Davis Freeberg’s Digital Connection

Dr Divx Or Mr Hyde Hosted on Zooomr

DivX may be unable to comment on the success of their IPO right now, but the rules that relate to their quiet period certainly haven’t kept the markets from talking about their stock. After sucessfully pricing their IPO well above their initial target range, the stock took off after Jim Cramer gave it a Buy Buy Buy on his Mad Money program. What’s interesting about Cramer’s comments is that despite the difficulty behind understanding the complex revenue structures and technological issues associated with DivX, his recommendation was enough to convince investors to bid up the stock to a 54% gain from their IPO. Unfortunately, the Mad Money crowd can be a fickle bunch and after seeing a healthy sell off near the close on Friday, DivX took a bath on Monday after investors moved to exit the stock.

One of the problems that we will find with DivX is that all it will take is a little bit of interest or lack of interest and the stock can really move. While the market cap currently stands at $745 million, the actually number of shares that are floating in the market is really closer to about $200 million. This means that if good news comes out you can expect that the stock will surge, but with a little bit of pessimism you’ll see the stock come crashing down. This makes the company ideal for big money hedge funds that can profit from the volatility, but individual investors need to think twice about their comfort with volatility before considering a company like DivX. Because of the small float, the most important piece of advice that Cramer gave his audience was to make sure to use limit orders with this stock. Limit orders don’t ensure that you will end up getting stock, but they do ensure the price that you are willing to pay for the company. This is important with thinly traded stocks like DivX because if demand exceeds supply you will find that the stock gaps up significantly as it takes much higher prices to bring new sellers to the market.

Of course using a limit order doesn’t answer the most important question of all and that is what should DivX be worth. This is a question that even the experts can never agree upon and to make things even more complicated, in the case of DivX, there doesn’t appear to be any Wall St. analysts that have initiated coverage on the stock.

Part of what makes DivX such a tough company to value is that standard PE calculations aren’t very helpful. In fact, assuming that they stayed in just cash for the next year, the interest payments from their IPO proceeds alone would be enough to boost DivX’s earnings by nearly 33%. This would normally be great growth for a company, but investors shouldn’t be content with just clipping the interest on the IPO proceeds. If DivX was a mature company, a PE ratio would be more helpful, but given their ambitions and their stated plans to use the IPO proceeds for research and acquisitions, you can’t count on money market yields to turn this small cap stock into a solid mid cap play. Instead the issue that investors should be asking themselves is what DivX plans on doing with their $145 million in cash and how will this impact the bottom line for the stock. For as cool as their technology is and as much buzz as they may end up getting, DivX’s will ultimately need to continue to produce solid earnings and impressive growth for investors to justify paying a premium for the company.

In looking at the company, I believe that DivX has a couple of fundamental weaknesses that they could use their cash to shore up. Most importantly, the company has a high revenue concentration in licensing deals with consumer electronic companies. These deals are fantastic for DivX because they produce high gross margin sales because most of the costs associated with these arrangements have already been paid for with the development of their codec. Unfortunately for investors though, many of these deals are only 1 – 2 years in nature and it puts DivX in a tough position of having to constantly be renegotiating these arrangements in an industry that seems to undergo dramatic shifts on a week by week basis. If DivX can continue to gain in it’s popularity, these deals shouldn’t be at risk, but if enough people abandon DivX and start using iTunes, Amazon and other VOD solutions, then this could put DivX’s licensing deals at serious risk, especially if the CES companies begin to ask themselves whether or not consumers really want the ability to play DivX files on their DVD players.

The key for DivX to maintain their relevance with the consumer electronic firms will be their ability to convince consumers to continue to download DivX files and to demand access to burn these file for play on their DVD players. Right now most DivX files are traded illegally on the P2P networks, but as DivX continues to move legitimate, it will become increasingly important for them to strike partnership deals and for them to demonstrate that there is clear consumer demand for their product.

DivX has clearly recognized this risk to their business model and have spent a lot of energy on developing their Stage 6 internet property. Stage 6 is DivX’s own solution to video on demand. Consumers can go to their website and can stream content for free or for a small fee they are allowed to download films and then burn them to play in a DivX certified DVD player. In an effort to help encourage the adoption of DivX technology, DivX has created revenue sharing arrangements for those who upload their independent films to the site. After paying some minimum hosting costs, DivX shares revenue with independent content owners whenever they sell a DivX film on stage 6. The breakdown of the distribution arrangement is 65% to DivX and 35% to the content owners. While I like this aspect of their business plan, I remain unconvinced that stage 6 will be the video on demand powerhouse that DivX hopes it will be.

Consumers have already adopted YouTube and MySpace and given the online competitive environment for video sharing properties, DivX faces an uphill battle in getting consumers to adopt their video sharing site. Without significant mainstream content to sell to customers, DivX will face an intense battle in trying the do it alone business model when it comes to content sales and I think that their focus on stage 6 is a huge distraction from higher gross margin opportunities.

If DivX uses their $145 million in cash to go out and purchase content for the site, it could give web users a more compelling reason to visit stage 6, but it would also crush the gross margins that they are able to achieve by moving the business away from licensing and software revenues and towards content distribution. While it may help to firm up their CES royalty arrangements, there are no guarantees that access to content will even make stage 6 popular with consumers and I would argue that the company should be directing their efforts to better opportunities.

If DivX instead uses their $145 million in cash in order to pursue licensing arrangements with other companies, then DivX could be a much more attractive canidate from an investment stand point. These relationships could be with the cell phone providers looking to break into VOD or they could be existing partners of the studios who want to make use of DivX software.

As anyone who has tried to negotiate with Hollywood knows getting access to content deals is not an easy process. The studios love to enter into exclusive arrangements and have a clear interest in postpoining the sucess of VOD in lieu of the higher licensing fees they can get from DVD revenues. If DivX chooses the go it alone model and tries to negotiate directly with the studios, then it could be a tough road ahead for them, especially for an industry that is distrusting of technology to begin with.

Fortunately for DivX though, the one ace they hold up their sleeve is the quality of their video codec. Studios may be reluctant to license their content directly to DivX, but when it comes to partners that are already working with the studios, there is a clear economic benefit to the VOD providers to license DivX’s technology. If Amazon is having to pay substantial bandwidth costs because the .wma file they using is twice the size of a DivX file, then by giving DivX a high margin cut of their proceeds, they could see substantial savings on their bandwidth costs. No one wants to pay a middleman to distribute video, but on the other hand, if it’s cheaper then paying the telecoms hosting costs, then there is a real incentive for people to partner with DivX and to use their technology to save money.

If DivX pours their money and effort into expanding these relationships, they very well could justify their current valuation, but if DivX continues to focus on their stage 6 investment, then this will undoubtably eat into their gross margins and should cause investors to think twice before paying such a large premium for their stock. At a market cap of $750 million, DivX is by no means cheap, but on the other hand, with $145 million in cash, very little debt and an impressive income statement, DivX could be positioned to tap into a multi billion dollar industry, if they can effectively leverage their technology

DivX may look expensive at a market cap of $750 million, but online video is hot right now and it’s clear that investors are willing to pay a premium to gain exposure to the industry. With Akamai trading at a premium of nearly 8 times their book value, DivX would need to hit over $34.50 per share before it achieved a similar valuation to Akamai. This doesn’t necessarily mean that DivX deserves to trade at such a premium, nor does it mean that Akamai deserves to trade at 8 times book value, but it does mean that DivX could still go up quite a bit before their bull run is over. If DivX fails to capitalize on the expectations surrounding their business, it will be a scary ride for investors, but if you believe that their technology is going to lead the digital revolution, then it may be worth paying a premium for that future growth.

Posted on October 3rd, 2006 by Davis
Filed under: DivX, Media, Movies, VOD