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Tivo uses a hardware-based decoder on the motherboard, which handles the MPEG2 variant used in the recordings. Anything else would require the CPU to handle decoding, and I doubt the MIPS processor used in the Series-2 is up to the task, especially not while handling all the other regular duties which run on a Tivo.
Now, that's not to say you couldn't use an external program to transcode AVI files to a videostream Tivo can understand.
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