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TIVO INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion and analysis in conjunction with the condensed consolidated financial statements and the accompanying notes included in this report and our most recent annual report on Form 10-K filed on March 14, 2011 and Amendment No. 1, filed on August 25, 2011, the sections entitled "Risk Factors" in Item 1A of our most recent annual report on Form 10-K and Part II, Item 1A of this quarterly report, as well as other cautionary statements and risks described elsewhere in this report and our most recent annual report on Form 10-K filed on March 14, 2011, and Amendment No. 1 filed on August 25, 2011, before deciding to purchase, sell or hold our common stock. Company Overview We are a leading provider of technology and services for advanced television solutions, which are included in such products as DVRs, non-DVR set-top boxes and connected televisions. The TiVo service redefines home entertainment by providing consumers with an easy intuitive way to record, watch, and control television and receive videos, pictures, and movies from cable, broadcast, and broadband sources. We offer features such as Season Pass™ recordings, integrated search (including content from both traditional linear television, VOD, and broadband sources in one user interface), WishList® searches, the ability to transfer content amongst our DVRs and to other consumer electronics devices, access to broadband video content, TiVo Online/Mobile Scheduling and applications on third party devices such as tablet computers and smartphones (such as iPads and iPhones). As of July 31, 2011, there were approximately 1.9 million subscriptions to the TiVo service through our TiVo-Owned and MSO businesses. In our TiVo-Owned business, we distribute the TiVo DVR through consumer electronics retailers and through our on-line store at TiVo.com. We also have agreements with Comcast and Cox for them to market, provide free installation services for TiVo Premiere customers in select regions who also subscribe to Comcast's or Cox's television service in those regions, and provide these same customers integrated access to each provider's VOD content in the future. Additionally, in our MSO business, we provide the TiVo service through agreements with leading satellite and cable television service providers and broadcasters such as DIRECTV, RCN, Cablevision Mexico, Virgin Media (U.K.), and Suddenlink (U.S.), and in the future ONO (Spain), Canal Digital (Scandinavia), Grande Communications, and Charter Communications. We also provide innovative marketing solutions for the television industry, including a unique platform for advertising and audience research measurement services and have developed a broadband connected television incorporating the TiVo user interface and non-DVR software with Best Buy's Insignia brand television sets. TiVo also generates technology revenues from licensing technology (Refer to Note 9. "DISH Network Corporation" of Notes to Unaudited Condensed Consolidated Financial Statements included in Part I. Item 1. of this report) and through the provision of engineering professional services in connection with our provision of the TiVo service to our MSO customers. Executive Overview Fiscal year 2012 In the fiscal year ending January 31, 2012, we will continue to be focused on our efforts to build leading advanced television products, enter into new distribution agreements, engage in development work for existing distribution agreements, and commence and continue deployment activities for our existing distribution agreements. Additionally, we have been and will continue to actively protect our intellectual property. For the fiscal year ending January 31, 2012 we expect to focus on the following priorities: •We expect to continue our efforts to increase our subscription base by adding new subscriptions through our TiVo-Owned direct and retail sales with the roll out of our new products, as well as our mass distribution partnerships both in the U.S. and internationally. However, we may experience further net losses in our overall subscription base in fiscal year 2012. This potential decrease would be due to further losses in the TiVo-Owned subscription base stemming from continued competition and our efforts to efficiently manage the amount of TiVo-Owned marketing dollars we are devoting to acquisition activities, outweighing potential net MSO subscription gains. Our installed base of MSO subscriptions increased 25-------------------------------------------------------------------------------- Table of Contents slightly in the quarter ended July 31, 2011 and we expect this trend to continue through the second half of fiscal year 2012 with the expected future launch or broad deployment of additional distribution deals. •As a result of the continuation of recently launched lower hardware pricing and higher subscription pricing (which allow consumers to pay lower upfront costs for the TiVo box with higher monthly subscription fees), we expect to have decreases in TiVo Hardware revenue leading to increases in total acquisition costs and subscription acquisition costs when compared to the prior year period. However, we expect that this lower hardware pricing will have a positive impact on our TiVo-Owned ARPU and Service revenues over time leading to a positive impact to our financial results in the future as we start realizing higher monthly subscription fees. •We believe that investments in research and development are critical to remaining competitive and being a leader in advanced television solutions that go beyond the DVR. Therefore, we plan to increase our research and development spending from the prior year by an additional $25 million to $30 million in our current fiscal year to engage in these new technological and product developments such as but not limited to development to integrate the TiVo service onto non-DVR set-top boxes and connected televisions, development of multi-room and multi-device offerings, increasing the capacity to handle increased operator deployments and gaining more efficiency in our distribution efforts. •We will continue our efforts to protect our technological innovations and intellectual property. As a result, we expect our litigation expenses for our ongoing patent infringement lawsuits, which include our ongoing lawsuits involving AT&T, Verizon, Microsoft, and Motorola Mobility, to increase significantly from our most recent fiscal year ended January 31, 2011. •We expect to continue development efforts under our existing MSO deployment agreements. To the extent that the upfront development effort is not paid for through development fees from such arrangements, but is recoverable through future service fees from these MSOs, we will defer the cost of the development and expense it in our Statement of Operations until later when related revenues from service fees are received and first recognized as technology revenues until the previously deferred costs of development are expensed. However, despite the deferral of these development costs, we do incur cash expenses associated with these development efforts resulting in potentially higher cash usage in the near term. Key Business Metrics Management periodically reviews certain key business metrics in order to evaluate our operations, allocate resources, and drive financial performance in our business. Management monitors these metrics together and not individually as it does not make business decisions based upon any single metric. Subscriptions. Management reviews this metric, and believes it may be useful to investors, in order to evaluate our relative position in the marketplace and to forecast future potential service revenues. Below is a table that details the change in our subscription base during the last eight quarters. The TiVo-Owned lines refer to subscriptions sold directly or indirectly by TiVo to consumers who have TiVo-enabled DVRs and for which TiVo incurs acquisition costs. The MSO lines refer to subscriptions sold to consumers by multiple system operators and broadcasters such as DIRECTV, Cablevision Mexico, Virgin Media (United Kingdom), RCN, Suddenlink, and Comcast (under the prior agreement with Comcast) and for which TiVo expects to incur little or no acquisition costs. Additionally, we provide a breakdown of the percent of TiVo-Owned subscriptions for which consumers pay recurring fees, including on a monthly and a prepaid one, two, or three year basis, as opposed to a one-time prepaid product lifetime fee. 26-------------------------------------------------------------------------------- Table of Contents Three Months Ended Jul 31, Apr 30, Jan 31, Oct 31, Jul 31, Apr 30, Jan 31, Oct 31, (Subscriptions in thousands) 2011 2011 2011 2010 2010 2010 2010 2009 TiVo-Owned Subscription Gross Additions: 25 27 60 35 32 33 46 34 Subscription Net Additions/(Losses): TiVo-Owned (43 ) (58 ) (55 ) (45 ) (48 ) (51 ) (72 ) (45 ) *MSOs 10 (30 ) (168 ) (67 ) (77 ) (45 ) (59 ) (269 ) Total Subscription Net Additions/(Losses) (33 ) (88 ) (223 ) (112 ) (125 ) (96 ) (131 ) (314 ) Cumulative Subscriptions: TiVo-Owned 1,165 1,208 1,266 1,321 1,366 1,414 1,465 1,537 MSOs 763 753 783 951 1,018 1,095 1,140 1,199 Total Cumulative Subscriptions 1,928 1,961 2,049 2,272 2,384 2,509 2,605 2,736 Fully Amortized Active Lifetime Subscriptions 286 307 310 282 280 282 279 237 % of TiVo-Owned Cumulative Subscriptions paying recurring fees 57 % 57 % 56 % 56 % 56 % 57 % 58 % 58 % * MSOs Subscription Net Additions/(Losses) in the third quarter ended October 31, 2009 would have been a loss of (123,000) subscriptions, excluding a one time reduction of (146,000) subscriptions associated with a subscription over-reporting error by DIRECTV, as reported on our Form 10-Q for the quarter ended October 31, 2009. We define a "subscription" as a contract referencing a TiVo-enabled DVR for which (i) a consumer has committed to pay for the TiVo service and (ii) service is not canceled. We count product lifetime subscriptions in our subscription base until both of the following conditions are met: (i) the period we use to recognize product lifetime subscription revenues ends; and (ii) the related DVR has not made contact to the TiVo service within the prior six month period. Product lifetime subscriptions past this period which have not called into the TiVo service for six months are not counted in this total. We amortize all product lifetime subscriptions over a 60 month period. We are not aware of any uniform standards for defining subscriptions and caution that our presentation may not be consistent with that of other companies. Additionally, the subscription fees that our MSOs pay us are typically based upon a specific contractual definition of a subscriber or subscription which may not be consistent with how we define a subscription for our reporting purposes nor be representative of how such subscription fees are calculated and paid to us by our MSOs. Our MSOs subscription data is based in part on reporting from our third party MSO partners. TiVo-Owned subscriptions declined by 43,000 subscriptions decreasing the TiVo-Owned installed subscription base to approximately 1.2 million subscriptions as of July 31, 2011 as compared to April 30, 2011. We believe this decrease in total TiVo-Owned subscriptions was largely due to continued pressure on subscription gross additions resulting from increased competition from DVRs distributed by cable and satellite companies as we continued to have fewer TiVo-Owned subscription gross additions than we had TiVo-Owned subscription cancellations. As a result of this continued competition and current economic conditions, we likely will experience further net losses in our TiVo-Owned subscription base in the fiscal year ending January 31, 2012. Our MSO installed subscription base increased by 10,000 subscriptions to 763,000 subscriptions as of July 31, 2011 as compared to April 30, 2011. The increase in subscriptions is due to subscription growth from partners such as RCN, Suddenlink, and Virgin Media, with additional MSOs expected to launch prior to year-end. TiVo-Owned Churn Rate per Month. Management reviews this metric, and believes it may be useful to investors, in order to evaluate our ability to retain existing TiVo-Owned subscriptions (including both monthly and product lifetime subscriptions) by providing services that are competitive in the market. Management believes factors such as service enhancements, service commitments, higher customer satisfaction, and improved customer support may improve this metric. Conversely, management believes factors such as increased competition, lack of competitive service features such as high definition television recording capabilities in our older model DVRs or access to certain digital television channels or MSO Video On Demand services, as well as, increased price sensitivity and installation and CableCARDTM technology limitations may cause our TiVo-Owned Churn Rate per month to increase. We define the TiVo-Owned Churn Rate per month as the total TiVo-Owned subscription cancellations in the period divided by the Average TiVo-Owned subscriptions for the period (including both monthly and product lifetime subscriptions), which then is divided by the number of months in the period. We calculate Average TiVo-Owned subscriptions for the period by adding the average TiVo-Owned subscriptions for each month and dividing 27-------------------------------------------------------------------------------- Table of Contents by the number of months in the period. We calculate the average TiVo-Owned subscriptions for each month by adding the beginning and ending subscriptions for the month and dividing by two. We are not aware of any uniform standards for calculating churn and caution that our presentation may not be consistent with that of other companies. The following table presents our TiVo-Owned Churn Rate per month information: Three Months Ended (Subscriptions in Jul 31, Apr 30, Jan 31, Oct 31, Jul 31, Apr 30, Jan 31, Oct 31, thousands) 2011 2011 2011 2010 2010 2010 2010 2009 Average TiVo-Owned subscriptions 1,188 1,238 1,296 1,345 1,390 1,437 1,506 1,560 TiVo-Owned subscription cancellations (68 ) (85 ) (115 ) (80 ) (80 ) (84 ) (118 ) (79 ) TiVo-Owned churn rate per month (1.9 )% (2.3 )% (3.0 )% (2.0 )% (1.9 )% (2.0 )% (2.6 )% (1.7 )% Included in our TiVo-Owned Churn Rate per month are those product lifetime subscriptions that have both reached the end of the revenue recognition period and whose DVRs have not contacted the TiVo service within the prior six months. Conversely, we do not count as churn product lifetime subscriptions that have not reached the end of the revenue recognition period, regardless of whether such subscriptions continue to contact the TiVo service. TiVo-Owned Churn Rate per month was (1.9)% for the quarters ended July 31, 2011 and 2010. We expect churn to be approximately the same on a percentage basis but lower on an absolute basis in the fiscal year ending January 31, 2012 as compared to the fiscal year ended January 31, 2011 as a result of a continued increase in inactive product lifetime subscriptions, competition from other providers, and the growing importance of encrypted digital and high definition television recording capabilities which can only be accessed through either a cable or satellite provided set-top box or through a box which incorporates CableCARD™ technology (which is only available through cable and some telecommunications providers) and a switched digital adapter if necessary. Subscription Acquisition Cost or SAC. Management reviews this metric, and believes it may be useful to investors, in order to evaluate trends in the efficiency of our marketing programs and subscription acquisition strategies. We define SAC as our total TiVo-Owned acquisition costs for a given period divided by TiVo-Owned subscription gross additions for the same period. We define total acquisition costs as sales and marketing, subscription acquisition costs less net TiVo-Owned related hardware revenues (defined as TiVo-Owned related gross hardware revenues less rebates, revenue share and market development funds paid to retailers) plus TiVo-Owned related cost of hardware revenues. The sales and marketing, subscription acquisition costs line item includes advertising expenses and promotion-related expenses directly related to subscription acquisition activities, but does not include expenses related to advertising sales. We do not include third parties' subscription gross additions, such as MSOs' gross additions with TiVo subscriptions, in our calculation of SAC because we typically incur limited or no acquisition costs for these new subscriptions, and so we also do not include MSOs' sales and marketing, subscription acquisition costs, hardware revenues, or cost of hardware revenues in our calculation of TiVo-Owned SAC. We are not aware of any uniform standards for calculating total acquisition costs or SAC and caution that our presentation may not be consistent with that of other companies. Three Months Ended Jul 31, Apr 30, Jan 31, Oct 31, Jul 31, Apr 30, Jan 31, Oct 31, 2011 2011 2011 2010 2010 2010 2010 2009 (In thousands, except SAC) Subscription Acquisition Costs Sales and marketing, subscription acquisition costs $ 2,441 $ 1,233 $ 2,214 $ 1,398 $ 1,366 $ 3,191 $ 2,022 $ 1,206 Hardware revenues (11,580 ) (6,915 ) (14,436 ) (9,532 ) (9,481 ) (18,169 ) (23,389 ) (10,030 ) Less: MSOs'-related hardware revenues 8,079 2,765 4,431 3,416 1,601 5,437 12,818 190 Cost of hardware revenues 13,401 8,853 24,702 13,566 11,546 19,219 27,962 14,436 Less: MSOs'-related cost of hardware revenues (6,019 ) (1,795 ) (3,298 ) (2,618 ) (1,222 ) (4,158 ) (12,064 ) (203 ) Total Acquisition Costs 6,322 4,141 13,613 6,230 3,810 5,520 7,349 5,599 TiVo-Owned Subscription Gross Additions 25 27 60 35 32 33 46 34 Subscription Acquisition Costs (SAC) $ 253 $ 153 $ 227 $ 178 $ 119 $ 167 $ 160 $ 165 28-------------------------------------------------------------------------------- Table of Contents Twelve Months Ended Jul 31, Apr 30, Jan 31, Oct 31, Jul 31, Apr 30, Jan 31, Oct 31, 2011 2011 2011 2010 2010 2010 2010 2009 (In thousands, except SAC) Subscription Acquisition Costs Sales and marketing, subscription acquisition costs $ 7,286 $ 6,211 $ 8,169 $ 7,977 $ 7,785 $ 7,257 $ 5,048 $ 4,716 Hardware revenues (42,463 ) (40,364 ) (51,618 ) (60,571 ) (61,069 ) (60,350 ) (48,787 ) (36,279 ) Less: MSOs'-related hardware revenues 18,691 12,213 14,885 23,272 20,046 19,961 14,497 2,041 Cost of hardware revenues 60,522 58,667 69,033 72,293 73,163 74,552 65,909 53,711 Less: MSOs'-related cost of hardware revenues (13,730 ) (8,933 ) (11,296 ) (20,062 ) (17,647 ) (17,858 ) (13,706 ) (2,027 ) Total Acquisition Costs 30,306 27,794 29,173 22,909 22,278 23,562 22,961 22,162 TiVo-Owned Subscription Gross Additions 147 154 160 146 145 144 148 161 Subscription Acquisition Costs (SAC) $ 206 $ 180 $ 182 $ 157 $ 154 $ 164 $ 155 $ 138 As a result of the seasonal nature of our subscription growth, total acquisition costs vary significantly during the year. Management primarily reviews the SAC metric on an annual basis due to the timing difference between our recognition of promotional program expense and the subsequent addition of the related subscriptions. For example, we have historically experienced increased TiVo-Owned subscription gross additions during the fourth quarter, however, sales and marketing, subscription acquisition activities occur throughout the year. During the three months ended July 31, 2011, our total acquisition costs were $6.3 million, an increase of $2.5 million from the same prior year period. This increase in total acquisition costs was related to an increase of $1.1 million in our sales and marketing, subscription acquisition costs, largely stemming from the write-down of trade credits. This increase in total acquisition costs also included an increase of $1.4 million in our hardware sales gross margin loss due to our new pricing structure that includes a lower upfront box price to consumers resulting in lower upfront hardware price. The increase in SAC of $134, for the three months ended July 31, 2011 as compared to the same prior year period, was largely a result of the increase in total acquisition costs combined with fewer subscription gross additions during the three month period as compared to the same prior year period. During the twelve months ended July 31, 2011 our total acquisition costs were $30.3 million, an increase of $8.0 million compared to $22.3 million during the same prior year period. TiVo's sales and marketing, subscription acquisition costs decreased by $499,000, as compared to the same prior year period offset by an increase in TiVo's hardware gross margin losses of $8.5 million as compared to the same prior year period. The increase in SAC of $52, for the twelve months ended July 31, 2011 as compared to the same prior year period, was largely a result of the increase in total acquisition costs. Average Revenue Per Subscription or ARPU. Management reviews this metric, and believes it may be useful to investors, in order to evaluate the potential of our subscription base to generate revenues from a variety of sources, including service fees, advertising, and audience research measurement. You should not use ARPU as a substitute for measures of financial performance calculated in accordance with GAAP. Management believes it is useful to consider this metric excluding the costs associated with rebates, revenue share, and other payments to channel because of the discretionary and varying nature of these expenses and because management believes these expenses, which are included in hardware revenues, net, are more appropriately monitored as part of SAC. We are not aware of any uniform standards for calculating ARPU and caution that our presentation may not be consistent with that of other companies. Furthermore, ARPU for our MSOs may not be directly comparable to the service fees we may receive from these partners on a per subscription basis as the fees that our MSOs pay us may be based upon a specific contractual definition of a subscriber or subscription which may not be consistent with how we define a subscription for our reporting purposes or be representative of how such subscription fees are calculated and paid to us by our MSOs. For example, an agreement that includes contractual minimums may result in a higher than expected MSOs ARPU if such fixed minimum fee is spread over a small number of subscriptions. We calculate ARPU per month for TiVo-Owned subscriptions by subtracting MSOs'-related service revenues (which includes MSOs' subscription service revenues and MSOs'-related advertising revenues) from our total reported net service revenues and dividing the result by the number of months in the period. We then divide the resulting average service revenue by Average TiVo-Owned subscriptions for the period, calculated as described 29-------------------------------------------------------------------------------- Table of Contents above for churn rate. The following table shows this calculation: Three Months Ended TiVo-Owned Average Revenue Jul 31, Apr 30, Jan 31, Oct 31, Jul 31, Apr 30, Jan 31, Oct 31, per Subscription 2011 2011 2011 2010 2010 2010 2010 2009 (In thousands, except ARPU) Total service revenues 34,016 33,334 34,453 34,298 35,654 36,244 38,442 37,701 Less: MSOs'-related service revenues (4,371 ) (3,962 ) (4,294 ) (3,670 ) (3,819 ) (3,760 ) (4,190 ) (1,893 ) TiVo-Owned-related service revenues 29,645 29,372 30,159 30,628 31,835 32,484 34,252 35,808 Average TiVo-Owned revenues per month 9,882 9,791 10,053 10,209 10,612 10,828 11,417 11,936 Average TiVo-Owned per month subscriptions 1,188 1,238 1,296 1,345 1,390 1,437 1,506 1,560 TiVo-Owned ARPU per month $ 8.31 $ 7.91 $ 7.76 $ 7.59 $ 7.63 $ 7.54 $ 7.58 $ 7.65 The increase in TiVo-Owned ARPU per month for the three months ended July 31, 2011 was largely due to the higher monthly subscription pricing that we initiated during the fourth quarter of the fiscal year ended January 31, 2011, as compared to the same prior year period. We calculate ARPU per month for MSOs' subscriptions by first subtracting TiVo-Owned-related service revenues (which includes TiVo-Owned subscription service revenues and TiVo-Owned related advertising revenues) from our total reported service revenues. Then we divide average revenues per month for MSOs'-related service revenues by the average MSOs' subscriptions for the period. The following table shows this calculation: Three Months Ended MSOs' Average Revenue per Jul 31, Apr 30, Jan 31, Oct 31, Jul 31, Apr 30, Jan 31, Oct 31, Subscription 2011 2011 2011 2010 2010 2010 2010 2009 (In thousands, except ARPU) Total service revenues 34,016 33,334 34,453 34,298 35,654 36,244 38,442 37,701 Less: TiVo-Owned-related service revenues (29,645 ) (29,372 ) (30,159 ) (30,628 ) (31,835 ) (32,484 ) (34,252 ) (35,808 ) *MSOs'-related service revenues 4,371 3,962 4,294 3,670 3,819 3,760 4,190 1,893 Average MSOs' revenues per month 1,457 1,321 1,431 1,223 1,273 1,253 1,397 631 Average MSOs' per month subscriptions 753 768 905 984 1,063 1,120 1,165 1,378 *MSOs' ARPU per month $ 1.94 $ 1.72 $ 1.58 $ 1.24 $ 1.20 $ 1.12 $ 1.20 $ 0.46 * MSOs'-related ARPU in the third quarter ending October 31, 2009 would have been approximately $0.88, excluding the one time reduction of $1.8 million in MSOs'-related service revenues related to the one time reduction of 146,000 subscriptions associated with the correction of subscription over-reporting error by DIRECTV previously disclosed in the form 10-Q for the quarter ended October 31, 2009. The MSOs' related service revenues for the quarter ended July 31, 2011 increased $0.74 per subscription to $1.94 per subscription, as compared $1.20 for the same prior year period. The increase in MSOs' ARPU is related primarily to DIRECTV's fixed minimum commitment (which extends through the term of our agreement with DIRECTV which expires on February 15, 2015, unless extended until February 15, 2018 by DIRECTV) being spread over a declining subscription base and we expect this trend in MSOs' ARPU to continue until our new deployment agreements launch and gain a significant amount of subscriptions. Critical Accounting Estimates In preparing our condensed consolidated financial statements, we make assumptions, judgments and estimates that can have a significant impact on our revenue, operating income (loss) and net income (loss), as well as on the value of certain assets and liabilities on our condensed consolidated balance sheets. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. At least quarterly, we evaluate our assumptions, judgments and estimates and make changes accordingly. Historically, our assumptions, judgments and estimates relative to our critical accounting estimates have not differed materially from actual results. With the exception of a change in our accounting policy for revenue recognition, which is more fully described below, during the six months ended July 31, 2011 there were no material changes to our critical accounting policies or in the matters for which we make critical accounting 30-------------------------------------------------------------------------------- Table of Contents estimates in the preparation of our condensed consolidated financial statements as compared to those disclosed under the heading "Critical Accounting Estimates" in our Annual Report on Form 10-K for the fiscal year ended January 31, 2011, as amended. Revenue Recognition TiVo generates service revenues from fees for providing the TiVo service to consumers and operators and through the sale of advertising and audience research measurement services. We also generate technology revenues from licensing technology (Refer to Note 9. "DISH Network Corporation" of Notes to Unaudited Condensed Consolidated Financial Statements included in Part I. Item 1. of this report) and by providing engineering professional services. In addition, we generate hardware revenues from the sale of hardware products that enable the TiVo service. A substantial part of our revenues are derived from multiple element arrangements. TiVo recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, collectability is probable, and there are no post-delivery obligations. Service revenue is generally recognized as the services are performed which generally is ratably over the term of the service period. Multiple Element Arrangements TiVo's multiple deliverable revenue arrangements primarily consist of bundled sales of TiVo-enabled DVRs and TiVo service to consumers; arrangements with multiple system operators ("MSO") which generally include delivery of software customization and set up services, training, post contract support ("PCS"), TiVo-enabled DVRs and TiVo service; and bundled sales of advertising and audience research measurement services. In October 2009, the Financial Accounting Standards Board ("FASB") amended the accounting standards for revenue recognition to remove tangible products containing software components and non-software components that function together to deliver the product's essential functionality from the scope of industry specific software revenue recognition guidance. In October 2009, the FASB also amended the accounting standards for multiple deliverable revenue arrangements to: • provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and how the consideration should be allocated; • require an entity to allocate revenue in an arrangement using its best estimated selling price ("BESP") of deliverables if a vendor does not have vendor-specific objective evidence ("VSOE") of selling price or third-party evidence ("TPE") of selling price; and • eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method. TiVo adopted this guidance at the beginning of our first quarter of fiscal year 2012 on a prospective basis for applicable transactions originating or materially modified after January 31, 2011. We apply and will continue to apply the previous applicable accounting guidance for continuing arrangements that originated prior to the adoption date of February 1, 2011. The adoption of the new guidance did not have a significant impact on our consolidated financial statements. We currently do not expect changes in our products, services, bundled arrangements, or pricing practices that could have a significant impact on the consolidated financial statements in periods post adoption, however, this may change in the future. TiVo allocates revenue to each element in a multiple-element arrangement based upon their relative selling price. We determine the selling price for each deliverable using VSOE of selling price or TPE of selling price, if it exists. If neither VSOE nor TPE of selling price exists for a deliverable, we use our BESP for that deliverable. Since the use of the residual method is eliminated under the new accounting standards, any discounts offered by TiVo are allocated to each of the deliverables. Revenue allocated to each element, limited to the amount not contingent on future performance, is then recognized when the basic revenue recognition criteria are met for the respective element. Consistent with our methodology under previous accounting guidance, if available, TiVo determines VSOE of fair value for each element based on historical standalone sales to third parties or from the stated renewal rate for the elements contained in the initial contractual arrangement. We currently estimate selling prices for our PCS, training, TiVo-enabled DVRs for MSOs, and consumer TiVo service based on VSOE of selling price. In some instances, we may not be able to obtain VSOE of selling price for all deliverables in an arrangement with multiple elements. This may be due to TiVo infrequently selling each element separately or not pricing products within a narrow range. When VSOE cannot be established, we attempt to estimate the selling price of each element based on TPE. TPE would consist of competitor prices for similar deliverables when sold separately. 31-------------------------------------------------------------------------------- Table of Contents Generally, our offerings contain significant differentiation such that the comparable pricing of products with similar functionality or services cannot be obtained. Furthermore, we sell TiVo-enabled DVRs to consumers whereas our competitors usually lease them to their customers. Therefore, TiVo is typically not able to obtain TPE of selling price. When TiVo is unable to establish a selling price using VSOE or TPE, which is generally the case for sales of TiVo-enabled DVRs to consumers and advertising and audience research measurement services, we use our BESP in determining the allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or service were sold on a standalone basis. BESP is generally used for offerings that are not typically sold on a standalone basis or for new or highly customized offerings. TiVo establishes pricing for ours products and services by considering multiple factors including, but not limited to, geographies, market conditions, competitive landscape, internal costs, gross margin objectives, and industry pricing practices. TiVo-enabled DVRs and TiVo service TiVo sells the DVR and service directly to end-users through bundled sales programs through the TiVo website. Under these bundled programs, the customer receives a DVR and commits to a minimum subscription period of one to three years or product lifetime and has the option to either pay a monthly fee over the subscription term (monthly program) or to prepay the subscription fee in advance (prepaid program). After the initial committed subscription term, the customers have various pricing options at which they can renew the subscription. The VSOE of selling price for the subscription services is established based on standalone sales of the service and varies by service period. TiVo is not able to obtain VSOE for the DVR element due to infrequent sales of standalone DVRs to consumers. The BESP of the DVR is established based on the price that we would sell the DVR without any service commitment from the customer. Under these bundled programs, revenue is allocated between hardware revenue for the DVR and service revenue for the subscription using on a relative basis, with the DVR revenue recognized upon delivery, up to an amount not contingent on future service delivery, and the subscription revenue recognized over the term of the service. Subscription revenues from product lifetime subscriptions are recognized ratably over our estimate of the useful life of a TiVo-enabled DVR associated with the subscription. The estimates of expected lives are dependent on assumptions with regard to future churn of product lifetime subscriptions. TiVo continuously monitors the useful life of a TiVo-enabled DVR and the impact of the differences between actual churn and forecasted churn rates. If subsequent actual experience is not in line with our current assumptions, including higher churn of product lifetime subscriptions due to the incompatibility of its standard definition TiVo units with high definition programming and increased competition, we may revise the estimated life which could result in the recognition of revenues from this source over a longer or shorter period. End users have the right to cancel their subscription within 30 days of subscription activation for a full refund. TiVo establishes allowances for expected subscription cancellations. Arrangements with MSOs TiVo has two different types of arrangements with MSOs under technology deployment and engineering services agreements. Our arrangements with MSOs typically include software customization and set up services, limited training, PCS, TiVo-enabled DVRs, and TiVo service. In instances where TiVo hosts the TiVo service, we recognize revenue under the general revenue recognition guidance. We determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. Revenue recognition is deferred until such time as all of the criteria are met. Elements in such arrangements usually include DVRs, TiVo service hosting, associated maintenance and support and training. Non-refundable payments received for customization and set up services are deferred and recognized as revenue ratably over the longer of the contractual or customer relationship period. The related cost of such services is capitalized to the extent it is deemed recoverable and amortized to cost of revenues over the longer of the contractual or customer relationship period. TiVo has established VSOE of selling prices for training, DVRs, and maintenance and support, based on the price charged in standalone sales of the element or stated renewal rates in the agreement. The BESP of TiVo service is determined considering the size of the MSO and expected volume of deployment, market conditions, competitive landscape, internal costs, and gross margin objectives. Total arrangement consideration is allocated among individual elements on a relative basis and revenue for each element is recognized when the basic revenue recognition criteria are met for the respective elements. 32-------------------------------------------------------------------------------- Table of Contents In arrangements where TiVo does not host the TiVo service and which include engineering services that are essential to the functionality of the licensed technology or involve significant customization or modification of the software, we recognize revenue under industry specific software revenue recognition guidance. Under this guidance, such arrangements are accounted for using the percentage-of-completion method or a completed-contract method. The percentage-of-completion method is used if we believe we are able to make reasonably dependable estimates of the extent of progress toward completion and the arrangement as a whole is reasonably expected to be profitable. We measure progress toward completion using an input method based on the ratio of costs incurred, principally labor, to date to total estimated costs of the project. These estimates are assessed continually during the term of the contract, and revisions are reflected when the changed conditions become known. In some cases, it may not be possible to separate the various elements within the arrangement due to a lack of VSOE of selling prices for undelivered elements in the contract or because of the lack of reasonably dependable estimates of total costs. In these situations, provided that TiVo is reasonably assured that no loss will be incurred under the arrangement, we recognize revenues and costs based on a zero profit model, which results in the recognition of equal amounts of revenues and costs, until the engineering professional services are complete. Costs incurred in excess of revenues are deferred up to the amount deemed recoverable. Thereafter, any profit from the engineering professional services is recognized over the period of the maintenance and support or other services that are provided, whichever is longer. If we cannot be reasonably assured that no loss will be incurred under the arrangement, we will account for the arrangement under the completed contract method, which results in a full deferral of the revenue and costs until the project is complete. Provisions for losses are recorded when estimates indicate that a loss will be incurred on the contract. Advertising and Audience Research Measurement Services Advertising and audience research measurement service revenue is recognized as the service is provided. Such services are usually sold in packages customized for each campaign which generally lasts for up to three months. Because of the significant customization of offerings, TiVo historically has not been able to obtain VSOE of selling prices for each element in the package. Accordingly, we would combine all elements in the package as a single unit and recognize revenue ratably over the campaign period. As a result of the updated guidance on multiple element revenue arrangements, we can now estimate BESP for each element in the package and separate them into individual units of accounting. Nonetheless, the new units of accounting have very similar revenue earning patterns and timing and the amounts of revenue recorded in each period are not significantly impacted by the new guidance. Hardware Revenues Hardware revenues represent revenues from standalone hardware sales and amounts allocated to hardware elements in multiple element arrangements. Revenues are recognized upon product shipment to the customers or receipt of the products by the customer, depending on the shipping terms, provided that all fees are fixed or determinable, evidence of an arrangement exists, and collectibility is reasonably assured. End users have the right to return their product within 30 days of the purchase. TiVo establishes allowances for expected product and service returns and these allowances are recorded as a direct reduction of revenues and accounts receivable. Certain payments to retailers and distributors such as market development funds and revenue share are recorded as a reduction of hardware revenues rather than as a sales and marketing expense. TiVo's policy for revenue share payments is to reduce revenue when these payments are incurred and fixed or determinable. TiVo's policy for market development funds is to reduce revenue at the later of the date at which the related hardware revenue is recognized or the date at which the market development program is offered. Results of Operations Net Revenues. Our net revenues for the three and six months ended July 31, 2011 and 2010 as a percentage of total net revenues were as follows: 33-------------------------------------------------------------------------------- Table of Contents Three Months Ended July 31, Six Months Ended July 31, 2011 2010 2011 2010 (In thousands, except percentages) Service revenues $ 34,016 56 % $ 35,654 69 % $ 67,350 63 % $ 71,898 64 % Technology revenues $ 15,586 25 % $ 6,415 12 % $ 21,089 20 % $ 13,388 12 % Hardware revenues $ 11,580 19 % $ 9,481 19 % $ 18,495 17 % $ 27,650 24 % Net revenues $ 61,182 100 % $ 51,550 100 % $ 106,934 100 % $ 112,936 100 %Change from same prior year period 19 % (11 )% (5 )% - % Service Revenues. The decrease in TiVo-Owned service revenues of $1.6 million and $4.5 million in the three and six months ended July 31, 2011 as compared to the same prior year periods was due to a lower cumulative subscription base and an increased number of fully-amortized product lifetime subscriptions which no longer generated subscription revenues. Technology Revenues. Technology revenues for the three and six months ended July 31, 2011 increased by $9.2 million and $7.7 million as compared to the same prior year periods primarily due to our agreement with DISH Networks, which generates $11.1 million in revenue per quarter (Refer to Note 9. "DISH Network Corporation" of Notes to Unaudited Condensed Consolidated Financial Statements included in Part I. Item 1. of this report). Hardware Revenues. Hardware revenues, net of allowance for sales returns and net of revenue share and marketing development fund payments for the three months ended July 31, 2011, increased by $2.1 million, as compared to the same prior year period. This increase in net hardware revenues is largely related to increased hardware sales to our MSO customers during the period. Hardware revenues, net of allowance for sales returns and net of revenue shares and marketing development fund payments for the six months ended July 31, 2011 decreased by $9.2 million as compared to the same prior year period. The decrease in net hardware revenues for the six months ended July 31, 2011 is largely related to the decrease of approximately 29,000 hardware units sold, as compared to the same prior year period when we launched our TiVo Premiere boxes. Also contributing to the decrease is the continuation of our recently launched lower hardware pricing and higher subscription pricing (which allow consumers to pay lower upfront costs for the TiVo box with higher monthly subscription fees) for TiVo-Owned subscriptions. Cost of service revenues. Three Months Ended July 31, Six Months Ended July 31, 2011 2010 2011 2010 (In thousands, except percentages) Cost of service revenues $ 9,089 $ 9,887 $ 17,889 $ 20,290 Change from same prior year period (8 )% 1 % (12 )% 2 % Percentage of service revenues 27 % 28 % 27 % 28 % Service gross margin $ 24,927 $ 25,767 $ 49,461 $ 51,608 Service gross margin as a percentage of service revenues 73 % 72 % 73 % 72 % Cost of service revenues consist primarily of telecommunication and network expenses, employee salaries, service center, credit card processing fees, and other expenses related to providing the TiVo service. Cost of service revenues decreased by $798,000 and $2.4 million for the three and six months ended July 31, 2011, as compared to the same prior year periods. These decreases in cost of service revenues are largely related to lower service call center costs. Cost of technology revenues. 34-------------------------------------------------------------------------------- Table of Contents Three Months Ended July 31, Six Months Ended July 31, 2011 2010 2011 2010 (In thousands, except percentages) Cost of technology revenues $ 3,813 $ 4,211 $ 10,833 $ 9,232 Change from same prior year period (9 )% (28 )% 17 % (11 )% Percentage of technology revenues 24 % 66 % 51 % 69 % Technology gross margin $ 11,773 $ 2,204 $ 10,256 $ 4,156 Technology gross margin as a percentage of technology revenues 76 % 34 % 49 % 31 % Cost of technology revenues includes costs associated with our development work primarily for Comcast, DIRECTV, Virgin, and our other international and domestic projects. The decrease of $398,000 in cost of technology revenues in the three months ended July 31, 2011, related to a decrease in the amounts of revenue we were able to recognize for development work performed during the period as compared to the same prior year period. The increase of $1.6 million in cost of technology revenues in the six months ended July 31, 2011 related to the number of customers we were performing development work for in the current year period as compared to the same prior year period and the fact that development work for one current customer resulted in recognition of cost of technology revenues of $1.5 million will not be recoverable from the customer. The increase in technology gross margin for the three and six months ended July 31, 2011, as compared to the same prior year periods is primarily due to the revenue recognized from our DISH agreement as most of our newer deployment arrangements such as Virgin are accounted for under a zero margin method during the development period. In certain of our distribution deals, such as Virgin, TiVo is not being paid in full for the upfront development cost. However, in exchange, TiVo is receiving guaranteed financial commitments over the duration of the distribution deal. If we are reasonably assured that these arrangements as a whole will be profitable (assuming successful completion of development), we do not expense the development costs that exceed cash payable for the development work as incurred but rather we defer those costs and recognize these costs later when we receive service fees. As a result, a portion of service fees used to recover the initial development costs would be classified as technology revenues and timing of recognition of these costs and revenues may differ from when these costs are actually incurred. Thus, in accordance with our revenue recognition policies, we have deferred costs of approximately $25.6 million related to development work, largely related to Virgin, ONO, Charter, and DIRECTV and these costs are recorded on our condensed consolidated balance sheets under deferred cost of technology revenues, current and deferred cost of technology revenues, long-term at July 31, 2011. These costs (up to the amount billed) will be recognized when related revenues are recognized upon billing our customers, as specified in the agreement. Cost of hardware revenues. Three Months Ended July 31, Six Months Ended July 31, 2011 2010 2011 2010 (In thousands, except percentages) Cost of hardware revenues $ 13,401 $ 11,546 $ 22,254 $ 30,765 Change from same prior year period 16 % (11 )% (28 )% 31 % Percentage of hardware revenues 116 % 122 % 120 % 111 % Hardware gross margin $ (1,821 ) $ (2,065 ) $ (3,759 ) $ (3,115 ) Hardware gross margin as a percentage of hardware revenue (16 )% (22 )% (20 )% (11 )% Cost of hardware revenues include all product costs associated with the TiVo-enabled DVRs we distribute and sell, including manufacturing-related overhead and personnel, warranty, certain licensing, order fulfillment, and freight costs. We sell this hardware primarily as a means to grow our service revenues and, as a result, do not intend to generate positive gross margins from these hardware sales. Our cost of hardware sales for the three months ended July 31, 2011 increased as compared to the same prior year period as we sold more units into the MSO channel during the three month period as compared to the same prior year period. Our cost of hardware sales for the six months ended July 31, 2011 decreased as compared to the same prior year period as we sold significantly more TiVo units into the retail channel during the six months ended July 31, 35-------------------------------------------------------------------------------- Table of Contents 2010 due to the launch of our new TiVo Premiere boxes in the first quarter of fiscal year 2011. Hardware gross margin loss for the three months ended July 31, 2011 decreased by $244,000, as compared to the same prior year period largely due to increased number of units sold into the MSO channel, during this quarter as compared to the same prior year period. Hardware gross margin loss for the six months ended July 31, 2011 increased by $644,000, as compared to the same prior year period largely due to our new bundled pricing model which allows a customer to purchase a TiVo box at a lower upfront box price when the customer commits for at least one year to one of our new higher priced service plans. Research and development expenses. Three Months Ended July 31, Six Months Ended July 31, 2011 2010 2011 2010 (In thousands, except percentages) Research and development expenses $ 26,042 $ 19,326 $ 53,270 $ 37,954 Change from same prior year period 35 % 35 % 40 % 29 % Percentage of net revenues 43 % 37 % 50 % 34 % Our research and development expenses consist primarily of employee salaries, related expenses, and consulting expenses related to our development of new technologies and products, such as whole home DVR technology and new features and functionality as well as investments in creating an integrated software code base across our product lines to increase the efficiency of our product development efforts in the future. Thus, the increase in research and development expenses of $6.7 million and $15.3 million for the three and six months ended July 31, 2011 as compared to the same prior year periods, was largely related to increased headcount, headcount related, and consulting costs. . For the fiscal year ending January 31, 2012 we expect to increase our research and development spending as we believe that investments in research and development are critical to remaining competitive and being a leader in advanced television solutions beyond the DVR. Sales and marketing expenses. Three Months Ended July 31, Six Months Ended July 31, 2011 2010 2011 2010 (In thousands, except percentages)Sales and marketing expenses $ 6,905 $ 6,622 $ 13,242 $ 14,382 Change from same prior year period 4 % 21 % (8 )% 29 % Percentage of net revenues 11 % 13 % 12 % 13 % Sales and marketing expenses consist primarily of employee salaries and related expenses. Sales and marketing expenses for the three months ended July 31, 2011 remained relatively flat, as compared to the same prior year period. The decrease for the six months ended July 31, 2011 of $1.1 million, as compared to the same prior year period was primarily related to decreased headcount related costs of $523,000, decreased costs of channel support of $195,000, and decreased public relations spending of $171,000. Sales and marketing, subscription acquisition costs. Three Months Ended July 31, Six Months Ended July 31, 2011 2010 2011 2010 (In thousands, except percentages) Sales and marketing, subscription acquisition costs $ 2,441 $ 1,366 $ 3,674 $ 4,557 Change from same prior year period 79 % 63 % (19 )% 150 % Percentage of net revenues 4 % 3 % 3 % 4 % Sales and marketing, subscription acquisition costs include advertising expenses and promotional expenses directly related to our efforts to acquire new TiVo-Owned subscriptions to the TiVo service. The increase for the 36-------------------------------------------------------------------------------- Table of Contents three months ended July 31, 2011, as compared to the same prior year period was largely related to the write-down of advertising trade credits. The decrease for the six months ended July 31, 2011, as compared to the same prior year period was largely related to additional sales and advertising costs related to the launch of our TiVo Premiere and TiVo Premiere XL boxes in the retail channel during the six months ended July 31, 2010, offset by the write-down of trade credits during the six months ended July 31, 2011. General and administrative expenses. Three Months Ended July 31, Six Months Ended July 31, 2011 2010 2011 2010 (In thousands, except percentages) General and administrative $ 17,826 $ 14,103 $ 40,278 $ 25,800 Change from same prior year period 26 % 26 % 56 % 10 % Percentage of net revenues 29 % 27 % 38 % 23 % General and administrative expenses consist primarily of employee salaries and related expenses for executive, administrative, accounting, information technology systems, facility costs, and legal and professional fees. During the three and six months ended July 31, 2011, general and administrative expenses increased by $3.7 million and $14.5 million, respectively. The increase for the three months ended July 31, 2011 as compared to the same prior year period was largely related to increase litigation related spending of $3.1 million and increased headcount and headcount related costs of $831,000. The increase for the six month period ended July 31, 2011 as compared to the same prior year period was primarily due to an increase in litigation related spending of $8.8 million, which was largely related to our EchoStar, Verizon, and AT&T litigations combined with increased non-cash stock compensation expenses of $1.5 million and increased headcount and headcount related costs of $3.8 million, of which $1.6 million related to non-recurring transactions. Litigation proceeds. On April 29, 2011, TiVo entered into a Settlement and Patent License Agreement with EchoStar Corporation ("EchoStar") and DISH Network Corporation ("DISH"). Under the terms of the agreement, DISH and EchoStar agreed to pay TiVo $500.0 million, including an initial payment of $300.0 million received by TiVo on May 2, 2011 with the remaining $200.0 million to be distributed in six equal annual installments of $33.3 million between 2012 and 2017. The total consideration of $500.0 million was allocated on a relative fair value basis as $175.7 million to the past infringement and litigation settlement element, $2.9 million to interest income related to past infringement and $321.4 million to the future license royalties element. The amount related to past infringement and settlement was recorded under "Litigation proceeds" in the six months ended July 31, 2011. The amount related to interest income was recorded under "Interest income" in the six months ended July 31, 2011. There was no similar transaction for the six months ended July 31, 2010. Interest income. Interest income for the three and six months ended July 31, 2011 was $678,000 and $3.8 million, respectively. Interest income for the three and six months ended July 31, 2010 was $381,000 and $750,000, respectively. The increase of $297,000 for the quarter ended July 31, 2011 as compared to the same prior year period was related our increased cash balance. The increase of $3.1 million for the six months ended July 31, 2011 as compared to the same prior year period was largely related to the EchoStar and DISH settlement and interest of $2.9 million associated with their past infringement. There was no such similar transaction in the six month period ended July 31, 2010. Interest expense and other. Interest and other expense/(benefit) for the three and six months ended July 31, 2011 was $2.0 million and $4.6 million, respectively as compared to $145,000 and $147,000 for the three and six months ended July 31, 2010, respectively. The increase in interest expense for the three and six months ended July 31, 2011 as compared to the same prior year periods were due to interest associated with the convertible senior notes that were issued during the quarter ended April 30, 2011. We had no long-term debt in the three and six month periods ended July 31, 2010. Benefit (provision) for income taxes. Income tax benefit (provision) for the three and six months ended July 31, 2011 was $71,000 and $(1.0) million, respectively. Income tax benefit (provision) for the three and six months ended July 31, 2010 was $(29,000) and $(63,000), respectively. We have determined our interim tax provision for the three and six months ended July 31, 2011 by projecting an estimated annual effective tax rate. The 37-------------------------------------------------------------------------------- Table of Contents provision for income taxes for the three and six months ended July 31, 2011 differs from the U.S. statutory tax rate primarily due to the inclusion of benefits from release of the U.S. valuation allowance. The remaining income tax expenses are comprised primarily of state income taxes. Despite achieving profitability in the three and six months ended July 31, 2011 we expect to have a significant amount of net operating losses and R&D credits remaining and we continue to maintain a full valuation allowance against the remaining deferred tax assets as realization is dependent upon future earnings, the timing, and amount of which are uncertain. Liquidity and Capital Resources We have financed our operations and met our capital expenditure requirements primarily from the proceeds from the sale of equity securities, issuance of convertible senior notes, and cash flows from operations. Our cash resources are subject, in part, to the amount and timing of cash received from our license agreements, subscriptions, deployment agreements, and hardware customers. As of July 31, 2011, we had $627.8 million of cash, cash equivalents, and short-term investments. We believe our cash, cash equivalents and short-term investments, provide sufficient resources to fund operations, capital expenditures, future repurchases of TiVo shares in connection with our recently announced share repurchase program, and working capital needs through the next twelve months. On March 10, 2011, TiVo issued convertible notes with the aggregate principal amount of $150 million and received approximately $144.5 million in net proceeds. On March 30, 2011, TiVo issued an additional $22.5 million aggregate principal notes and received approximately $21.8 million in proceeds pursuant to the exercise of the initial purchaser's overallotment option. The notes will pay interest semi-annually at a rate of 4.00% per year and mature on March 15, 2016. On May 2, 2011, we received $300 million in cash (and we are entitled to receive more cash over time) from DISH Networks in connection with the settlement and patent license we entered into with EchoStar and DISH on April 29, 2011 to settle and dismiss all litigation and claims between the companies. For additional information about our settlement and license with EchoStar and DISH, please refer to Note 9. "DISH Network Corporation" of Notes to Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 of this report. Statement of Cash Flows Discussion The following table summarizes our cash flow activities: |