Turning the corner at TiVo?

TiVo insiders refer to the last day in March as the "blue moon" holiday, a reference to a month in which two full moons appear. On that day three years ago, the company began initial shipments of its digital video recorders.

That was an important milestone for TiVo and its Chief Executive, Mike Ramsay, who had unexpectedly pushed up the shipment date in order to beat out rival start-up ReplayTV to market.

Digital video recorders are similar to VCRs. But instead of storing shows on tape, the systems store shows onto a hard drive. TiVo provides a subscription service that allows viewers to pause live broadcasts and restart them--as well as program DVRs to record shows in the future.

By the middle of this month, when its second-generation DVRs, the Series2, begin hitting retail stores, TiVo may be setting itself up for another milestone: the end of subsidizing manufacturing costs and the start to a clear path toward cash-flow breakeven. When it came out of the gate in 1999, the company was willing to share the cost of manufacturing because it was keen on keeping prices low to build demand for its recorders and subscription services.

The gambit worked. With approximately 400,000 subscribers, TiVo now says it is on track to reach breakeven next year. That's a more optimistic picture than the one offered by management last year. After failing to convincingly explain to analysts how it would get to breakeven without needing additional funding, TiVo's stock got whacked and analyst criticism was harsh. Now even some of its sternest critics are suggesting that TiVo is about to turn the corner.

CNET News.com recently paid a visit to TiVo's headquarters, based in San Jose, Calif., to catch up with Ramsay and get his thoughts on the company's new strategy.

Q: Being a TiVo subscriber myself, I've always thought of TiVo as being a service company. But with some of the upcoming features for the Series2 box, it sounds like you're looking to become a platform company where third-party developers can develop applications to be run on the platform. What kind of company do you see TiVo becoming?
A: We're still very much a service company. Despite all the ups and downs of the market, we've continued to believe that that's the core of our business. Our business is to get a slice of the $70 to $80 a month that consumers are spending on home entertainment. What you're seeing though is, in our endeavor to grow that (service) business, we have to do some other things to help that to happen, such as this idea of platform proliferation. To encourage that, what we're doing is creating a licensing business where people can license our technology around DVRs. We've done a deal with Sony. We've got some other deals in the works, and it's certainly worked with DirecTV.

"The idea of home networks and home servers is a bit ahead of its time. I just don't think that consumers are ready for it yet."

And you're right, the idea is to do it in a way that creates a platform much in the same way that the PC's a platform or the Internet's a platform, where you can have third parties develop for that platform.

Some critics and financial analysts have said that TiVo is a service masquerading as a company and that you can't build a service into a company. What do you say to them?
I might question the statement that you can't build a company out of a service. There are a lot of good examples. We sometimes compare ourselves with AOL, who, back in the early days, had 200,000 to 300,000 subscribers, and the Internet was free and people were asking how could AOL succeed. Well, 34 million subscribers later, they've definitely succeeded. The challenge in any service business is that, typically, you have a large up-front investment to build up critical mass. In our case, the up-front investment was to underwrite the cost of the hardware so that it was inexpensive for consumers to buy.

Back two years ago, when we could raise a lot of money that seemed okay. Of course today that is very different, and what we've accomplished between then and now is that we've dramatically lowered the cost of acquiring subscribers, by an order of magnitude.

What's critical mass for TiVo?
Critical mass is probably when you cross a million people. We actually have declared inside the company that when we talk about subscribers, it's all based on millions. So right now, we're talking about 0.4 million--just to get in the mindset that we're not there until we get to 1.0. When we get to a million and we're generating free cash flow, which we will be at that point, then we will have the ability and flexibility as a company to start reinvesting in advertising and audience research activities that can generate real positive margin immediately.

Earlier this year at CES, TiVo and Moxi Digital had announcements that sounded very similar to one another. How do you distinguish TiVo from the soon-to-be-merged Moxi Digital and Digeo?
I suppose, philosophically they're an infrastructure company. They're pitching this idea of home server, home network and satellite boxes around the home that can deliver television to a central hub for all incoming and out coming content via broadband or television. So it's build the infrastructure and they will come. Just like cable companies do.

Our philosophy is more build the killer app and they'll want more. It's not the infrastructure that drives it; it's the application. Our killer application was intended to be DVR--still is. The idea of home networks and home servers is a bit ahead of its time. I just don't think that consumers are ready for it yet.

You've talked about your subscribers, or fan base, and how much they love TiVo--and yet sales and subscriptions have been slower than expected. What do you attribute that slower than expected sales growth to?

"That said, we have made a conscious decision to get out of the subsidy business, and we'll take whatever the consequences are. If that's slower growth, then so be it."

It's never as fast as you would like. Mind you, if we had gotten to the million subscribers under the old model, we would probably be bankrupt, so it's kind of a mixed blessing where we are.

So when we look at our growth profile with respect to arguably one of the fastest-growing consumer-electronics categories, we're a bit ahead, frankly. And so it does remind us that consumers accept something at their rate, not ours. And while there's a barrier to entry, there's a massive barrier to exit. But that process of getting consumers educated and getting them comfortable with technology simply takes time. And you have to build volume to get the cost down, and as the cost comes down it builds volume. It's a whole geometric process, and sometimes it has a flash point, where it just takes off. The DVD was like that. Once it got below $199 it hit a flash point and it took off, and I'm convinced that we'll get there with this technology, but it's not going to happen as soon as everyone wants it to happen.

What do you think will be the flash point for TiVo and DVRs?
History will tell you that $199 is a good point to be at to get to the mass market. So if you can hit that price at a point in time when consumers are thoroughly educated and have a mass desire to buy, then you have a flash point.

There are two ways to get to mass deployments. One is through consumer-electronics companies adopting DVR technology, probably in combination with something like rewriteable DVDs, to create sort of a VCR replacement. And we've got a lot of interest in that, and over the next three years you'll see that emerge as a category to be driven down in cost just like DVD is, and eventually it will become commoditized. Along the way, hopefully, consumer-electronics companies will make a lot of money promoting that category.

The other (way) is to build it into set-top boxes, and our work with (satellite network operator) DirecTV has been very good from that standpoint. Nearly half our business comes from DirecTV. It will take longer to get into cable for a lot of reasons that are unique to cable. But it will eventually get there.

What are the differences in the approaches?
The difference between getting it into a set-top and the consumer-electronics world is the life cycle. Consumer-electronics companies are going to innovate rapidly, create new versions very quickly, and so as this technology matures, they will take advantage of that. In the cable world, their life cycles (for set-top boxes) are 5 to 7 years. And guess what, in 5 to 7 years, we're going to see a terabyte in a smart card, so anything that is locked in now is going to be very quickly obsolete. So it's questionable what that means. Does that mean that they are going to hold off because the life cycles are too short, or does it mean that they will have to be willing to stay behind the technology. Who knows?

Satellite companies tend to be more forward-looking because they have a retail model for selling set-tops and they're willing to innovate. And I think that companies like EchoStar and DirecTV have shown much more flexibility and desire to get into this space.

When do you think that flash point will occur for TiVo?
Will that occur this year? I don't know. We're not planning on that occurring this year. If it does occur it would be great. I think that it is highly likely for it to occur by the end of next year.

Another flash point would be if a cable company or a satellite company decided to go for mass deployments. And that could happen at any time. I think that EchoStar is sort of playing around with it. But still the economics is probably not very attractive for them because they're not charging a service fee there's no way to recover the cost of doing it other than lower churn or increased buy rates on premium services.

You touched on subsidies, and many critics have pounded TiVo about its cash position. Were subsidies a mistake?

"We are a company who has spent a lot of money, and so people ask the question in hindsight: Would you have spent that much money, given that money is tight right now?"

We are a company who has spent a lot of money, and so people ask the question in hindsight: Would you have spent that much money, given that money is tight right now? I think that is a hard question to answer because, at the time, it was the right thing to do. It was one of the ways we beat Replay (TV) initially. We were very focused on keeping the prices low. We were very focused on partnerships with the consumer-electronics companies and the service providers, and we knew we had to subsidize them in order to keep them in the game. We weren't happy about that, but we knew that we had to do that.

Replay (TV) didn't do that, and they were unable to go out with an IPO. And they couldn't raise enough money and they had to retreat back, and they were eventually bought out by Sonicblue. We were able to stay independent and grow and gain the largest market share, and so in that respect, I think that investment was essential because without it we would not be in business.

That said, we have made a conscious decision to get out of the subsidy business, and we'll take whatever the consequences are. If that's slower growth, then so be it. And we've guided to relatively conservative growth this year, and some of that is because of the fact that we've put a higher priority on generating cash than we have on subscriber growth.

What made you change the priorities of the company?
Our ability to raise additional capital because of the meltdown was a big impact. We decided not to raise anymore capital because it would be too dilutive to our company, and we want to have the discipline of not burning through cash like crazy.

Formerly critical analysts have said that you may have turned the corner because you aren't offering subsidies anymore. Do you agree with that?
I think that is a big factor. The things that have improved the Street's confidence in us are the more rational nature of the model, especially those surrounding licensing and having backed that up with real deals. I think the reduction in the subscriber acquisition cost, which subsidies make up the biggest part of, and the fact that we are pretty determined not to subsidize. They can take that and put that in their models, and they figure out how much cash we're going to use and they can see how it's all going to work.

Whereas before, they couldn't see how it worked without us having to raise additional capital, and that was a source of concern for them. So we've helped take away that concern and that has improved confidence. We still have a long way to go there, but we've beat analyst expectations for the last 6 or 7 quarters.

What continues to keep you up at night?
I do concern myself with people's perception to the value of our company in general. And I hate to put that in terms of stock price--you can't run your company always focused on stock price--but really I think the intrinsic value of our company is higher than people give us credit for.

We have a superb technology base protected by patents enforceable against anybody who is in the DVR space. We can't tell for sure, but we feel that we've got by far the strongest (intellectual property) position (in this market) at this point. We've got the largest market share and a sub base that loves us. It's a lovefest going on between our subscribers and us--and how many companies have the good fortune to be in that position?