|Shares Out. (in M):||88||P/E||14.5||10.2|
|Market Cap (in $M):||2,024||P/FCF||13.7||9.5|
|Net Debt (in $M):||638||EBIT||204||264|
|Borrow Cost:||General Collateral|
We always have different discussions with different IP rights holders. It's usually -- it can be contentious sometimes. But, it would be jointly Dish and EchoStar on some of those, and some of them, it would just be EchoStar. I think when that deal was done with Rovi, it was under a different time and place, and a lot of their patents have expired. So, we will just have to see what happens there.
---Mark Jackson, President of Echostar Technologies, 2/20/20/15 conference call
While I am neither a lawyer nor an electrical engineer, I have spent a great deal of time in the patents and IP licensing space in the last few years. For some background, you can read my comments on the VHC, PRKR and ACTG threads as well as my unfortunately timed long write-up on UPIP. Some of my most profitable shorts in the past few years have been patents trolls such as VHC, PRKR and ACTG while my worst long has probably been UPIP. One thing has become very clear during my time in IP land: it has become very hard to enforce IP rights in the United States, especially for IP incorporated into complex technology products. While this trend has first manifested itself in the general failure of patent trolls (check out the multi-year charts of all the aforementioned companies), I believe even legitimate technology companies who have products and spend significant sums on R&D will have a difficult time if their business model depends on extracting licensing payments rather than selling products. Thus, while I previously differentiated between patent trolls and legitimate R&D-based technology companies, I believe the time is right to find other shorts in the IP space. This trend obviously bodes poorly for Qualcomm (in particular I do not think that QTL would get anywhere near its current royalty rate if it were forced to litigate in today’s environment), IDCC and OLED, but I am not currently short any of these companies due to the fact that they mostly have long term IP licensing deals in place with no near-term renewal cliffs.
However, I believe that ROVI is a timely and compelling short. The vast majority of ROVI’s earnings derive from IP licenses to companies in the Pay TV industry, and it faces a large number of significant license renewals in the next 12 months. While bulls expect rapid earnings growth in 2016 and 2017 as a result of renewing legacy prepaid deals with Comcast and Dish that do not generate current revenue, my analysis suggests that the current street estimates are unrealistic and even if these deals are successfully renewed the stock may have limited upside. In contrast, I believe that the “big four” Pay TV companies facing renewal may balk at re-licensing at expected rates given current IP case law trends, ROVI’s complete failure to score any legal victories in recent actions and key patent expirations. An important court case with Netflix may underscore this point sooner rather than later. According to segment disclosures ROVI generates over 95% of its adjusted EBITA from intellectual property licensing, so if investors begin to seriously question this earnings stream things could get ugly- very ugly. Given the company’s net debt position, ROVI could conceivably be a single digit stock. The stock spiked on Friday as I was completing this write-up based on a Reuters article suspiciously timed at the end of the day on the last day of the month, and in a perfect world I would have posted the write-up then, but I believe the risk/reward to a short at current prices is favorable.
Company Description and History
ROVI describes itself as “focused on powering content discovery and personalization through our technology and intellectual property, using data and analytics to monetize interactions across multiple entertainment platforms”. In practice ROVI provides Pay TV companies and consumer electronics manufacturers with software for interactive programming guides (“IPGs”), search and recommendation engines, entertainment metadata (think of the show descriptions when you click on “info” on an IPG) as well as analytics and advertising solutions. ROVI holds patents around many areas of content discovery, including IPG format, digital video recording, video on demand, parental controls, internet-based video delivery and multi-screen experiences. While ROVI makes its own IPGs, every large Pay TV company with the exception of Cox wants to own the customer experience and therefore develops IPGs internally. Thus the largest Pay TV companies do not buy ROVI’s IPG, rather they pay an IP license for the functionality and may or may not purchase metadata, advertising and analytics products in addition. In ROVI’s filings the company reports separate IP Licensing and Product segments. In 2014 IP licensing was 53% of ROVI’s $542M of revenue but 96% of its $233M of adjusted EBITDA. 74% of revenue was from service providers, 20% from consumer electronics manufacturers and the remainder from legacy content protection products that should decline to zero in the next few years.
Macrovision’s 2008 acquisition of Gemstar-TV Guide International created ROVI in its current form. Gemstar-TV Guide held key patents around the grid-based display of TV listings in IPGs and won significant licensing payments after prevailing at trial in the early 2000s. The trial track record of these particular patents was so good that even Dish/Echostar’s Charlie Ergen, a notoriously reluctant patent licensor, paid a large upfront sum to Gemstar for a multi-year prepaid license expiring in April 2016 prior to the merger with Macrovision. Comcast had also executed a multi-year prepaid license expiring in March 2016. DirecTV (expires December 2015) and Time Warner Cable (expires September 2015) struck ongoing royalty deals with Gemstar, and have continued to generate revenue for ROVI after the merger. It is important to note that the IP deals with the “Big Four” licensees coming up were struck nearly 12 years ago in much more plaintiff-friendly IP litigation environment and particularly the battle-tested guide patents that drove the licenses have expired. The deferred revenue from Dish and Comcast’s prepaid deals with Gemstar-TV Guide was written down to zero in the acquisition, so neither customer currently generates basic level IP licensing revenue for ROVI. These deals expire in 2016, and the key idea behind the bull case is that in 2016 ROVI will grow revenue and EBITDA significantly by signing Dish and Comcast to current deals. For reasons detailed later, I seriously doubt the bull case and think the potential realistic outcome will actually range from less benefit than the bulls expect to the licensees (especially Dish) completely balking and forcing ROVI into litigation that will simultaneously depress revenue and elevate expenses.
Given the relative stagnation of the U.S. pay TV market subscriber base and consumer electronics market, ROVI’s revenue was little changed between $541M in 2010 and $542M in 2014. Adjusted EBITDA declined over the time period to $242M in 2014 and an expected $224M in 2015. In late 2010 the company announced the disastrous acquisition of Sonic Solutions for $775M, which has been almost a complete loss and resulted in a change of management. I believe only a company that did not like the hand of cards it was holding would do such a stupid and desperate acquisition. The stock peaked in early 2011 at $68.58 and bottomed at $12.50 in early 2012 after investors realized that Sonic Solutions was an enormous mistake and there was no underlying growth in ROVI’s business. Almost the entire U.S. pay TV industry is currently under a ROVI IP license, so the company has attempted to grow its IP licensing business by suing international pay TV companies and OTT video companies like Amazon and Netflix. These efforts to date have been a resounding failure in the courts, but the stock has appreciated since 2012 on the hope that revenue and EBITDA will grow from bringing Dish and Comcast to current licenses in 2016, and around $23 the stock is near its highest levels since early 2012.
Current State of the IP Market
Unfortunately for ROVI, they face a dismal market for licensing IP. Over the last few years- I believe due to the abuses of patent trolls and attempted enforcement of dubious software patents by troll and operating company alike- the case law has steadily trended away from enforcement of IP rights. I think the first major move in this direction was the Supreme Court’s decision in the eBay vs. MercExchange, LLC case in 2006 in which the court determined that an injunction should not be automatically issued based on a finding of patent infringement. This kept district court judges from implementing damaging injunctions on technology companies who lost to a patent troll at the district court level. By ensuring that a losing defendant could appeal to the CAFC, technology companies no longer had to negotiate against patent holders with a gun to their head. Notably, I believe that NTP never would have collected its large settlement against Research in Motion in a post eBay vs. MercExchange LLC world.
After this decision, patent holders continued to win some big jury verdicts in district court, especially the patent troll friendly Eastern District of Texas. However, defendants began routinely appealing to the Court of Appeals Federal Circuit (“CAFC”), which has generally turned out to be much less patent holder friendly and has routinely tossed these infringement verdicts and/or the damages calculations on appeal. I once researched the top ten jury awards in patent cases and found that in every case the decision had been reversed or settled for much less after the appeal. This is why I was utterly unsurprised when VHC’s large award against Apple was tossed on appeal in mid 2014. PRKR’s jury verdict against Qualcomm didn’t even survive scrutiny by the district court judge. The precedents from the CAFC have trickled down to the district court and the U.S. judiciary seems to be more frequently ruling for IP defendants at all levels.
IP holders used to have another avenue for enforcement: the Federal Trade Commission. The FTC hears IP disputes and has the authority to stop the imports of infringing products which should in theory place patent holders in a strong bargaining position. However, in the past few years the FTC has declined to use this authority in nearly every case I have seen. VHC, UPIP, IDCC and even mighty Apple have taken cases to the FTC and I am not aware of a single case in recent years where the FTC has enforced an import ban against a significant technology company. ROVI filed with the FTC to block imports of the Roku streaming box, arguing that the software on the box violated its IP, but completely failed to get an injunction.
Thus, patent holders have had an increasingly though time enforcing their IP. Defendants, especially large technology and telecom companies, are well aware of the current state of the IP market and have increasingly refused to license even solid-seeming patent portfolios. Part of the problem is that even owners of large amounts of IP have to select a handful of patents to litigate on for practical reasons, and in the current environment a good defense counsel can frequently poke holes in individual patents or tie them up in patent office reviews. Another problem is that modern complex technology products, especially the smartphone, arguably practice tens of thousands of patents, making it enormously difficult to apportion the value of a single family. With both the U.S. federal court system and the FTC declining to implement injunctions patent holders have no options to block usage of their IP and limited options for forcing licenses. As mentioned in my introduction, you can check the long-term chart of virtually every publicly traded pure play patent troll (VHC, PRKR, VRNG, UPIP, ACTG, etc.) to see the impact of the environment on companies whose business is enforcing IP rights.
As bad as the environment has been, I believe that the June 2014 Supreme Court Alice Corporation Pty. Ltd. V. CLS Bank International ruling dealt a significant further blow to patent enforcement, especially of software patents. Mathematical formulas and abstract ideas have never been patentable according to Section 101 of the Patent Act of 1952, which is why software and business model patents have always been controversial. However, the exact contours of what is patentable under Section 101 have never been clear. The Court’s Alice ruling appears to have significantly devalued software patents, as the court essentially appears to say that if the only innovation was applying an abstract idea through a computer it was not patentable. While the implications of the ruling were initially unclear, according to legal consultants I have engaged since the Alice ruling a mind boggling 80-90% of the Section 101 challenges being issued to patent suits are succeeding, particularly in the NDCA where ROVI is litigating against Netflix. In particular, the September 2014 case Cogent Med., Inc. v. Elsevier Inc. was tossed out on Section 101 grounds. The patents at issue covered searching a digital library for information arguably similar in concept to ROVI’s IPG patents. According to the consultants an additional twenty cases have been thrown out on Section 101 grounds in the past 2.5 months, including a separate case involving somewhat similar technology filed against Netflix. I believe that ROVI’s patents can largely be classified as software patents, and may be vulnerable to Section 101 challenges in the post-Alice world.
The Bull Case and ROVI’s Current Situation
As discussed above, ROVI not grown during the last few years. While the company has introduced some new in-guide advertising features and analytics products, its main hopes for growth are licensing its IP to international Pay TV providers, licensing its IP to newer online OTT providers like Netflix and Amazon and getting Dish and Comcast on current licenses. The company also makes the case that given higher subscriber ASPs and expanded use cases such as DVRs and TV Anywhere current licensees owe them more money per sub upon renewal. While ROVI has had some success getting IP licenses and selling IPGs to international carriers, its efforts to enforce its IP in international courts have largely failed and I don’t expect any great uptick in overseas licensing. Similarly, the company successfully convinced Hulu to pay a small license, but thus far Netflix and Amazon have fought them in the courts and won at every turn. Thus, successfully bringing Comcast and Dish up to currently paying licenses is key to the ROVI bull story. However, there is one thing to keep in mind: before re-licensing Comcast and Dish in the first half of 2016 the company has to re-license currently paying licensees Time Warner Cable and DirecTV in September and December of 2015.
ROVI discloses service provider revenue as well as a count of “licensed” subscribers and “paying” (i.e. excluding Comcast and Dish which are under license but not currently paying) subscribers. In 2014 ROVI generated $403M of service provider revenue among 124M paying licensed subs, working out to $2.27 per paying licensed household. Dish has about 14M video subscribers and Comcast has about 22M. ROVI’s asking price is something over $3.00 per sub per year. Thus, many ROVI bulls believe that in 2016 ROVI will add a run-rate of $108M ($3.00 x 36M subs) of virtually 100% incremental margin annual revenue . This is largely why as you look at analyst estimates you see EBITDA growing from an expected $224M in 2015 to $339M in 2017, the first year of having a full run rate of Dish and Comcast revenue.
However, I believe that even if sell-side analysts are correct that the company re-licenses Dish and Comcast, they are significantly exaggerating the upside potential. As readers are no doubt aware, the Pay TV industry is undergoing significant consolidation. Comcast is buying Time Warner Cable and AT&T (who is already a licensee for U-Verse) is buying DirecTV. Obviously larger entities will push for larger discounts and can credibly threaten to litigate as the tradeoff between litigation spend of a few million dollars versus potential license spend of tens of millions per year looks incrementally more attractive. Additionally, ROVI in 2014 started breaking out its service provider revenue between IP licensing and products (i.e. IPGs and metadata). I calculate that IP revenue per licensed household was only $1.57, which lowers the money theoretically up for grabs to only $56M per year if the new larger entities push for pricing closer to ROVI’s corporate average. The exact calculation for U.S. subscribers is opaque, since the $1.57 average may include international subs who do not pay very much, but the average is obviously well below the asking price. As a matter of fact despite the fact that its subs appear in the “unlicensed” bucket according to ROVI’s disclosures, Comcast is already a top 3 customer. I believe Comcast took a license for the TV everywhere use case and buys ROVI’s metadata. So I think the realistic incremental revenue after consolidation is probably more like $40M-$60M after discounts and accounting for the fact that Comcast is already making some IP payments, which would only bring EBITDA up to $260 to $280M. In fact, my realistic bull case EBITDA number for 2016 is just over $260M. At 10x my 2016 bull case EBITDA, the stock would trade at $26 even after accounting for 2 years of cash generation. You could argue for a lower multiple given that after this one-time reset, ROVI’s prospects for growth will be just as poor as actual growth the last five years.
As mentioned in the introduction, ROVI spiked on Friday due to a Reuters article. Besides the suspicious end-of-day on end-of-month timing, there are other reasons to be skeptical. First, it is hard to believe that private equity would want to purchase the company or could even get financing given that contracts that count for potentially half of forward EBITDA come up for renewal in the next 15 months. The company indeed had conversations with private equity firms in recent months about selling assets, culminating in the sale of the DivX and MainConcept businesses for $50.3M. I am unaware of any other business units appropriate for sale except for maybe the dwindling legacy content protection. The company already buys back stock and employs leverage, although I guess it could always do more- in fact I hope they do. Activists could potentially push for opex cuts and prevent future disastrous M&A like Sonic Solutions but I do not think those things could save ROVI. In my opinion any activists may have a vicious value trap on their hands and I suggest they sharpen their diligence on the IP side.
As you can probably guess at this point, I don’t believe even my realistic bull case and think they will have a hard time re-licensing their “Big Four” given the current IP licensing environment. In my opinion the bear case is more likely and very bleak indeed:
Event Path and Short Catalysts
Although Time Warner Cable, the first of the big four licensees, doesn’t go off license until near the end of the year there is a potentially significant potential catalyst that could play out earlier. The company has repeatedly failed to get Netflix to take a license by persuasion or litigation, and the latest attempt will play out in the Northern District of California court during 2015. The current trial is scheduled for a hearing on claims construction and pre-trial motions in March of 2015. In its previous successful defenses against ROVI, Netflix has never issued a Section 101-related challenge to ROVI’s patents to the best of my knowledge. However, at the last minute in the current trial, Netflix’s lawyers added a pre-trial motion that contested ROVI’s patents in suit based on the Alice ruling. Given the recent success of such motions, it is easy to understand why Netflix’s lawyers did this. Note that the judge could have struck down the motion on procedural grounds due to its late inclusion, but chose not to. I believe this means the motion will get serious consideration. If it succeeds, I think investors may not just give up on ROVI ever licensing the OTT players and getting significant additional payments for TV Anywhere, but question the sustainability of its licensing efforts overall. More importantly, I think current licensees will take note and harden their bargaining positions especially on the newer IP that ROVI will be using to argue for higher prices. If this motion is not granted, it still seems reasonably likely given recent history against Netflix and the current environment that Netflix will prevail at trial.
Time Warner is the first of the big four licensees to come up in September of 2015. If the Comcast/Time Warner deal is approved, it should be closed by then. Based on the behavior of other companies in the IP licensing space, I would not be surprised to see Time Warner go off license while Comcast negotiates a deal for the combined entity. Even between companies with ongoing licensing relationships, it is not uncommon for negotiations to stretch past a renewal date and indeed this has happened between ROVI and its consumer electronics licensees in the past. While ROVI has been coy about exactly what assumptions it made around Time Warner in its guidance, if TWC were to go off license even for a time while Comcast negotiates an over-arching deal the company could possibly miss 2015 revenue and/or earnings estimates by the fourth quarter. It is also possible that Time Warner subs are renewed for a short period while Comcast continues to negotiate for the entire entity, which I also believe could be perceived negatively.
DirecTV goes off license after TWC in December of this year and will be a very interesting test for ROVI. By that time AT&T should own DirecTV. As mentioned above, DirecTV was ROVI’s largest customer the last few years at 11% of revenue, virtually all of which was IP. DirecTV has about 20.4M domestic subs and 12.5M Latin American subs. If you assume that Latin American subs are worth only $0.50 per year to ROVI, this implies that DirecTV is paying ROVI around $2.60 per year per U.S. sub, well above the current corporate average of around $1.60 per year per paying licensed sub. If you assume DirecTV only pays a nominal amount for Latin America, the per-year average for U.S. subscribers rises to nearly $3.00. This may be due to the fact that DirecTV has one of the most technically advanced product sets and is paying ROVI for additional use cases, but I also believe that having your largest (and getting larger) customer paying prices well above corporate average is probably not tenable and the combined DirecTV/AT&T will have plenty of leverage to argue for lower prices. Recall that their original deal with Gemstar was struck 12 years ago in a much different IP environment largely due to patents now expired. AT&T has licensed ROVI in the past and even took an additional license for the TV Anywhere use case, but AT&T is also a large sophisticated entity that is constantly sued by patent trolls so I think they are well aware of the current IP litigation environment and would take note if ROVI failed against Netflix yet again. In fact, they are currently fighting ACTG’s Adaptix wireless portfolio in the Eastern District of TX. If AT&T/ DirecTV decides to litigate instead of license it will be a bloodbath as ROVI investors face the prospect of losing a customer potentially responsible for 25% of EBITDA.
Comcast is the biggest wild card in all of this. Their prepaid deal comes up in 2016, and as mentioned above I would not be surprised if they let TWC subs go off license while they negotiate. They have shown some willingness to work with ROVI in the past, taking a TV Anywhere license and I believe paying them for metadata. However, according to ROVI’s disclosures Comcast and Time Warner Cable combined (keep in mind that Comcast is not taking a basic IP license) are already a combined 11% of revenue. Given that Comcast would theoretically owe even more after its 2016 license expired, there could be $50M to $80M of annual revenue at issue here and Comcast has a lot of incentive to litigate its way out. In my opinion, with pretty good odds of success. If the relationship turns adversarial, Comcast can also threaten to pull its metadata and other business, which would make the situation even uglier for ROVI.
I am more comfortable speculating on Dish’s negotiating position, which is why I put a quote from the Echostar conference call in the preface. Given Charlie Ergen’s history with TIVO and every other IP dispute, I would expect him to refuse a license at anything near what ROVI is asking. I am sure he is more aware of the current IP licensing environment than I am. He theoretically already owes ROVI for the Slingbox’s TV Anywhere capability, but thus far he has not licensed and ROVI has wisely not pushed the issue. I would be shocked if he pays a license anywhere near where ROVI is asking without a fight.
Putting this all together, I think around $130M of my $260M realistic bull case EBITDA is in danger: $60M of DirecTV revenue, $22M of Dish revenue bulls are implicitly expecting, $34M of incremental Comcast revenue and $17M of Time Warner video sub IP revenue. If it looks like ROVI is a $130M EBITDA company, this is a single digit stock. In fact, it may trade for a low multiple of that EBITDA because investors will naturally question why any other service provider or consumer electronics manufacturer would continue paying them when its license was up and IP licensing is currently over 95% of EBITDA. With ROVI’s net debt we could be talking a low single digit stock. There is plenty of room for intermediate outcomes as well, if Comcast and AT&T negotiate hard but ultimately sign while Dish balks, I think we could still be looking at a disappointing $240M to $250M run-rate go forward EBITDA. I think if that happens the multiple would compress and the stock could trade in the mid teens.
I first started looking closely at ROVI a couple of years ago, when I thought that the Comcast and Dish prepaid licenses coming up in 2016 could make for a nice time arbitrage long position. However, my conversations with industry people led me to question how easy it would be for ROVI to re-license even at current rates. The IP licensing environment has taken a significant turn for the worse since then culminating with the recent Alice ruling which could de-value ROVI’s key IP. The grid based guide patents it originally won its trials on have expired and lot of the other key “foundational” patents around parental controls, search and discovery etc. are expiring between 2015 and 2017. While ROVI has hundreds of other patents to license, many of these are incremental and virtually all are completely unproven in court. Publicly, ROVI states that it is pleased with the state of negotiations with the “Big Four” and that it does not believe its patents are subject to Alice Section 101 invalidation, but I put little faith in this because the company can take no other position without weakening its bargaining position and cratering the stock. The recent developments in the IP licensing environment and Pay TV service provider market consolidation have made me go from wondering if ROVI would be able to re-license to seriously doubting they will be able to get it done at all. If I am right about that, the implications are devastating.
• Most obviously, that I am wrong about large Pay TV providers’ willingness to pay ROVI $3.00+ per year per sub for IP licenses
• Rumors about activist pressure are true and activists push for value-enhancing changes like cost cuts, capital return or M&A
• ROVI prevails against Netflix at trial and subsequently at the CAFC, opening up the OTT market for licensing
• U.S. case law turns back towards enforcement of IP rights
Disclaimer: The fund that I work for is short shares of ROVI and may buy or sell shares at any time without notice.