Why Is Seth Klarman in This Stock?

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Rovi Corporation (NASDAQ: ROVI) is one of the most recent targets by Seth Klarman’s hedge fund, the Baupost Group.  The track record of the Baupost Group warrants inspection of any new stocks they begin to acquire.  The Baupost Group is fourth among hedge funds in net gains since its inception in 1983 and has an average annual return of 19% in aggregate.  Klarman is traditionally a value investor so where does Baupost see the value in Rovi?

Rovi Corporation describes itself as “a global leader in digital entertainment technology solutions, powering the creation, distribution, discovery, and enjoyment of entertainment at home or on the go.”  Rovi provides the guides for 130 million cable/satellite service viewers, in over 219 million consumer electronic devices, through DIVX on over 500 million devices, and has an advertising network that reaches over 40 million households.  Simply, Rovi makes its money through licensing its patents and intellectual property. 

A portion of this revenue, largely the guides associated with monthly cable/satellite service, is paid to Rovi on a per month per subscriber basis.  The other portion or a bit over 40% is largely associated with consumer electronics and is more one time in nature based on sales volumes.  The latter portion is in a secular decline with consumers getting more content from tablets and laptops. Concern around the potential magnitude of this decline in consumer electronic revenue and the associated hit to EPS is partially responsible for the shares selling off from the mid-30s earlier in 2012 to a low of slightly under $10.    

The question on the table is, has the stock found a bottom or is it a value trap at these levels.  Baupost & Klarman obviously see value here at these levels.  First, the shares seem to have found support in the mid-teens at a little over 1x book value.  While consumer electronics is down year over year, it appears the bleeding has stopped for Rovi with the declines leveling off.  Management implemented cost cutting and production rationalization measures that result in $36 million in annualized savings.   

The case to own the shares of Rovi is simple; earnings bottomed in 2012 and will grow in 2013 along with strong free cash flow.  The outlook for revenue and profitability in the Service Provider Segment are good.  The recurring revenue stream of this business provides steady and stable revenue for Rovi and consistent cash flow.  Rovi can beat near-term expectations by the Street based on renewals, which were delayed, by larger customers.  Any new deal would likely include catch up payments for Rovi, likely leading to earnings beats. The expectation is likely there by the Street that these payments are made and are one-time in nature so while the beats provide some upside potential for the shares, it is not the compelling reason to own it.  However, renewals by large customers would shore up any concern that large providers are looking elsewhere for the services Rovi provides. 

Rovi has a new service, the Total Guide Solution, that its customers are migrating toward.  The service will result in increased revenue per customer, from around $0.20-$0.25 per month per subscriber to around a $1.00 per month per subscriber.  The mix for the business will improve as the margin associated with this is also likely significantly higher with much of the higher cost falling straight through to profits.

One of the bigger risks is unconventional providers such as Netflix (NASDAQ: NFLX) and Apple’s (NASDAQ: AAPL) iTunes. Both of these providers have grown substantially in viewership within the last 5 years and require no guides.  Netflix and iTunes have their own menu systems and content is viewed on demand.  Many Netflix and iTunes sobscribers continue to use satellite and cable services, but many have turned off the cable box for good.

Rovi is not an expensive stock, is still expected to generate a little over $1.50 in FCF in FY12 based on current analyst estimates, and has likely found a level of support.  Earnings should return to growth, as long as management executes on its cost cutting measures and consumer electronics does not fall off in a more significant way. The Street should regain confidence in Rovi’s earnings power, driving the shares higher since its service provider business is attractive.  

mthiessen has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple and Netflix. Motley Fool newsletter services recommend Apple and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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