows that TiVo's business is still stalling out.

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.