Assessing TiVo In The Wake Of The Verizon Settlement

| About: TiVo Inc. (TIVO)
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TiVo (NASDAQ:TIVO) closed up 4 percent on Monday -- with intraday gains as high as 9% -- after announcing a $250 million settlement with Verizon Communications (NYSE:VZ) related to Verizon's alleged abuse of TiVo's so-called "time warp" patent.

The settlement follows similar deals with DISH Network (NASDAQ:DISH) and AT&T (NYSE:T), who paid $500 million and $215 million, respectively, to the DVR maker to end other TiVo patent suits. The successive patent wins have allowed TiVo to amass an impressive balance sheet; counting the $100 million upfront payment from Verizon, the company now has some $643 million in cash, over half of its $1.18 billion market capitalization at Monday's close of $9.94 per share. The Verizon settlement may also bode well for additional litigation; as analysts told Reuters, the settlement sets yet another precedent for pending cases against Motorola (now owned by Google (NASDAQ:GOOG)) and Time Warner Cable (TWC).

Another analyst, Tony Wible of Janney Capital Markets, was similarly bullish, arguing that the remaining suits had the potential to bring in $1-$2 billion in total, and noting that it was "increasingly difficult for TiVo defendants to hope for favorable rulings" given TiVo's repeated victories in the courtroom. Wible argued that TiVo had a fair value of $14.50 and was now a potential acquisition target, echoing comments he made a year ago.

At the midpoint of Wible's estimate, the $1.5 billion in potential litigation proceeds is double TiVo's $718 million enterprise value (the company still has $172.5 million in convertible debt outstanding). As such, assuming a 50% chance of the company winning all three suits, TiVo's operating business is essentially available for free.

That's the good news. The problem is that the underlying TiVo operating business does not make money -- and, in fact, never has. TiVo has only been profitable for 2 years since its 1999 IPO, and only due to litigation proceeds. The company actually lost some $48 million -- $0.41 per share -- in the first six months of fiscal 2013 (ending January). Bulls respond that the company's growth and new partnerships with Virgin Media (NASDAQ:VMED), Suddenlink Communications, and Spain's ONO mean a turnaround is under way.

With the highest-profile litigation now settled, the question for TiVo investors becomes: can the operating business create any real value for shareholders?

Looking at Q2, TiVo's net revenues were $65.3 million, and its net loss $27.7 million. While those numbers are abysmal, there should be some help on the cost side. Quarterly litigation spend was $12.8 million in the quarter; the company is also working toward lowering its research and development expenses. Guidance from CFO Anna Brunelle on the Q2 conference call suggests total R&D savings in the second half of FY13 will be about $5 million lower relative to the first half, with the bulk of the reductions coming in Q4.

Thus, by Q4, TiVo could easily see a $10-12 million reduction in quarterly expenses, as litigation expenses drop from $13 million to the $5-6 million rate of previous quarters and R&D sees a $4 million drop from current levels. But, still, TiVo needs a $15 million boost to the top line to reach GAAP profitability. $6 million will come from quarterly payments from Verizon, but the legacy business still needs to grow net revenue by $9 million.

And here is the problem. TiVo is still $9 million short from GAAP break-even. Its subscriber growth is predominantly coming from MSO, or third-party agreements with cable operators such as Suddenlink and Virgin Media. ARPU for the company's MSO business was $1.15 per month in the most recent quarter, though, as the company noted in its 10-Q, that number has been depressed by the number of customers coming from new agreements. Those revenues are booked as technology revenues until the cost of customer development is fully reimbursed. ARPU reached as high as $1.94 per MSO subscriber in Q2 of FY12; but that number was inflated by payments from a legacy agreement with DIRECTV (NYSE:DTV).

A return to a more normal ARPU -- perhaps $1.50 monthly -- would boost the top line by about $1.6 million per quarter ($1.05 per quarter x 1.54 million current MSO subscribers). But TiVo still needs an additional $7.4 million to reach breakeven. At $1.50 per month, $4.50 per quarter, and service revenue gross margin of 73% according to the 10-Q, TiVo needs another 2.25 million subscribers -- nearly one and a half times its current base -- to reach break-even.

There is a catch, however, as MSO subscriber growth does not occur in a vacuum. New subscribers require new hardware, which TiVo sells at a loss. Hardware revenues were down slightly in Q2, but up sharply during Q1 due to increased sales to MSO customers. Gross loss from hardware rose $1.5M in Q2, and over $4.7M in the first half.

Secondly, the effect of MSO growth is being blunted by decreases in retail subscriptions, or what the company calls "TiVo-owned." The TiVo-owned subscriber base continues to decrease, falling by a relatively modest 23,000 subscribers in Q2 (the smallest drop in over two years). But TiVo-owned ARPU is substantially higher; $8.42 monthly in the most recent quarter, more than seven times that of third-party subscribers. The drop in TiVo-owned subscribers would cost another $0.5M in the coming quarter, assuming gross service revenue margin stays steady.

The combined effect of increased hardware sales and subscriber mix means that TiVo needs at least another $2 million per quarter -- or over half a million subscribers -- to get to breakeven. All told, even with optimistic assumptions, TiVo needs something in the range of 3 million new subscribers -- roughly double its current base. The difficulty in growing TiVo's top and bottom lines is shown by its performance over the last year; despite better than doubling its MSO base, revenues have grown just over 6 percent, while adjusted EBITDA excluding litigation proceeds and expenses saw a larger loss in Q2 versus the year-prior period.

The amount of subscriber growth TiVo needs is a serious issue for the company. At even the relatively booming subscriber growth of late -- averaging right around 250,000 net MSO additions over the last three quarters -- it would take TiVo three years to reach break-even. That figure may even be optimistic, as it assumes TiVo-owned churn stays at recent, lower levels; it assumes hardware loss will not increase from current levels; and it assumes that litigation spend does not again need to be ramped in the cases against Cisco and Motorola.

This trouble squares with my previous coverage of TiVo, which took a bearish tone primarily because the road for TiVo was so long. To be sure, the company should be credited for the steps it has taken over the last year, which have moved further down that road. The 900,000 new subscribers and the combined $465 million taken from Verizon and AT&T -- dwarfing analyst estimates of a $300 million payday -- show that TiVo has moved forward. But it still has a very long way to go; with a tripling of the subscriber base required simply for break-even results, even more substantial growth is needed for the company to post operating profits.

In short, an investment in TiVo at $10 per share is a bet that either litigation proceeds will come in higher than anticipated -- indeed, higher than the Verizon and AT&T wins -- or that a business that has been unprofitable for 13 years will execute a multi-year turnaround and generate significant cash flow before its key "time warp" patent expires in 2018. With an enterprise value of $718 million -- and losses of $50-100 million likely over the next four quarters -- TiVo will need a monster win in the courtroom, or accelerating growth in the MSO market, simply to justify its current price. Betting on the company to succeed isn't the dumbest bet in the stock market -- but the risk and time involved don't seem to be justified by the potential rewards.

The problem for TiVo is that, Monday's one-day jump aside, the settlements haven't done much for shareholders. The stock has been range-bound for the past two years, trading with rare exception between $8 and $12 per share. Behind the headline-grabbing litigation wins is an operating business that has never made any money during TiVo's 13 years as a publicly traded company. With the focus of TiVo investors and analysts moving away from litigation wins, and back towards a business that is burning cash, today's optimism about TiVo could vanish -- quickly.

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.