Tivo: Where is the stock headed?

Tivo is a leading DVR (Digital Video Recorder) service company. The company's product revolutionized the way people watch TV. DVR records TV programs and allows to viewers to skip commercials. While watching TV programs, the viewers can also instantly rewind, pause, or play the programs in a slow-motion mode, making the device very useful for the sports program. Once you are used to DVR, watching TV without it is a painful experience. DVR is to watching TV as microwave is to cooking a meal. When you don't have it, you do not know what you are missing. Once you have it, you would feel terribly inconvenienced without it.

For this reason, DVR has been adopted by the TV viewers at a brisk clip. In 2000, any one hardly knew of DVR. Today there are estimated 10 to 12 million DVR users in the US. By 2009, this number is expected to surpass 50 million. The adoption of the DVR is accelerating among many TV viewers. If you knew this trend, you would think that Tivo share would be going higher and higher. However, the reality has been quite the opposite for Tivo. Since reaching the peak around $78 in 2000, the share price has seen sometimes abrupt and other times steady decline. And it has spent most of the time trading between $4 and $8 last two years. Shorts love this stock with 20% of the entire float being shorted today. Whenever the stock reaches the upper trading range, the shorts automatically sell shares, frustrating many long term investors. So why does investor remain so skeptical about Tivo long term future?

It is all about the competition.

Competition is the primary reason for Tivo stock's underperformance. Tivo currently makes money charging monthly subscription fees for DVR service, ranging $10 to $16 depending on your term commitment. Although Tivo was the very first company to market DVR for the mass, the big cable and satellite TV companies saw the big lucrative market in the DVR space and started selling their copycat version to their own subscribers. These big companies have the resources to subsidize the hardware and have the easy product distribution channel to promote their product. Tivo initially have struck a deal with AT&T cable for distribution partnership. Unfortunately, when AT&T cable unit was acquired by Comcast, the partnership fizzled as Comcast pursued its own DVR over Tivo solution. Tivo also had partnership with DirectTV; however, when the contract term ended in early 2006, DirectTV chose to go with its own DVR powered by NDS software. In the meanwhile, other cable companies such as Time Warner, Charter, Cox, and Cablevision started to deploy their own DVR system. In addition, Dish Echostar also had promoted their own DVR units, capturing 4 million DVR subscribers within a few years time frame. All these competition news clobbered the Tivo share price. Long time partner DirectTV going with its own DVR product took the share price from $12 to below $3 and at one point, I thought the company was not going to make it.

The concern of the competitions is legitimate. However, in my opinion, shorts have become too complacent on the prospect of the competition eating away all Tivo's lunch. For example, the news of DirectTV terminating relationship with Tivo has plagued the Tivo shares for last year and a half. Then finally Tivo struck a business partnership with Comcast to deploy Tivo software on Comcast DVR network. In addition, Tivo eked out DVR distribution deal with NCTC independent cable providers with 14 million subscribers. Tivo also announced small trial deal with Cablevision. Yet this news has been largely ignored over DirectTV terminating the business relationship with Tivo.In my opinion, more the shorts become complacent, larger the upside potential becomes for Tivo. Business fundamentals for Tivo have improved to the best level it has seen since 2000. Yet, the market has not properly accounted that into the share price. I believe this has created a good opportunity for us to put some of our speculative money with Tivo.

Improving business fundamentals and catalyst for share price appreciation

Tivo has been a pioneer in developing DVR product and owns extensive patent portfolio in DVR hardware and software. In April of this year, Tivo finally won long battled patent litigation against Dish. The jury has awarded Tivo with roughly 85 mil in damages. Following the lawsuit, DirectTV renewed business relationship with Tivo for existing DirecTV Tivo customers till 2010. Just last month, Texas court granted Tivo the injunction against Dish, forcing Dish to disable all 4 mil affected DVR. Next day, Dish was awarded the stay on the injunction while the higher court gathers all the legal documents to hear the appeal claim by Dish. I expect Dish will be forced to settle once injunction is enforced by the appellate court. This could instantly add 4 mil DVR subscribers available for service revenue and ad market. The settlement will instantly boost the subscriber count to 8.4 mil.

On the heel of possible injunction against Dish, cable providers are now rethinking their strategy to abandon Tivo. Cable providers can now use Tivo to snatch satellite customers who faces the terrible inconvenience once their DVR is no longer working until Dish finds the alternate solution that does not infringe on Tivo's patent. In addition, cable providers themselves face the prospect of litigation from Tivo. In lieu of this prospect, Cox recently announced the Tivo software deal on their DVR network. I expect Tivo to announce additional MSO deals from other cable providers such as Time Warner, Charter, Cablevision, ect. Tivo may also approach DVR manufacturers such as Motorola and Cisco for future business partnership based on recent patent win that validates its extensive IP in the DVR space.

Aside from the favorable litigation outcome that portends further business deals, Tivo also has the product momentum. Long waited HD DVR with internet content viewing capability (series 3) is about to be launched this fall. Also clearly differentiated current product which includes ability to control what kids watch (Kid's zone), internet content availability, and transferring recorded TV programs to mobile devices such as iPod and laptop is likely to create marketing momentum for the existing DVR product line.

And don't forget about the ad market.

If Tivo was a purely a hardware company, I would not be interested in the company as much as I am now. After all, all hardware products are eventually commoditized and if you are a single product hardware company, your chance of making prolonged success is very very slim. But Tivo is a service and ad company and many people don't perceive the company as such. Tivo DVR has a powerful software platform that is able to measure viewer habits, insert pop-up ads while the commercials are being skipped, and offer on-demand commercials for the targeted viewers. Tivo has recently struck business deals with ad agencies. In addition, Tivo also has business relationship with Neilson rating agency which rates TV program.

As DVR becomes more prevalent, more and more commercials will be skipped. Thus, traditional 30 sec TV ad will be highly ineffective as most of these ads will be skipped. Ad money is likely to flow into other methods that will capture the viewer's attention. This change in how the ad money is distributed into different channels is likely to benefit Tivo as the company has a software platform that accommodate several means of inserting ads according to selective TV viewers. Ad revenue has a high margin and large potential. I see Tivo possibly becoming Google of the TV world. Google used its powerful search engine capability to dominate in the internet ad market. Tivo has the best search capability of the TV programs and platform to measure people's viewing habits. As Tivo garners more and more subscribers, ad revenue will become a bigger piece of the overall company revenue. In the future, I expect ad revenue will surpass that of core DVR business.

Latest earning results and secondary stock offering

Last week, Tivo released Aug earning results. Loss came in at 7 cents which is less below expected 14 cents. Net sub adds were low at 1000 as the company pull backed on the marketing expense and mainly relied on Tivo web site to sell its DVR. If you take out the high litigation expenses against Dish, Tivo actually had a earning close to breakeven this Q. Over the next two Qs, I expect Tivo could be more aggressive in marketing its DVR in the seasonally strongest Q of the year. This will show higher loss figures. However, as Comcast deployment which kicks in late this year and additional subs added in the second half of this year may help Tivo to achieve profitability by Aug of next year as the company pulls back on the marketing expenses. So Tivo shows higher loss figures to grow faster in the second half of the year and as it pulls back on the hardware subsidy cost and marketing expenses in the first half, larger sub number helps the company to achieve higher profitability.

After the market close today, Tivo announces secondary offering of additional 8.2 mil shares. I expect the company to use the proceeds to work on engineering cost to help MSO to adopt Tivo software, to fund the more aggressive marketing campaign, and to support litigation expenses against Dish and other companies. Secondary offering will dilute current shares counts and hence could pressure the stock in the near term. However, I want you to use the dip to add your position as I see positive catalysts mentioned above to be the topics to focus as we go forward.

Conclusion

Tivo is a high speculative play. In my opinion, shorts have overstayed its welcome. Expect volatility in the near term. If injunction against Dish is overturned, the stock could shave off another $1 from its current price. However, given the improving outlook, the stock will come back eventually. On the other hand, if injunction against Dish is enforced, I see the stock bleaching above $10. More than 20% of the shares are shorted. Too many analysts have sell or hold rating. Jim Cramer always talks down on the stock. I believe that when everyone hates the stock, you buy the stock. And do not be surprised to see the shares break above $15 when some analysts mildly turn positive.