Davis Freeberg’s Digital Connection

I’ve always been a bit of a strange bird when it comes to the things that I look forward to. Most people will get excited when their favorite TV show comes out of summer reruns or when a band they liked in college is coming to town. Sometimes, people will even line up overnight just to have the opportunity to see an event that they really care about. While I like entertainment as much as the next person, it’s not the movie premiers that make me drool, it’s events like the JP Morgan Global Internet Conference that was held in New York, earlier this week.

I find these “stuffy” business events exciting, in part because I’m naturally interested in business, but more importantly because I get an opportunity to hear some of my favorite companies share information with the investing public. Often times, these types of presentations offer consumers a unique glimpse into the real motivation behind some of your favorite brands. When these companies normally present to consumers, they tend to focus on their low prices or positive benefits of their services, but if you lock technology executives into a room filled with shareholders, a very different perspective comes out.

The one downside to these investor conferences is that there are so many great presentations, it’s next to impossible to cover all of them and this year’s event was no exception. JP Morgan hosted 70 different public and private companies that compete in the internet space, including many of the companies that I follow closely.

I would have liked to have done a write up on all of the presentations that I’ve listened to over the past couple of days, but the company I have been the most interested in recently, has been DivX, so I’ve focused my coverage of the event to CFO John Tanner’s presentation to investors. Nonetheless, I’d encourage you to listen to some of the other presentations, if you happen to be interested in any of the companies that attended this years event.

During his presentation, Tanner gave a great rundown on the different moving pieces that make up DivX’s business model. He told investors that their codec has now been disseminated over 240 million times. On it’s own, this number is impressive, but it’s even more remarkable when you consider that when they first filed their S1 to go public, they referenced 180 million downloads. When they filed their first earnings report, they had hit the 200 million download mark and now approximately 6 months later, they are reporting 240 million downloads. While DivX doesn’t necessarily earn any revenue from disseminating their codec, they do have an opportunity to pick up some advertising revenue when people install their media player. Seeing this number continue to increase is also a very good indication that DivX has not only maintained their community over the last year, but has been increasing their relevance as well.

When planning for their future, DivX has had to make some assumptions in how they see the market for digital video unfolding. In a world where technology seems to change everyday, this can be a difficult task. To help investors better understand how DivX sees the digital video market unfolding, Tanner listed five different assumptions that DivX is making when analyzing the evolution of the digital video market.

1.) Open systems win – This is at the core of everything that DivX does. They don’t charge excessive mark ups for their technology, they don’t try to isolate partners by granting exclusivity, they want to be an open standard for the world and if you believe that people will embrace choice, then DivX is well position to benefit from this trend.

2.) Consumers get what they want despite artificial economic or market barriers – Given DivX’s history, this assumption makes a lot of sense, but it has also caused some trouble for them as well. Consumers have embraced the DivX standard over the bit torrent networks, in large part because Hollywood has refused to legally sell their movies in a digital format to consumers. If you try and take away this technology from consumers they will take it back whether content owners like it or not. While DivX does not support piracy, the fact that consumers have used their technology to gain access to digital films has created problems when it comes to licensing content from the Hollywood studios.

3.) Digital reshapes media – In the past it has taken serious financial backing to make and distribute a film. Because the distribution channels for film were largely controlled by the studio’s it’s made creating a film a very expensive process. Digitization is democratizing content and has shifted the power equation back to consumer and the independent producer. As this technology infiltrates it’s way into our lives, it will create change and DivX hopes to be there as the economics of the film business transform.

4.) Communities will end up driving the market – This is something that I’ve been recently thinking quite a bit about. Of all the mainstream media shows out there, I think that Stephen Colbert understands this better then anyone. Colbert will often drive his fans to places like YouTube or Wikipedia where they can communicate and interact. By doing so, he’s been able to extend his brand beyond his time slot on Comedy central and into other areas of the net. As television and movies increasingly begin to interact with the communites that consume their content, there will be opportunities for film makers to create a whole new dimension to how their customers experience their video.

5.) The entire market for digital video will be transformed – I don’t think that anyone would disagree that the digital revolution is changing how content is being produced and consumed. With so many players having their own unique vision for digital video, this seems to be the most obvious assumption. Even though this assumption doesn’t guarantee that DivX will be the end solution, this shift could be a catalyst for creating demand for DivX’s brand.

One of the things that I found interesting during Tanner’s presentation was that he gave some great commentary on DivX’s growth cycle and the sales process that they’ve adopted in the past. DivX’s development cycle typically starts by partnering with a single inexpensive chip manufacturer, so that their OEM partners aren’t turned off by a high cost to implementing DivX support into their products. They then try to expand these relationships with even more chip makers, in order to provide more flexibility to their CE partners.

“We design our technology to work on the very cheap silicon, but that takes a little more work to process, then it would by having a very expensive chip available to us, so we get into a first IC reference platform and then we get into multiple reference platforms to allow our OEM partners some choice in the chips that they use, both from a cost perspective and from a design perspective. Then we get into an early adopter OEM, who provides us with a first to market product. Once that product starts to establish it’s ability to take market share from the other OEMs, the first mass market OEM will adopt the technology and get into the market and then shortly thereafter multiple mass market OEMs will come in.”

While this is represents a typical product development cycle for DivX, it is worth noting that Tanner told investors that when it comes to their DivX connected product, they’ve been able to bypass the early adopter OEMs and that the demand for the product has been coming from their tier 1 CE partners. This is a good indication that DivX is gaining momentum with their most important partners and is something investors should watch.

Tanner also mentioned an interesting footnote while discussing DivX Connected, he told investors that DivX management hasn’t settled on DivX Connected as being the final name for their living room hub. I’m not sure what I would try and brand the product as, but I found it interesting that they are still considering alternatives for what they might name the product.

Another intriguing part of Tanner’s presentation was when he broke down the different ways that DivX is integrating content into their brand. While these revenues only represent 2 – 3% of what the company is earning right now, it’s importance in driving demand for their codec, as well as diversifying their future revenue streams, really can’t be understated. Currently, DivX is serving in multiple capacities when it comes to content.

On one level they serve as a wholesale broker for content. They do this by licensing films from studios and then distributing DVDs with multiple DivX films on them, to people who buy DivX certified machines. Tanner used their relationship with LG electronics as an example of how they are leveraging their OEM partners to help them sell content to the end consumer. They’ve been distributing content this way for about 6 months now and Tanner indicated that they have been earning 55 – 60% gross margins serving as a middleman. From the standpoint of the consumer, they get a bonus that highlights DivX’s functionality when they buy a certified machine and from the standpoint of the OEM, this program helps to reinforce the value created by including DivX in their products. While it’s still too early to tell how lucrative of a revenue stream this could end up being, it is worth noting that just this morning, DivX announced an extension of this program and will be licensing content from the CBC to include with DivX certified devices distributed by Samsung.

On another level, DivX is serving as an actual distributor of content using their Stage6 brand. Content owners can sell their content directly from Stage6 and DivX will split whatever profits they make, 50/50 with the creators. This strategy leverages the relationships that they have within their own community, but in my mind also has the most question marks when it comes to monetizing this potential revenue stream.

Finally, DivX is getting involved in the content game by licensing their technology to other video sites and letting partners be responsible for licensing and distribution of the content. It is these relationships that intrigue me the most and where I see Stage6 being the most attractive for the company.

While most of Tanner’s comments were pretty broad in nature, there were a few new juicy details leaked out at the conference. One of the more interesting questions that was raised was how DivX was pricing the licensing of their codec to the cell phone manufacturers.

Tanner hinted that because the market for cell phones was bigger then the market for DVD players, PVRs & Personal media players combined, that they would be open to pricing their technology even more aggressively, if they could make up the discounts on the volume. While the company hasn’t finalized what they intend to eventually charge the cellular industry, Tanner did say that currently, they are charging the cell phone OEMs their standard DVD player rates while they sort this out. This means that for each F500 movie phone that Samsung can sell, DivX should get $1 – $2 in licensing revenue, depending on the total number of units sold.

At the very end of the presentation, Tanner addressed concerns over DivX’s lock up expiration period ending. Beginning March 21st, investors who were contractually restricted from selling after their IPO, will now have the option of getting out. The closer this date has gotten, the bigger this issue has become for some investors. While I believe that insider selling would help to increase the liquidity for investors, by allowing more shares to trade in the open market, people have nonetheless been concerned about the potential for insider unloading once the lock up expires.

Tanner addressed these concerns by pointing out that when they first tried to take the company public, they had trouble getting their VC backers to actually sell.

“I can only report what their disposition was during the IPO. It was very difficult for me, as you know, to get enough shares from the secondary providers of shares during the offering, to make the offering as big as it was. I finally did get some cooperation on the part of some investors, whether or not their own particular circumstances for each of the VCs has changed since then, is known only to them, so even if they were to offer me up a prognostication of their behavior, I would have to take that with a grain of salt anyway, having dealt with VCs in the past. The best thing that I can say is that nobody has expressed a desire to do any share dumping to me and I’m confident that most of them still have a strong holding from the story.”

At $30 a share I could see why the end of the lock up could create some concern that insiders might bolt for the exits, but with the stock now trading under $20 a share, it’s hard for me to take this threat seriously. While no one knows for sure what DivX’s VC backers will do, if DivX had a tough time convincing them to let go of the shares at the IPO, then I’m not sure that I’d expect them to sell after DivX’s stock has sold off.

DivX continues to be one of the more exciting companies that is operating in the digital media space. While their business model is tough to understand, they’ve positioned themselves in an enviable position to have exposure to the growing digital market, but they’ve also been able to build a fairly secure competitive moat around their business by focusing on their community to help drive growth. While there is certainly a healthy degree of long term risk and short term volatility associated with investing in their business, if DivX can continue to perform at these levels, they should become the undeniable de facto standard for digital distribution for the 21st century.

Posted on March 14th, 2007 by Davis
Filed under: DivX, Movies, TV, Technology, VOD