Davis Freeberg’s Digital Connection

If you can say one thing about DivX, it’s that it’s not an easy company to understand. I’ve been following the company pretty closely ever since they went public, but last month, DivX CEO Jordan Greenhall said something at an investor presentation at CES that really caused my head to spin. Greenhall was responding to investor concerns over DivX potentially being replaced by a technologically superior codec, when he told investors that DivX wasn’t really a codec company.

When I first heard him make the statement, I had to go back and listen to it a couple of times for the ramifications to sink in, but after spending the past several weeks mulling over the implications of what this statement means, I now believe that it was the single most important thing said at the conference. Given how much confusion the statement caused among investors at the conference and given the importance of this concept to understanding DivX’s business model, it came as no surprise to see Greenhall return to this idea on DivX’s quarterly conference call yesterday afternoon.

“It’s extremely important to understand that DivX is not a codec company. Clearly the DivX codec is a core piece of our technology portfolio, however it is only one element of our overall value proposition, which is the Divx community itself.”

What made this concept so hard for me to understand was that I’ve always thought of DivX as a codec company. Their technology allows you to compress digital video into the highest quality experience possible. Not only does the picture come in crisp, sharp and in vivid detail, but they accomplish this using very small files, that are much quicker to download, at the same time.

If you compare the video quality on DivX’s Stage6 with the quality from YouTube or .wmv downloads, you’ll see how much of an advantage that DivX really has. How is it then that they aren’t a codec company and why is this important for investors to understand?

It’s important because if you build a business around technology, then as soon as superior technology is developed, it puts your product at risk, but if you build your business around community, then each user that you reach with the DivX language represents a deepening of the moat that protects DivX’s brand.

The codec itself is really a means to an end. It’s the way that DivX is able to transport their technology into the digital home. In order to understand DivX’s core business, you have to step back and take a more simplistic view about what it is that the company actually sells.

To say that they are a codec company is like saying that they are in the business of selling zeroes and ones, while technically true, it’s not what they are really selling. What DivX is really providing is a way for consumers to create, share, transfer and consume digital video in their homes. Consumers don’t care if their TV comes from DivX, .wmv or mpeg2, they care about being able to enjoy a high quality experience, while watching their videos within their own entertainment eco-system.

The problem with looking at the company as a common media language is that it makes the idea behind DivX much more theoretical and significantly more difficult to grasp. If they are not a codec company, then how do you value what they are worth and if the technology itself doesn’t have any intrinsic value, what then is it that DivX owns and what makes them worth so much?

In order to answer these questions, you must look at the DivX community. DivX makes their money from their CE partners and the value that DivX provides to these partners is access to their community for a fee. Essentially, they have positioned themselves to be a gatekeeper that can charge CE companies in order for them to be able to plug into the DivX community that they’ve built. This concept is both brilliant and terrifying at the same time. On one hand it reduces their dependency on technology, but on the other hand it means that DivX must continue to grow in order to protect their community and if they want to see revenues expand. Divx’s monopoly on open source video is what gives them value and if you can assign a value to this, then you’ll have a better understanding of how much DivX is really worth.

In order to determine how to value this monopoly, you must look at how effectively DivX can monetize this community as well as how competition will affect their future ability to monetize the consumers that use their brand. In looking at just the past quarter, the results are impressive, but not the mind blowing numbers that some on Wall St. will need to see before they’ll understand the true value that DivX has. For the fourth quarter, DivX had $16.7 million in revenue and $7.4 million in net income. For all of 2006, DivX earned $59 million in revenue and $16.4 million in net income.

With a market cap of about $735 million right now, DivX is trading at a pretty nice premium if you only look at earnings for the last 12 months. Looking forward, if all that DivX does for the next 12 months is to maintain their quarterly profit of $7.4 million, it would give the company a p/e ratio of approximately 25, if they stayed at their current price. If they actually continue to grow their earnings each quarter, then the company will start looking ridiculously cheap after not too long. The analysts understand this which is why five of the six analysts have a buy recommendation on the stock.

I believe that the company deserves to trade at a growth multiple because they stand on the precipice of a digital revolution that will transform the way we think about video. They are well positioned to capitalize on an industry that is still in its birth years and if they execute properly, the payoff will be huge. What makes me so excited about this company is the potential for explosive growth. This is why Greenhall isn’t nervous about competition and why investors should be wiling to pay up for that future growth. During the earnings conference call, Greenhall addressed their competition by saying that he was largely unimpressed.

“There is nothing out there in the marketplace, either currently in the market or on any of the R&D blackboards of any entity that we are aware of, that is particularly awe inspiring. With regards to existing technologies that are interesting, things like the open centered h.264 or the proprietary technology of On2. While both of those certainly have a role to play in the digital media market, neither places a substantial amount of competitive pressure on DivX, no more so than Apple’s use of AAC puts any particular pressure on mp3.”

What Greenhall understands, but the market is missing, is that the digital video market will not be a winner take all game. DivX clearly faces competitive threats. They come in large sizes and they come in small sizes, but the threats are real and being addressed. With Microsoft and Apple breathing down their necks, DivX could find their industry standard threatened by other codecs, but what protects DivX from these threats is their open standard solution that appeals to more then just the big guns.

Sure Apple is quickly becoming a media powerhouse and from the looks of Vista, it appears that Microsoft finally has the studios in their back pockets, but these aren’t considerable threats to DivX because the proprietary nature of their systems won’t allow other players into the market. AppleTV is great for iTune fans, but it doesn’t help Toshiba, Panasonic or Phillips bring digital video to the living room and that is DivX’s real advantage over the various closed systems that have been coming out. DivX is a company that wants to be everyone’s friend. They are not only willing to license their technology to just about anyone, but they do so at a very reasonable price. This makes them an ideal solution for the thousands of other companies who want into the digital video game, but don’t have the critical mass of an Apple or a Microsoft to bully their way in. Wall St might not understand why DivX isn’t trying to jack up prices and increase their profits, but luckily for them DivX management does.

The DivX entertainment ecosphere is still in a fragile state. The company has proven their business model through their relationships with the DVD manufacturers, but they need to increase the number of devices that DivX can touch. The more licensing deals they can get, the stronger their monopoly on open source video will become and the more pricing power they will eventually have. Someday in the future, there will come a time when DivX will raise prices, but doing so at the birth of an emerging market would be a serious misstep. For investors who are looking to make the quick buck, DivX is the wrong stock. This is a growth company in a developing market, but it will take time for DivX to prove the long term viability of their business model.

In the meantime, DivX could find that investors might grow fearful of Apple and Microsoft’s inroads into North America, but investors will be foolish if they overlooked the real global potential for the DivX brand. Two of the more exciting developments that DivX saw over the last quarter was an agreement to offer Spanish content from a distributor in Mexico and an agreement to use the DivX codec for Bollywood content in India. These are important moves by the company because content ultimately drives consumers to adopt the technology and it’s this audience that provides so much value to their CE partners.

In looking at the potential for DivX to succeed on a global basis I am remarkably optimistic. The company doesn’t break down where CE devices are being shipped globally in part because their partners don’t share that information, but there is no doubt that DivX isn’t really a domestic stock, it’s an international play on the VOD market. If you look at the troubles that Apple is having in Europe right now, you’ll see that the rest of the world isn’t very comfortable with letting one company control how you can consume your content. Interoperability, has been a huge issue in Europe, where DivX has their largest consumer penetration and will become a greater issue as DivX continues to gain critical mass in more countries.

In looking at how this market will unfold, I get very excited when I think about the number of potential DivX consumers in places like India, Latin America, China and Japan. These are large addressable markets that will be fertile ground for a system that puts all CE manufacturers on equal footing. Between DivX’s price sensitive policies and their willingness to allow anyone to license their technology, they’ve put themselves into a position to take the VOD beachhead that they’ve establish and turn into a global standard for digital video.

Between the increases in the number of users who will interact with their content and the increase in the types of consumer electronic brands that can support their common media language, DivX is in a great position to capitalize on the emerging markets without the same level of political risk that would be required if you made a direct play in India or China. When you think about the opportunities for expansion, you have to think globally when it comes to DivX and when I look at the number of cell phones, DVRs, DVD players, portable electronic devices and digital cameras that are sold on a global basis, my eyes pop out of my head.

One of the things that investors got hung up on at DivX’s CES investor conference in January and on yesterday’s earnings call, was DivX’s reluctance to start heavily advertising through Stage6. Investors understand that the company gets a decent amount of traffic, in fact Greenhall told analysts that Stage6 is now receiving 3 million unique page views a month, but what investors don’t understand is how DivX is leveraging the site to build their brand. They desperately want to be able to look towards a revenue line item that they can understand from a more traditional aspect, but when it comes to DivX, things will always be complex.

Stage6 will eventually have a revenue component, but it will look less like Yahoo’s banner ads and more like Google’s ad sense program only for video. More importantly though is the role that Stage6 plays in marketing the DivX to their end consumers.

The amazing thing about what DivX has created is that they’ve done this with almost no marketing expenditures. You don’t see DivX commercials on TV, no Super Bowl ads, the technology is spread virally because the videos they encode are viral. Every time a consumer touches a DivX file, it really contains a commercial for DivX’s software inside because you need their technology in order to unlock the content that consumers want to get at. This is an extremely powerful marketing network and it is why investors should be looking at Stage6 more as a marketing expense, then as a revenue driver. The hedge funds and day traders may want DivX to capitalize on their traffic to make the quick buck, but without a large community using their files, there won’t be any advertising opportunities and until Divx can establish their brand as the undeniable de facto standard for video, they are well served in using this channel to increase the number of people who come into contact with the DivX brand, instead of trying to spam the consumers that have played such an important role in building DivX’s brand. During the conference call, Greenhall described the power of this marketing channel much better then I ever could.

“You can imagine DivX being a form of black hole that the more that a consumer uses DivX, the more content they create in the DivX format. The more they are personally invested in the software, consumer electronics devices and personal learning, the more relationships they have with service providers. The more people who use DivX as a common media language, the more mass there is in that overall black hole.”

In looking at the competitive threats to DivX it’s not the big companies that scare me, it’s actually the small ones. Because DivX’s business model is built on providing access between CE devices, anything that can take out the middleman by translating the DivX language into another codec is the real threat. For the most part, these solutions have been confined to the early adopter crowd, but when I see software like DVD Flick, that allows consumers to burn DivX files that will play on non-DivX certified DVD players, I see this as the scary threat.

One major concern that has surfaced over the last six months has been rumors that DivX plans on doing a secondary offering once their lockup expires on March 20th. The company tried to dodge the question the first time analysts asked, but later in the call, they admitted that there wasn’t a big need for cash, but left open the possibility that we could still see an underwriting.

Only DivX really knows if they are planning on doing another underwriting, but I believe that fears of an underwriting are misplaced. The company doesn’t necessarily need the cash, but with more cash in place, it would increase the number of options available to DivX to help them expand. Investors would face dilution of their shares, but one of the biggest problems with DivX’s stock is that there simply isn’t enough of it to go around. Since DivX has gone public their stock has been extremely volatile because traders are forced to pay a significant premium to buy large dollar amounts and a significant discount if they want out. With only 33.5 million shares outstanding and 10.6 million shares that are actually floating in the market, all it takes is about $10 million worth of interest in the stock and the market cap can easily jump up or down by $100 million. With such a small float, there simply isn’t the liquidity necessary for many institutional investors to be attracted to the stock, but by completing another offering, DivX could help to increase that liquidity and could bring new buyers into the market for their stock. There might be short term volatility associated with such a move, but over the long run, I believe the additional capital would greatly benefit the stock.

Divx’s business model is incredibly tough to understand, but where there are misperceptions in the market, alpha exists. What DivX is trying to accomplish with video is the same thing that Adobe accomplished with .pdf. They faced a larger rival with Microsoft’s word format, but their openness allowed the .pdf to become an industry standard despite the advantages Microsoft had with their operating platform. DivX has developed a large open source user base that can interact with their files and are well past the first step towards creating the critical mass necessary to monetize their common media language.

Management’s commitment to driving growth and profitability, while remaining frugal in how they invest will help prevent the company from flaming out like many technology companies did in the dot com bust. Meanwhile, they face a growing international presence, they are seeing a dramatic increase in the number of consumer devices that could utilize DivX’s standard and there is still an amazing upside potential to DivX’s stock if they surprise the market with a miracle deal with Xbox, PS3 or Nintendo. At a market cap of $735 million, Wall St may not understand the true value of the stock, but for high risk investors who step back and consider the possibilities of their common media language, tremendous value exists.

Posted on February 9th, 2007 by Davis
Filed under: DRM, DivX, Media, Movies, TV, Technology, VOD