Quick take: The Most Important Two Minutes From The TiVo Conference Call

TiVo (TIVO)
Fiscal Q4 2006 Earnings Conference Call
March 8th 2006, 5:00 PM EST

Executives

Marilyn Lattin - Head of IR
Tom Rogers - CEO
Dave Courtney - CFO
Stuart West - VP, Finance

Analysts

Tony Wibel - Smith Barney Citigroup
Lee Westerfield - Harris Nesbitt Gerard
Brian Coyne - Friedman, Billings, Ramsey
Jeff Shelton - Natexis Bleichroeder
David Miller - Sanders, Morris, Harris
Richard Baldry - First Albany Corporation
Robert Malachi - JP Morgan
Daniel Ernst - Hudson Square Research
Chris Rowen - SunTrust
Lloyd - Thomas Weisel Partners
Robert Hailey - Gabelli and Company
Jeff Schreiner - American Tech Research
Michael Kelman - Susquehanna Financial
J.D. Abouchar - Pacific Edge Investments
John Sheridan - Deutsche Bank

Presentation

Operator

Good day, everyone. Welcome to the TiVo fourth quarter fiscal 2006 earnings conference call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Marilyn Lattin, TiVo’s Head of Investor Relations.

Marilyn Lattin

hank you, operator. Good afternoon everyone. With me today are Tom Rogers, Chief Executive Officer; Dave Courtney, Chief Financial Officer; and Stuart West, Vice President of Finance. We are here today to discuss TiVo’s financial results for the period ending January 31, 2006 which is the fourth quarter of our fiscal year 2006.

About an hour ago we distributed a press release detailing these financial results. We have also released some visuals designed to guide you through the call. Additionally, within a few hours we will release a recording of this call, both in a streaming online format and through a downloadable MP3 podcast. You can access all of these through our investor relations website at www.TiVo.com/IR.

The prepared remarks will last about 30 minutes, and then we will leave another 30 minutes for the question-and-answer session. Before we begin, I would like to note that our discussion today will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that relates to TiVo’s future financial results, partnership products and other factors that may affect future earnings or financial results. You can identify these statements by the use of terminology such as guidance, believe, expect, will, or similar forward-looking terms. You should not rely on these forward-looking statements, as they involve risks and uncertainties that may cause actual results to vary materially from the forward-looking statements. We describe these risks in TiVo’s recent SEC filings including our annual report on Form 10-K and our quarterly report on Form 10-Q. I’d also like to note that any forward-looking statements made on this call reflect analysis as of today and that we have no plans or obligations to update them. I will now turn the call over to Tom Rogers. Tom.

Tom Rogers

Good afternoon. Thanks for joining us today to discuss TiVo’s fourth quarter earnings. I will cover four topics: highlights of the quarter, new pricing initiatives, feature differentiation, and the distribution update. I’ll begin by highlighting some of the trends in the quarter, beginning with a high-level view of our financial metrics. Please see slide 4 for some accompanying notes on that matter.

At the end of the fourth quarter, our total cumulative subscriptions hit approximately 4.4 million, 45% growth over last year. With this increased sub base, our service and tech revenue improved 37% to $47 million in the fourth quarter and increased 48% to $171 million for the year. Our net loss for the quarter improved to $19.5 million, compared to $33.7 million a year ago. On an annual basis, our net loss improved 57% to $34.4 million from $79.8 million last year.

Importantly, fiscal 2006 was our first year with positive cash flow from operations. We want to stress that our current model and mix was able to add 500,000 gross subs before churn on a cash flow positive basis. We think that is a key part of our model that has not been well understood.

Operationally, we added 356,000 net subscriptions during the quarter. Our stand- alone growth subscriptions were 221,000 which is our second-best gross sub add quarter in history. In addition, our stand-alone net subscriptions were also our second best in history, at 183,000.

Let me take a moment to comment on this. These numbers represent a decline compared to last year, reflective of the more challenging competitive environment. However, Q4’s results also suggest an improvement in year-over-year trends. For example, Q3 of this year was 47% below Q3 of last year. Q4 of this year was only 27% below Q4 of last year. The percentage sequential growth from Q3 to Q4 also improved significantly between this year and last year. I believe this improvement in the year-over-year trends shows the early traction from our new marketing programs.

We added 173,000 DirecTV subscriptions, in line with our expectations. As an aside, during the holiday season, it appears TiVo’s stand-alone units outsold the NDS box. Virtually all of our new subs during the quarter came on board with a one-year minimum contract. This is interesting, because many of the units purchased during the holiday season were given as gifts and therefore the recipient of the TiVo box was the one activating the TiVo service. However, we experienced no consumer resistance to signing up to a minimum one-year contract, even with the obligation to pay up to $150 penalty fee for early cancellation.

Sales through TiVo.com grew to 34% of our hardware unit sales. A significant increase from the fourth quarter of last year. With a bundled offer of one year of service and a box purchased with a single, upfront fee, there was no mail-in rebate. In fact, we had our best online quarter in TiVo’s history. Our direct channel is now our most efficient source of new subscriptions in terms of the acquisition cost of acquiring a new sub. Of course our retail channels also remained strong, with the peak holiday week — the week before Christmas — just as strong as ever.

Before I move on to discussing our new pricing initiative, I’ll discuss our subscription acquisition cost for the quarter. Our SAC was $157 in the quarter, compared $140 last year despite the fact that we raised our rebate by $50. The fact that our SAC has only increased by $17, even with the larger rebate, shows our progress in advertising efficiency. We spent our advertising dollars quite conservatively, while we were assessing what the best pricing and packaging options are. If we see results in the market as promising as the test results, we are going to look to more aggressively market the product.

Let me remind you that we take a conservative approach to the measurement of SAC. Our SAC calculation encompasses all of our sales and marketing costs, including fixed overhead structural costs, not just the variable components which other companies often limit their SAC calculations to. Also, the largest component of our SAC which will be an even larger component in our new zero-base pricing is the hardware subsidy. With the new pricing, those sales do involve an increase in SAC, but the increased pricing also creates a higher net present value per subscription.

Now onto the topic of our new pricing initiative which we just announced today, after completing several months of market research and extensive testing in the marketplace. We believe the additional pricing options being created will have a positive impact on driving our subscription base. When I spoke to you during my first earnings call at TiVo, I said that driving greater scale in our sub base is a critical goal, particularly with stand-alone sales driving a greater part of our growth over the next year, until the Comcast relationship kicks in. Over the past four to five months, we have taken a hard look at our pricing strategy, distribution model and the overall satisfaction of TiVo customers.

Just to remind you, when we tested the direct marketing of these new pricing options by providing longer form, more detailed messaging about the TiVo service, we found that call volume increased, but conversion rates were constrained by disenchantment with having to pay both an up-front fee and a monthly fee. That caused us to test various pricing options that took away the hybrid nature of the offer.

After careful research and testing, we believe that the bundling of the TiVo service together with the TiVo box will be highly appealing to a certain segment of subscribers, particularly analog cable subscribers, which are a prime target for us. We found in testing zero up-front offers we converted subs at a significantly higher rate than our current marketing approach and that result held up through a number of phases of testing. Thus, we will now be offering an all-in-one price based on a one, two, or three-year commitment at $19.95, $18.95, or $16.95 per month, with no up-front hardware cost. You can turn to slide 5 for details.

We also found that a number of potential subscribers under no circumstance want another monthly bill to add to their current array of cell phone, cable, Internet and other monthly charges. Therefore, we came up with pricing plans to be responsive to this kind of customer as well. So as an alternative, a subscriber can prepay $224 for one year of service, or $369 for two years of service, or $469 for three years of service for an all-in package that included the TiVo unit and service combined. With this new pricing plan we will no longer be offering a lifetime service option.

To be clear, this new pricing for now will only be available for sales done through TiVo.com. We are exploring the possibility of launching similar types of programs into retail later in the year. This delay is due to reasons such as tying into the IT infrastructure of retailers, which needs to be addressed. Note that this new pricing initiative will not have much impact to our first quarter sub growth, as it won’t be launched until next week.

We think these new pricing plans will be particularly attractive to cable analog subscribers, which are a key target for our stand-alone sub growth. In fact, in the fourth quarter, 49% of our new subs were analog subs. Under new bundled pricing, assuming a conservative set of assumptions, our lifetime value of a subscription could potentially increase by as much as $100 due to higher monthly fees and the benefits of reduced churn. It could increase more, depending on assumptions related to subscriber longevity.

In fact, we are already experiencing lower churn as a result of implementing our minimum one-year contract approach for new subscriptions over the last several months. Our churn has gone from 1% in the third quarter to 0.9% this quarter. Again, with no up-front fee, our SAC does increase by approximately $50 to $100, but as mentioned, we benefit because of higher revenue resulting in a much higher net present value per subscription.

The third topic I want to discuss is product differentiation. We continue to offer a number of major features which are truly differentiated from other DVRs in the market and further counter commoditization. Turn to slide 6 now. Last week, we launched TiVo KidZone, a powerful new tool that provides concerned parents the freedom and flexibility to choose specific television programming appropriate for their families. As part this initiative, TiVo is partnering with leading parenting and family groups including Common Sense Media and the Parents Television Council, the two largest grassroots organizations with over 4 million members between them, to create the first real answer to the 50-year-old question of how to create the right television environment for children in the home.

Families, public policymakers and the media and entertainment industry have been grappling for decades with the issue of what our children can and should be able to watch on television, but they’ve been unable to find the right solution. Parents do not have the time to create customized menus of what they want their kids to watch and to truly filter the most age-appropriate television for their kids. There are expert groups that represent different philosophies and values in what is good television programming for children, such as Common Sense Media and the Parents Television Council, that regularly provide recommendation menus for parents to follow. What TiVo has create is a simple means by which a parent can choose an entire menu of weekly recommendations for what children should watch, and the TiVo service will automatically record all of those shows so that there will always be a full array of quality TV choices any time the child turns on the TV. A parent can edit this menu by making specific programs or channel additions or deletions to customize an expert’s recommendations even further.

Most importantly, when a TiVo DVR is in the TiVo KidZone mode, it locks out all other programming, both live and recorded, for access by children in the home. This is all done with very specific age criteria in terms of choosing individual menu offerings. This is the kind of feature that will continue to distinguish TiVo from generic DVRs. There will be other announcements in the near term on features that we think will further differentiate TiVo from generic offerings, in terms of understanding what is important to viewers in how they watch television.

Finally, I want to discuss our distribution developments. Turn to slide 7 here. First I’ll discuss Comcast, which we are on track for rollout towards the end of the year. At the Consumer Electronics Show, we answered what many skeptics had questioned as to whether you could create a TiVo experience writing on top of a generic set-top box. We demonstrated that through a software upgrade without the need for a separate stand-alone TiVo Comcast box, we could put the TiVo experience into cable homes. With this now demonstrated, we are excited by the number of generic DVRs the cable industry is rolling out, because each of those boxes, as additional cable deals are done, becomes a potential TiVo home with both the sub and advertising revenue elements that we believe will create a powerful business model beyond the one that exists for our stand-alone retail business.

On another front, we’ve also announced an agreement that will allow Verizon to debut the new TiVo mobile application that lets TiVo subscribers schedule recordings directly from their mobile handsets. This partnership allows a growing base of TiVo users to integrate control of their TV life with the most widespread piece of consumer electronics, their cell phone. We expect to launch this service later this year.

On the retail distribution front, we are excited to announce that starting later in the year, Radio Shack will, for the first time, be offering TiVo units in stores. This is not only a great environment for people to be able to learn about the TiVo product, but we are very heartened that a key factor in Radio Shack’s decision is TiVo’s new TiVo KidZone feature.

While we fully recognize the challenges we must continue to address, we believe we are clearly growing. And with the ways we believe we can accelerate our stand-alone business through new pricing, lower churn, greater focus on the cable analog home opportunity, and the compelling nature of new features like TiVo KidZone, getting to 3 million stand-alone subscriptions is within our grasp.

We believe a focus on the high margin, high revenue segment of the market is a great avenue for TiVo’s ultimate success. For example, with 3 million stand-alone subscriptions, TiVo’s revenue characteristics could be quite similar to a basic cable channel, delivered to 90 million homes. This potential value of our stand-alone business is before layering in the Comcast deal; before the potential deals with other cable operators we are in the midst of negotiating with; before implementing the revenue upside from our new pricing model; before the upside that we believe we can be recognized from successful pursuit of our patent litigation; and before additional revenue lines which we think can be generated from new, standout TiVo features such as broadband content delivery and digital media center applications. Turn to slide 8.

TiVo is not simply the best-of-breed DVR providing the best way to watch television. It is increasingly going to be a way to bring new forms of content into the home that are not available on cable or satellite. TiVo has the unique ability to display broadband video on a television, which puts TiVo in a unique position, vis-à-vis this vast new source of developing TV programming.

Moreover, it has become clear through announcements we’ve made relative to Verizon Wireless, TiVo To Go through Microsoft, the Intel iChip, the Apple iPod, the Sony PSP, and Yahoo! Photo Distribution that the TiVo service is increasingly about being the central point of video integration in the home with other digital devices. We see that role growing and cementing TiVo’s place as an ongoing provider of simple solutions for an increasingly complex array of digital offerings.

I hope this gives you some insight as to what we are focused on and passionate about here at TiVo. Now I’m going to turn it over to Dave Courtney. Dave.

Dave Courtney

Thanks, Tom and good afternoon. We have grown our revenues substantially both annually and quarterly versus last year, while holding operating expenses at a reasonable level. Furthermore, as you’ve just heard Tom review, we are working on a number of exciting initiatives targeted towards expanding our subscription base. I’ll cover three topics today. (1) operational highlights. (2) financial metrics. (3) our financial guidance. Please turn to slide 10.

As Tom mentioned, in Q4 we added 221,000 total TiVo-owned gross subs. Our churn was 38,000 subs or 0.9% per month out of our total installed base of approximately 1.3 million subs at the beginning of the quarter, resulting in a net gain of 183,000 net new subscriptions. In addition, we added 173,000 net new DirecTV subs, giving us total subscription net additions of 356,000 for the quarter.

Now I would like to highlight some financial metrics for the year and quarter just ended. Please refer to slides 11 and 12. We achieved strong growth in service and tech revenue. In the year, we achieved $170.9 million in service and tech revenues, 48% higher than the $115.5 million we recorded last year. In Q4, service and tech revenue was $47 million, an increase of 37% compared Q4 of last year.

Hardware revenue from the sales of TiVo DVRs for the full year was $72.1 million, compared to $111.3 million in the previous year. Hardware revenue in Q4 was $32.3 million, down from last year. These decreases reflect lower hardware unit sales due to increased competition in the market. We generated negative margins on hardware in Q4 as the result of aggressive pricing and promotional activities that we engaged in as part of our subscription acquisition program.

Gross profit for the year was $76.7 million, a fivefold increase from the $15.8 million last year. For the quarter, we made $12.7 million gross profit, a sharp reversal from the loss of $3.7 million in the fourth quarter of last year. The power of our critical mass of subscriptions is generating significant gross profit, and we are consciously using some of that gross profit to fund subscription acquisition activity.

For fiscal 2006, operating expenses were $114.2 million, up 25% from last year and $33 million for Q4, up 23%. The increase for both the year and the quarter was attributable to a significant increase in our legal expenses in connection with ongoing patent litigation. In addition, we have made internal investments in our infrastructure to support the growth of the company as the volume and complexity of the business has changed. We have also added staff to support new initiatives and enhancements to our service.

Finally, customer service costs expanded significantly with the increase of our subscription base. Our net loss for the full year was $34.4 million, well less than half of last year’s loss of $79.8 million. The Q4 loss was $19.5 million, an improvement of 42% versus the loss of $33.7 million in the fourth quarter of last year.

As Tom mentioned, this was the first full year of positive cash flow from operations. In fiscal ‘06 our cash flow from operations was $3.4 million versus a negative cash flow of $37.2 million a year ago. For the quarter, our cash flow from operations was $15.7 million. This positive cash flow from operations stems from our having reached a critical mass of subscription volume and demonstrates the power of our model.

Total acquisition costs or TAC for fiscal year 2006 were $94.2 million. For the quarter, our TAC was $34.8 million, down from $38.5 million last year. TAC consists of rebates, revenue share, and other payments to the channel, plus the difference between our hardware sales and our cost of hardware sales, plus our sales and marketing expenses, including advertising and various other marketing programs. When looking at our TAC, remember we have both discretionary and nondiscretionary components. We can and do change our discretionary spending to optimize our objectives.

As Tom mentioned, we spent our advertising dollars conservatively as we assess the best pricing and packaging options, particularly in the second half of the year. As you will note on slide 13, our SAC per TiVo-owned gross ad was $157 in the fourth quarter of the year compared $140 last year. As we’ve discussed in the past, we believe it’s better to evaluate SAC over a longer time period such as a full year, as it’s more representative of a full seasonal cycle. As you can see on this slide, over the past 12 months our SAC has averaged $191, which is in line with our levels over the past five quarters.

Our balance sheet continues to be in very good shape. We ended the year and quarter with approximately $104 million of cash, cash equivalents and short-term investments. We remain comfortable with this cash balance in light of our anticipated growth and cash flows going forward.

Now let me spend a moment discussing our expectations for Q1’s financial performance which are summarized on slide 14. We are currently expecting service and tech revenues of $48 million to $50 million, and a net loss of $19 million to $22 million. This net loss guidance is significantly greater than the $0.9 million in Q1 of last year. Let me walk through four items I consider drivers this year-over-year trend, summarized on slide 15.

First, we expect to incur significant legal expenses in connection with ongoing patent litigation, especially in the first quarter as the EchoStar jury trial gets underway. This is a critical effort for TiVo, but it is an expensive activity which has driven significant increases in our G&A line. As a result of ongoing litigation costs, we expect our G&A expense to be greater than with the quarter just ended, a significant increase over Q1 of last year when we were not in the trial phase of this litigation.

Second, with the rollout of our new pricing plans which Tom covered in some detail, we expect to see two primary effects to our income statement. The first is that we will incur increased negative hardware margins in connection with our new, no-cost hardware plans for consumers. As a result, we expect our acquisition costs to increase.

The second relates to a potential one-time, $2.5 million to $3 million accounting expense. Let me spend a brief in a moment summarizing this. We began offering limited bundled prepayment plans last year through TiVo.com. In a prepayment plan, we received the cash up-front from consumers, which allows us to elect deferral of hardware costs over the service period. Our new zero up-front pricing plans ranging from $16.95 to $19.95 per month do not involve any consumer payment up front. As a result, we believe it is appropriate to expense hardware costs up-front for these new subscriptions. In order to be consistent, we have made a decision to change our accounting for prepayment bundled plans and write off the accumulated balance of deferred hardware costs for those devices sold to date. We believe this conservative accounting approach is the appropriate treatment in this situation.

Third, in Q1 of last year we experienced a one-time benefit to earnings related to rebates, which we do not expect to repeat in Q1 of this year. In Q1 of last year we experienced a lower than expected redemption of holiday season rebates. The effect of this was an approximately $5 million improvement to our results. This year, we were able to use the experience gathered last year to make what we believe to be more accurate estimates of holiday season rebate redemption.

Fourth, in line with the implementation of new regulations, we will begin expensing stock options in Q1. We expect a stock option expense of $3 million to $4 million per quarter. This expense is included in our guidance.

That concludes our prepared remarks. We’re now ready to take your questions. In order to give as many people as possible the chance to ask questions, please limit yourself to one question at a time. The operator will be helping us to do this as well. Operator.

Question-and-Answer Session

Operator

Thank you, sir. (Operator instructions) We’ll go first to Tony Wibel of Citigroup.

Tony Wibel - Citigroup

It’s one question, but it’s a complicated one. Can you walk us through more details on exactly how the economics of the bundled pricing work? Meaning, I presume that you guys will carry a higher working capital outflow up-front. How do you presume to fund that? What happens after the first year when someone’s commitment is up? If they elect, say, the $224 plan?

Tom Rogers

Well, when it comes to how the consumer decides to pick a plan, if he’s picked a one-year, $19.95 plan or to prepay for that year at a $224 level, they’ll have to make an additional election after that in terms of an ongoing one, two, or three-year commitment. Remember, in the last quarter, we basically had virtually all of our subscribers come on board with a minimum one-year commitment to service that included a penalty fee or cancellation fee in the event of early termination of that service.

We were a little bit concerned over the course of the holiday season, since there is so much gifting that the recipient of the gift, having to sign up on that basis, might resist some and in fact, it went very smoothly. We had no meaningful consumer resistance to that at all. So we do believe that people signing up on this basis where they clearly get healthy discounts by making longer commitments will work, and at the expiration of a commitment period they’ll make a different election.

When it comes to funding this, clearly the notion of a zero up-front fee package where somebody is solely paying on a monthly fee, increases our subscriber acquisition cost by the amount of that additional hardware subsidy compared to our current pricing. We believe that that is something that will be attractive to a fair number of subscribers. We’ll certainly keep a close eye on just how attractive that is. It tested very well.

We’ll see as we implement in the marketplace, if those test results hold up. If it looks like it’s something that will convert at the kind of levels that the testing suggested it would, we will look to market it aggressively. While we&# ...