TiVo By The Numbers, Part 4

Financial analysis isn’’t something I’m prepared to tackle publicly, so I’ve brought in some muscle for a multi-part series on TiVo’s numbers. Obviously this is speculative in nature and just one stockholder’s interpretation of the limited information TiVo chooses to disclose. Your mileage may vary. -DZ

As we listened to the 3Q earnings call from TiVo, we were struck by a number of statements made by TiVo’s management that seemed to be clues as to what we can expect from the company in the future. In this installment, we will look at some of these clues in light of the financial analysis we have just completed, and see what we can learn. But be advised: you are entering an area of higher speculation and greater interpretation than we have visited before.

Subsidize Less, Advertise More

We commented in Part 2 about the apparent reversal of position on hardware subsidy after working for so long to get the boxes to a zero-upfront model:

Following the holiday period, we will be evaluating the success generated by this kind of hardware pricing approach versus an approach where there is less rebate on hardware and a greater proportion dedicated to advertising the TiVo product. (Rogers)

We noted in Part 2 the advantages and disadvantages of an advertising approach versus a subsidy approach. One particularly important advantage to advertising was noted by Rogers:

Particularly given all the differentiation that we have now worked hard to accomplish, we really think that there is a credible basis to think about advertising benefiting TiVo and not just educating people about DVRs in general, where we would not necessarily see the benefit in TiVo sales of that increased advertising spend.

Not mentioned here, but extremely important, is that increased advertising, brand awareness, and product differentiation directly benefit not only TiVo’s standalone DVR sales, but also the TiVo-branded products marketed by its partners Comcast and Cox, which are due to become available within the next few months. While these are low-ARPU subscribers, they are also near zero-cost. Any advertising spillover that benefits these programs will work to the company’s advantage, but if the company fails to adequately differentiate the products and target its marketing efforts to the appropriate audience, it will risk competing with itself. A more general challenge will be for the company to maintain its lead in DVR technology and features, and to present those advantages to its target audience effectively and efficiently, something it has struggled with in the past.

Acquiring High-Value Subscribers

One of the most frequently touched-upon topics in the 3Q call was the “value” and “quality” of the standalone subscriber base. This relates directly to the NPV comparisons we made in Part 2, where we saw that subscribers under the new program are far more valuable than those acquired under the old pricing.

What was also clear from our analysis was that the new subs would be even more valuable if TiVo could reduce its SAC. Nearly two-thirds of FY07’s $260 SAC will be hardware subsidy. If TiVo could moderate its growth by decreasing the subsidy, but in the process acquire a subscriber who, because he values the service enough to pay for the hardware will churn at a lower rate than subscribers who are given the hardware for “free,” the company will reduce overall costs, increase the value of subscribers, and move much closer to profitability. This is what we believe is what management is attempting to achieve.

But what is the purpose of the standalone business? And, more specifically, what is the purpose of growth in the standalone business, as it relates to TiVo’s overall plans? After TiVo’s relationship with DirecTV soured, the standalone business carried the weight of all of TiVo’s future. But as the Comcast and Cox relationships begin to unfold in 2007, TiVo’s advertising business will get its mass distribution far more efficiently through those relationships than through standalone subscription growth. Cox and Comcast will also provide a growing stream of high-margin revenue to replace the slowly-disappearing DirecTV revenue.

That leaves the standalone business under much less pressure. Rather than depending on the standalones to drive mass distribution, this part of the business can be used more judiciously to produce a high-margin revenue stream to fund company operations. As Rogers described it:

…what we are trying to do is come up with that right level of growth that responsibly manages our cash, comes up with the highest quality net present value of a sub, and accelerates our growth somewhat beyond what it would be if we were to run the business for profitability today.

By making the standalone business slower-growing, but self-financing, TiVo effectively un-mortgages its future. The company no longer needs push its resources to the limit to accelerate growth. The challenge here will be to find a workable balance between SAC and growth in the face of increasing competition. If reduced subsidies result in dramatically slower growth, and increased advertising does not have the desired results, TiVo will continue to struggle with high acquisition costs and may eventually struggle to even maintain its subscription base against churn.

Going High-End?

One important aspect of TiVo’s business suggested by the quotes above, and others in the call, was that of product differentiation. It is clear that TiVo struggles to compete with “generic” DVRs on their own terms: cable companies distribute their boxes for no upfront cost, no commitment, and competitive monthly charges that are integrated with the customer’s cable bill. Most of the cable DVRs have dual tuners and can record and play high-definition signals, and can interface with the provider’s VOD and PPV offerings. (It is a testament to TiVo’s product and brand that despite its competitors’ advantages, the company continues to make sales in this segment.) TiVo’s best standalone growth opportunities are not in these digital cable markets where the competition comes not only from the MSOs, but soon integrated TiVo/MSO offerings. TiVo’s best opportunities are in analog cable, where the subscribers have few other options, and with higher-end customers who are willing to pay for TiVo’s more advanced features. The Series 2 and Series2 DT boxes have the analog market covered, but what about the high end?

TiVo’s flagship DVR is its recently-introduced Series 3 HD DVR. While its $799 MSRP suggests that it will not be a great driver of subscriptions, the NPV of its subscribers is so great that it doesn’t have to. The box carries no rebate or hardware subsidy, and speculation (though no hard data) suggests the hardware cost is in the $400 to $500 range, giving TiVo a margin – depending on the direct versus retail mix – of (let’s guess) $250. Thus the NPV of a Series 3 subscriber is:

• NPV_S3 = $250 + $434 – $100 = $584

Where $434 is the discounted cash flow of a new sub, and $100 is the non-hardware-subsidy part of SAC. $584 is more than three times the value of ordinary subsidized subscribers, and six times the value of subscribers acquired last year. If TiVo can sell just 20,000 of these boxes in the fourth quarter (an attainable goal, certainly), those sales will produce the value of 66,000 ordinary subscribers, or 120,000 of last year’s subscribers.

(TiVo is also offering current lifetime subscribers a one-time option to transfer their lifetime subscription to a new Series 3 for $199. Using the same numbers, we get an NPV of $250 + $199 – $100 – $99 (where $99 is the negative cash flow over the life of a lifetime sub). That gives TiVo a sub with an NPV of $250 and, more importantly, nets the company a profit from a money-losing lifetime sub acquired under the old system.)

While the Series3 box is an extreme example, it does demonstrate the desirability of attracting the “higher value” subscriber that Rogers and Sordello talked about. If, through continued product differentiation and advertising, TiVo can attract a class of subscriber that is willing to pay more for the features TiVo offers, the company stands a chance of finally stopping the flood of red ink that has plagued its history.

Notes:

• The DCF and NPV numbers used here are somewhat different from those used in earlier parts. We have revised those earlier numbers, and what is provided here is our current best analysis.