Contract Concerns Ding Rovi

On the licensing front, Rovi continues to focus on its big four intellectual property licensing deals (Comcast, Dish, Time Warner Cable, and DirecTV), which all come up for renewal in the next year. These deals will have a significant impact on Rovi's financial performance, if renewed. We believe the firm should come to amicable terms with each of the big four providers. A couple of highlights during the quarter support this conviction: Rovi signed a short-term licensing deal with Time Warner Cable and extended a licensing deal with Sky in Europe.

Sales fell 11% year over year to $114.9 million in the third quarter. Consumer electronics licensing revenue plunged 39% year over year to $11.6 million, while consumer electronics product revenue fell 13% year over year to $5.8 million. On a positive note for Rovi, intellectual property licensing, discovery, and metadata experienced good activity during the quarter, supporting more long-term growth-focused initiatives.

We Foresee Return to Steady Growth Rovi's backbone is the strength of its patent portfolio. We believe the company's 5,300 issued and pending patents worldwide give it a narrow economic moat. With roughly 90% of revenue booked before the year begins and licensing contracts that last from two to five years, Rovi is a leader in a high-growth but very high-risk industry, in our view. Rovi's intellectual property licensing business model delivers more than 50% of group sales. The company leverages its strong licensing position with additional sell-through of advertising, metadata, analytics, and interactive program guides. Our biggest concerns are associated with the fast-paced nature of the industry. Innovative competitors or industry changes could weaken the position of Rovi's patents.

With declining operating margins and slowing revenue growth as a result of company-specific and macroeconomic issues, new management has taken significant steps to improve the convoluted structure of the business. Given various restructuring initiatives, we expect the business to return to steady growth as it focuses on the more stable service provider business segment.

We believe Rovi's intellectual property portfolio will sustain the company's significance in the marketplace for the foreseeable future. The company plays an important role because of its deep existing relationships with key companies, and we see a number of growth opportunities for this business segment, namely the firm's big four service provider renewals.

We believe Rovi will continue to service the needs of consumer electronics manufacturers and service providers through the provision of compelling discovery, delivery, and advertising solutions. Its narrow moat, along with its installed base of customers, should help Rovi sell more add-on services to existing clients. We expect long-term growth to be driven by IP licensing, cloud-based platforms, geographic expansion of metadata, advanced search, and analytics. As a result, we think the business will continue to generate excess returns on its invested capital.

Patent Portfolio Provides Moat Rovi's competitive advantage is tied directly to its patent portfolio. The company has around 5,300 issued and pending patents that are primarily linked to its interactive program guide business. The company counts many of the largest technology, telecom, and media companies as clients, including Google, Facebook, Apple, AT&T, Comcast, Samsung, and Sony. What makes Rovi's IP portfolio attractive is its integrated profile, meaning the company isn't purely reliant on just one or two key patents. Moreover, licensees don't license from patent to patent, but from the entire portfolio. We believe this wide patent ecosystem drives Rovi's value. Additionally, the patent portfolio is supported by domestic and international protection, has staggered expiration dates into the 2030s, and is difficult to design around. As a result, we assign the company a narrow economic moat. Any significant legal losses or technological shifts could see Rovi's patent portfolio evaporate, in which case we would revisit our moat rating.

Must Protect Intellectual Property Rovi operates in a fast-paced industry where technology can change rapidly. New technological innovation could make existing patent assets irrelevant. It is also important that Rovi is able to protect its patent portfolio and that the judicial system takes action against those in breach of any intellectual property. If patents are not properly enforced, Rovi's competitive position would deteriorate considerably. Furthermore, Rovi may encounter conflicts with existing and potential customers and need to assert its IP rights against them.

Competition exists in many parts of the business. These competitors (Cisco CSCO, NDS, Nagra, and Arris ARRS) often have greater financial, technical, and marketing resources. Therefore, the potential to lose market share is a constant threat.

Finally, poor macroeconomic conditions have a considerable impact on Rovi. The recent weakness in the consumer electronics manufacturing industry exemplifies this. Additionally, the firm's advertising solution is a fairly new form of promotion and faces significant cutbacks relative to the traditional advertising media.

Rovi is in acceptable financial shape. The company has roughly $215 million in cash, investments, and securities and $1 billion in debt. It comfortably meets required interest expense and has strong recurring revenue streams, with roughly 70% of group revenue booked before the start of the year. We believe Rovi's strong and dependable cash generation puts it in a stable financial position. The company has taken advantage of low interest rates by obtaining a senior secured credit facility, adding financial flexibility and providing capital to acquire companies. It also continues to have an opportunistic approach to share buybacks.