Description

I am recommending shorting the equity of Tivo, Inc. Tivo licenses and distributes a digital video recording (DVR) service that gives the subscribers the ability to digitally record, pause, and rewind live television, storing the video in a hard drive, either built into a multi-channel set-top box or a stand alone device. Tivo is the leader in DVRs today, and it is a great product, but in my opinion DVRs are ultimately a feature of a multichannel video platform, and not an attractive standalone opportunity. Multichannel TV providers typically do not play well with others and in general have been reluctant to let another company have a meaningful relationship with their customer and participate in the monthly income stream. The company is losing money and their relationship with their primary distribution partner, DirecTV, appears to be in jeopardy.

Tivo sells through more than 3500 retail outlets and costs between $200-$400 per box. They also distribute through DirectTV. Tivo currently has approximately one million subscribers. About half are from DirecTV and half from retail. Once they purchase a unit, retail customers pay $12.95 per month or $299 for lifetime service. 50% of retail customers take the lifetime option initially, and ultimately a total of 2/3 rds of subscribers end up converting to lifetime subscribers. This creates deferred revenue, and a long –tail liability to service these “lifetime” customers.

While Tivo has a catchy name and has generated a lot of buzz, it continues to lose money, and its hold on the DVR market is slipping. This is a natural add-on to bundle with cable or satellite services, and all of the major cable MSOs are experimenting successfully with various offerings. Scientific Atlanta’s Explorer 8000 set-top box has an imbedded DVR and is beginning to ship briskly. Tivo has been working for the last few years on trying to reach a distribution agreement with a cable MSO, but to date there have been no takers. Why would there be when MSOs can buy a set-top box with basic DVR functionality from Scientific Atlanta and provide the same service to subscribers at a lower cost?

DirecTV’s primary satellite competitor Echostar (DISH) has its own proprietary DVR. In Echostar’s last conference call they cited their proprietary DVR as a competitive strength, because it gives them a lower cost structure vs. paying a third party. With premium packages, Echostar and DirecTV don’t currently charge any additional monthly fee - once subscribers pay for the box (currently $199). Basic subscribers pay $4.99 per month. Cable operators will are experimenting with similar models, such as bundling a free DVR with a digital package. Ultimately all multichannel TV providers will need to bundle DVR for free or for a very low cost to stay competitive. For that reason, the monthly subscription aspect of Tivo’s revenue stream is in jeopardy of never really happening in a big way. DirecTV has already reduced the monthly fees they pay Tivo down to an estimated $1.50 per sub, from as high as $9.95 in years past.

Much has been written recently about the future of Tivo’s deal with DirectTV. DirecTV will soon be controlled by NewsCorp., which owns its own proprietary DVR technology platform called NDS which is currently in use at BskyB in the UK. Rupert Murdoch has been outspoken recently about the importance of DVR in the battle between cable and satellite, and his desire to rapidly penetrate DVRs at DirecTV by greatly reducing their cost to consumers. If Murdoch decides to stay with Tivo at DirecTV, having his own DVR platform in hand will certainly give him a lot of leverage to recut the deal with Tivo again. I would expect that if this happened that Tivo would receive a very nominal license fee per subscriber in order to avoid the embarrassment of being dumped outright and to keep the hope alive for a cable deal and the retail business. More likely, I believe, is that DirecTV relaunches DVR with an aggressive promotion using the NDS platform, while continuing to support the old subscribers using the Tivo platform. Therefore, regardless of whether DirecTV stays partnered with Tivo or not, I believe that this relationship will ultimately contribute little to Tivo’s still negative bottom line.

That leaves Tivo with retail distribution where there is also increasing competition,(Replay TV recently bought out of bankruptcy by Denon)a small amount of licensing/technology revenue from hardware makers, and potential revenue from advertising and data sales - if these markets even develop. Hardware sales have a slightly negative gross profit.

With approximately 86 million shares including warrants and options the current market cap is about $775 million or roughly 11.9X this years expected service and technology revenues of $65 million. Cash stands at $62 million with last quarter’s loss of $4.4 million. This valuation should provide cushion for plenty of positive developments at the company. Bullish analysts don’t see marginally positive EPS for the first time until 2006. I don’t believe that they will ever get there because by 2006 DVRs will be bundled by everyone for free. Because of the competitive dynamics and the fact that the company is losing money, I believe the best way to value the company is by sum-of-the-parts analysis. I estimate that the Tivo brand is worth $100 million, the company’s NOLs are worth $90-$100 million, and cash of $60 million (and dropping) yields a value of a little over $3 per share.

The risk here is that Tivo has had strong subscriber growth this past quarter due to strong promotion and rebates. This will be highlighted again on their earnings call this Thursday. This recent sub growth is what accounts for the recent rebound in the stock price. Timing with shorts is always tricky and it would be better if subscriber growth was flattening. Of course, by the time that happens Tivo will have sold off hard. So, given that I firmly believe that Tivo will have a difficult time ever becoming profitable, I am OK with perhaps being a little early. I certainly don’t want to miss being there when any potential DirecTV announcement hits.

In summary, Tivo has a great product but it belongs in someone else’s bundle and I don’t believe that Tivo’s offering or intellectual property is unique enough to drive anything more than a marginal profit even if the company gets scale. The timing here is a little difficult, but after more than doubling already this year a lot has been discounted and the ultimate outcome to me seems fairly certain.

Catalyst

1. Renegotiation/termination of DirecTV deal.
2. Increased competition from cable operators.
3. Slowing growth at retail.