OpenTV OPTV
May 12, 2005 - 3:02pm EST by
lil305
2005 2006
Price: 2.29 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 291 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

OpenTV is a classic dot com in the process of a second coming. The Company has always been long on promise and short on profitability with a stock price that was over $200 in 2000 and under $1 in 2003. OPTV produces and sells software for interactive television (ITV) – a longstanding hot concept that is currently being touted as the wave of the future by everyone in media from Terry Semel to Brian Roberts. Here’s why:

1) The TV industry is scared that new technology such as digital video recorders (TIVO) is destroying its advertising revenue stream. The solution is to individually tailor advertising messages – apartment dwellers would be solicited for household products and suburbanites for lawn mowers, a family for a van instead of a sports car. TV executives are convinced that viewers will opt in for ads of products in which they are interested rather than avoid advertising altogether. The resulting database of likes and dislikes will result in highly targeted and much more effective advertising. In short, Google’s success with ads related to a website’s content will now be applied to television. The set top box will remember your credit card and other relevant information - with one click, you can buy what you see. OPTV’s contracts with its customers are being geared to the number of subscribers and/or a royalty stream from the transactions generated. A business such as QVC will become that much more attractive. 2) More sophisticated software will allow additional functions such as multiple camera angles for sporting events that make digital a must-have for many TV viewers. In this regard, satellite has had a big advantage over cable since they are all digital whereas cable has been slow to convert. 3) Gambling (outside the U.S.), interactive games, and video on demand are feasible and major engines for growth.

My thesis is that John Malone as the controlling shareholder of OPTV is about to sell his investment at maybe double today’s price. There are 2 potential transactions: as part of a much larger deal to neutralize Liberty’s 18% interest in News Corp or a sale to Time Warner. L’s recent announcement that they are spinning off their 50% interest in Discovery Network and Murdoch’s comments on 5/4/05 that buying back Liberty’s position was a crucial issue that he expected to resolve shortly are indications that Malone is reconfiguring Liberty.

This writeup is short on typical value measures and details of what Malone might trade and long on the potential value of TV interactivity. The catalysts listed at the end are the key to the accuracy of the recommendation.

Background
OPTV writes and sells middleware (between the basic functions of a TV box and the interactive programs available to viewers) for TV set top boxes and has an installed base of 55 million boxes in 96 countries, more than any other company. The Company has more than 1000 issued and pending patents. Middleware is in effect, an operating system for the TV set top box, allowing developers to write code for services such as video on demand. Middleware is analogous to Windows on a personal computer with modules (programs) added for different interactive features. OPTV’s largest customer representing 15% of its revenue is EchoStar – a fact which argues against the purchase of the company by Murdoch (DirecTV). Not surprisingly, Microsoft is the gorilla in the wings in the business, but there are many other competitors that have a larger installed base.

Liberty Media originally bought a controlling interest in OPTV in October, 2002 and melded another Liberty owned controlled company into OPTV in July, 2003. I calculate an average cost of $5.25 for Malone’s 32% economic and 79% voting interest in the Company. There are about 130 million fully diluted shares outstanding.

In 2001 and 2002 the Company wrote off $1.3 billion of goodwill and has had cumulative losses for the last 5 years of about $2.4 billion. In 2004 revenue was $77 million and the net loss was more than halved to $22 million (18 cents a share). The first quarter just reported showed a narrowing loss and a 30% increase in revenue. The balance sheet is clean with no debt and $60 million of cash and equivalents (tangible net worth ~ $50 million). Breakeven should be achieved in the 4th quarter of this year.

Current Situation
This is a classic Malone chess game – you can make an argument why at least 7 major players might want to buy OPTV (Newscorp, Comcast, Time Warner, IAC/Interactive, SBC/Yahoo!, Echostar, and Microsoft). Listed below is a discussion of the first three.

Malone saw the potential of interactive TV many years ago but misjudged the technology’s complexity and the speed at which digital set top boxes would be rolled out. Now, all the cable / satellite players recognize its potential and want to control its application on their systems. That perceived need for control is probably why OPTV is more valuable to a cable / satellite operator than an investor such as Malone. And although interactivity will be a big part of QVC’s future, QVC shouldn’t be at a disadvantage by having OPTV under another corporate umbrella.

It should be pointed out that a middleware industry standard (OCAP) has been developed, and that many people in the industry aren’t convinced that a proprietary system with its inherent incompatibility issues has long term value.

News Corp
BskyB, FOXTEL and Sky Italia have been successful satellite operators and although some of their boxes use OpenTV software, NDS Group’s middleware (European company also controlled by Murdoch) has the inside track. DirecTV (owned by News Corp) is expanding its services and interactive programming will be an important differentiating sales tool for them. Murdoch is aggressively promoting interactive features, but it would not be logical for News Corp to want to own OPTV given their NDS control.

Comcast
Comcast and Cox formed a joint venture (Double C; majority owned and controlled by Comcast) earlier this year and bought the assets of Liberate (an OPTV competitor and wanna-be) out of bankruptcy. Liberate’s bankruptcy was extremely odd and not well explained since they had roughly $200 million of net cash after all book liabilities at the time of filing. The Company claimed that they had to get rid of some onerous leases, but there was also a lawsuit in which OPTV wanted $100 million for Liberate’s violation of its patents (Liberate also has a counter claim, which I assume is frivolous). OpenTV made an offer to buy all of Liberate when it was in Chapter 11, but was outbid by Comcast/Cox. Interestingly, even though Liberate’s assets were sold, the OpenTV patent suit was not settled and the potential liability is now the responsibility of Double C. The case has been delayed a couple of times pending negotiation between the parties – the new court date for a negotiated settlement is May 26. Net net, one has to conclude that Comcast (and possibly, the Double C joint venture) is a potential buyer of OPTV, or more likely, of Liberty’s voting interest in OPTV, with an intent of combining it with Liberate.

Why would Comcast & Cox buy Liberate before the lawsuit was settled? Potential answer: OPTV has developed an interactive module for advertising (SpotOn) that has been tested in a couple of Comcast’s markets for the last year and a half. Luxury automobile ads for 2 makers have been running recently which supposedly have been met with an excellent response. One of the callers on the 5/10/05 conference call indicated that he had been told by a Comcast employee that SpotOn will be rolled out over the next 2 years in all 51 of Comcast’s markets. OPTV refused to comment, but if true, it would explain Comcast’s leverage over OPTV re the lawsuit. Obviously, Comcast’s adoption of SpotOn would provide an imprimatur for OPTV’s technology in this crucial area and should deliver an exciting new revenue stream.

Time Warner
Time Warner is the odd guy out – Comcast (Liberate) and Murdoch (NDS) have captive middleware investments. The CEO of OPTV is ex-Time Warner (left 4/04 to join OPTV) and has hired other people from TWX.

Others
I don’t consider the other firms listed (+Sony and others) as likely buyers for mostly obvious reasons and won’t elaborate here.

Published Documents
The top executives of OPTV have employment at-will contracts. Per the recent 10-K which came out in mid-March, the top 4 are covered by severance agreements that call for salary payments of a year or more if there is a change of control. That filing also indicated that the Compensation Committee had authorized the CEO to amend executive employment agreements as he saw fit to retain key personnel. Fifteen days later, OPTV indicated that the next 4 executives had entered into retention agreements which appear to increase their severance payments in the event of a change in control, from 6 months to 1 year. There is precedent for this situation: less than 5 weeks before Malone agreed to buy voting control of OPTV (5/8/02), the Company instituted retention agreements for its executives and subsequently paid out $2 million under such obligations.

At the end of March, it was also announced that OPTV’s CFO was leaving (problems instituting Sarbanes Oxley controls), but that he had agreed to stay until May 15. He will be paid about 1/3 of his yearly salary for the extra 45 days but no severance. OPTV has indicated that they have retained a search firm to find a replacement – standard corporate-speak until proven otherwise.

Roth Capital initiated coverage of OPTV in September, 2004 with a buy rating. Roth filed a report on May 9th recommending the stock. Here’s the last paragraph:
“However, the primary driving catalyst for the stock is the possibility of a strategic takeover by Time Warner, in our opinion (TWX-$17.12-Not rated). Such a deal seems more likely with the resignation of CFO Rich Hornstein on April 1, and as OpenTV CEO and Time Warner Cable veteran Jim Chiddix continues to fill the management ranks with other TWC colleagues such as Tim Evard, now SVP of Marketing and Applications Products.”

Early this morning (2 days later), Roth discontinued coverage of OPTV with this comment (I am not aware of a banking relationship with any of the companies I have listed):
“We are terminating coverage on OpenTV in order to focus research on companies more directly related to the advertising and media content sector.
The Company reported 1Q05 results yesterday, posting revenues of $22.8 million vs. a consensus estimate of $21.1 million and net loss per share of ($0.03) vs. consensus of ($0.04).
Effective with this coverage termination, prior estimates and ratings should not be relied upon. Before terminating coverage, we rated OPTV a Buy with a $4.30 price target.”

Catalyst

Transaction between Murdoch and Malone
Retention agreements with key executives
Roth termination of OPTV coverage – only logical explanation is a potential conflict of interest with an acquirer
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