Ahh, the DVD. Love it or hate it, it’s still one of the best ways to store data. I’ve yet to meet a hard drive that can survive for 5 years without failing, but as long you’re not using them for frisbees, the DVD can easily make it a decade or more without being damaged. There may be a question about whether or not we’ll have DVD players to play them with by then, but rest assured your data should be there.

Given my fondness for the scrappy little format, I thought it was interesting to see that TiVo was awarded a patent yesterday afternoon (Aug. 16th) for burning TV shows onto DVD. Just about anyone who has ever used a DVR has experienced hard drive related anxiety at one point or another. With the sheer amount of television out there, it’s easy to fall behind on your favorites and run out a space. Offloading programs to a DVD library is an excellent way to free up your hard drive without having to miss out on programming that you wanted to see. In the past, I’ve found this to be especially useful for archiving syndicated TV shows that aren’t always shown in their original order.

The abstract of the patent from TiVo’s application,

“According to an approach for storing digital content onto a DVD, digital content is received from a source, such as a DirecTV link, an over the air (OTA) broadcast, over a cable television link, or any other type of communications link, including the Internet. The digital content is formatted to comply with the MPEG standard to create MPEG digital content and stored on a non-volatile storage. Text-based information is received that describes one or more attributes of the received digital content. A set of DVD subpicture graphics is generated based upon the text-based information. The set of DVD subpicture graphics may represent a structure that can be navigated by a user when the DVD is played. The MPEG digital content is retrieved from the non-volatile storage, converted to DVD format and stored on the DVD with the DVD subpicture graphics. “

On the surface, the patent itself does seem a little bit obvious, but it’s also important to remember that it took the patent office almost 7 years to approve the application. Microsoft’s Media Center may have been using infringing on this technology for years, but I’m not sure that they had it in place prior to 2004. I think it’s also worth pointing out that even though TiVo now owns the patent on this technology, they don’t actually offer the service to their customers. Fortunately, the TiVo Community has managed to scrape together a way to do this on your own, but it would be nice to see a more elegant solution built directly into TiVo’s software.

Given it’s antique status, some may view this development as irrelevant, but because of the complex licensing issues that are tied to media, I believe that the DVD will have a much longer shelf life than most. When you consider how the studios are using artificial windows to try and dictate when you can and can’t watch certain things on Hulu and Netflix, it’s clear that if you don’t want to become a victim of disappearing windows, consumers will need the ability to archive content on their own.

Last week, Greg Meyer fired the first shot in a proxy war by submitting paperwork to have his name considered for a position on Blockbuster’s board of directors. To win, he’ll need to take on board of director incumbent, James Crystal. In the proxy filing, Meyer makes a strong case that he is the more qualified candidate for the position.

-In 2001 Meyer started a DVD kiosk business at a time when most thought the idea was crazy. Eventually, DVDXpress was sold to Coinstar and later merged with Redbox. Mr. Crystal on the other hand has spent his career running an insurance company and doesn’t have any DVD industry experience.

-Over the last year, Meyer has put his own money on the line by purchasing over 600,000 Blockbuster shares on the open market, Crystal on the other hand has less than $50,000 worth of Blockbuster’s stock and only because it was given to him for serving on the board of directors.

-While Crystal’s full time job is his insurance business, he also serves on 7 other boards for various insurance companies. Meyer’s only other board position is with a non-profit that uses movies to help reach young kids.

-Perhaps most damaging of all though, is the related transaction between Mr. Crystal and Blockbuster. Last October, Blockbuster made Frank Crystal & Company their exclusive insurance broker for the company. At the same time, Mr. Crystal, who sits on the compensation committee, was helping to award over $1.5 million in bonuses to Blockbuster executives in a year where Blockbuster lost over a half a billion dollars. Given that Blockbuster CEO James Keyes was awarded $400,000 of that bonus, perhaps it isn’t all that surprising to see him come out against Meyer’s nomination.

In a press release, Keyes rejected the idea of adding Meyer to the board and wrote,

“While we have an appreciation for Mr. Gregory Meyer’s investment and interest in the company, those are not sufficient reasons for his candidacy for the board. We are disappointed Mr. Meyer is pursuing a costly and disruptive proxy contest. A proxy contest can only serve as a distraction to the company when attention and resources would be better used in creating value for stakeholders by implementing our strategic plan. We assure all of our constituencies that we remain committed, as always, to doing what is right for our shareholders, debt holders, employees, and customers,”

Distraction or not, it’s understandable that Blockbuster’s shareholders would be disappointed in the current board of directors. Since bringing on Keyes, Blockbuster has seen their stock fall from $4.46 to $0.29 per share. During that time, they’ve seen Netflix and Redbox take market share from them, while they were concentrating on trying to figure out a way to save Circuit City from bankruptcy. Instead of focusing on offering an all you can eat streaming service, Blockbuster spent their operating income on redesigning their stores. Meanwhile, they’ve continued to lose the confidence of both the stock and bond market.

Given that there aren’t many people who’d be willing to run into a burning building in order to save a video store, I reached out to Mr. Meyers to help better understand what he hopes to accomplish with his proxy run. Below is a transcript from our interview.

Davis: I guess the biggest question on my mind is that with Blockbuster clearly hurting pretty bad right now, why you would even want to get involved with the company. You’ve already proven that you can build a DVD business from scratch, what is it about the challenge of turning the company around that appeals to you, instead of using your time and capital to create another new business?

Meyer: When our team was building the DVDXpress business early on, we spent years struggling to make customers aware of the fact that it was possible to rent DVDs from a kiosk and encouraging them to do so. Blockbuster was such a dominant force at the time that we felt like we were constantly swimming upstream against this 900lb gorilla.

Fast forward to today and the tables have turned so that many people say ‘Why would I ever go to Blockbuster?’ I think the pendulum has swung too far and believe there is an enormous amount of intrinsic value within Blockbuster that can be realized with proper guidance and forward-thinking strategic insight. Love ‘em or hate ‘em, everyone knows that Blockbuster means movies, and having such widespread brand awareness is extremely valuable.

Davis: Having served on the front lines of the bond market, what insights does this give you into how the banks and hedge funds might be thinking about Blockbuster’s debt right now? Specifically, what sorts of things do you think that they’d like to see in order to be amenable to restructuring overtures?

Meyer: The perception in the market is that Blockbuster’s subordinated notes will be equitized at the expense of shareholders. I believe there are some intelligent steps that management can take to avoid this outcome, which would obviously be advantageous for shareholders- and I have recently apprised them of one such structure. The Company and its legal and financial advisors need to be thinking about creative solutions to bring the company back to health and not take the easy way out by converting sub debt
to equity unnecessarily. My impression is that the Company and its advisors are looking at this as a zero sum game instead of trying to figure out how to creatively increase the size of the pie for all constituents, which I think is doable. That’s why I think it’s so important to have at least one shareholder advocate on the board.

Davis: You also mentioned in your filing that you’d like to pursue a solution that results in the lowest possible dilution, if any, of shareholders. Given the burden of having to service almost a billion dollars worth of debt, can Blockbuster be competitive in an industry whose competition is cutthroat right now? Can you share any thoughts on your rescue plan for Blockbuster and what it might take to save the company?

Meyer: Blockbuster has some incredibly valuable assets and competitive advantages. In addition to huge brand awareness, the Company has very strong relationships with the Hollywood studios. These studio relationships have become more apparent in the last few months with the Warner, Fox, and Sony supply deals providing Blockbuster with day-and-date availability of new release titles vs. the 28-day delay for other channels. This is a huge advantage relative to Netflix and kiosks competitors, and it’s one that Blockbuster has never had in the past. I think the company has done a reasonable job of communicating this advantage to customers with the recent release of ‘The Blindside’ and ‘Sherlock Holmes’.

For now, having closed many of its underperforming stores already and amid a significant reduction in overall brick-and-mortar industry capacity, Blockbuster’s physical stores represent a true asset if managed properly that can generate significant cash flow for years to come and act as a bridge to its various future distribution channels rather than an impediment.

Davis: Blockbuster released a press release urging shareholders to reject your advances, saying that they were disappointed that you were pursuing a “costly and disruptive proxy contest” at a time when their efforts should be focused on executing their existing turnaround plan. Do you feel that it’s appropriate for Blockbuster management to publicly respond this way and do you have any concerns that your actions could have any negative consequences by trying to shake up the status quo?

Meyer: The reality is that Blockbuster’s management is making the decision to perpetuate a proxy contest. I find it unconscionable that management would be willing to waste shareholders money to fight a full blown proxy contest to keep a qualified, industry relevant and highly motivated individual off the Board. If James W. Crystal is as valuable as James W. Keyes suggests then I would be happy to serve constructively with him on the board. This does not have to be mutually exclusive. Keep in mind the size of the board has shrunk from 9 to 7 over the past few months due to several departures, so having both of us as directors would actually return the board to a more normal size. But this is a decision that Jim Keyes and the Board has to make as it is out of my hands.

Davis: Beyond the finance side of the equation, is there anything that you feel Blockbuster should be doing to make their product more relevant to consumers?

Meyer: Yes, I think the value proposition to customers can be significantly improved. Look at the smart things that smaller brick-and-mortar video competitors like Family Video (rental) and MovieStop (retail) are doing. These companies have been growing rapidly over the past several years as they’ve figured out how to remain relevant with consumers despite growing competition from Netflix and the kiosk operators. These companies offer a variety of real services to their customers. As one small example, both of these chains offer a ‘Notification Service’ by which they will call or email their customers when a movie or game becomes available for rental or sale, either new or used. This builds goodwill and drives customer traffic. Sometimes a lot of small improvements at the margin add up to a much better experience.

And of course there are many innovative steps the company can take to serve customers digitally, some of which they’ve started to take with Blockbuster On Demand. The combination of near ubiquitous brand awareness and strong studio relationships has the potential to make Blockbuster a dominant player in digital delivery going forward, but this path needs to be navigated intelligently to ensure success.

Davis: Finally, Carl Ichan previously spent a lot of time and money trying to win board seats and concessions from Blockbuster management. While he ultimately won, his actions haven’t seemed to help the company all that much. Even if you were to win a seat, do you think that you’d have enough influence to create the kind of change that Blockbuster needs in order to save their business?

Meyer: All I can ask for is the opportunity to have my informed opinions heard at the board level and hope that the other directors would act in a rational and objective manner in the best interests of the shareholders.

Since I’m not a Blockbuster shareholder, my vote won’t count in this contest, but I am interested in what other shareholders think, so feel free to share your thoughts in the comments. Will you be voting for Meyer? For Crystal or do you plan to kick all the bums out? While fighting a proxy war can be a distraction and could potentially interfere with Blockbuster’s efforts to restructure their debt, it can also bring hope to a weary shareholder base at a time when things seem hopeless. I don’t think that Meyer can turn the company around single handedly, but as Johann Wolfgang Von Goethe once wrote, “in all things it’s better to hope than to despair.”

Update – In an open letter to shareholders, Meyer calls out James Keyes for perpetuating the proxy contest and reveals that he encouraged Blockbuster to adopt DVD kiosk technology over five years ago. At that time he also pointed out that Blockbuster could have saved $140 million per year by cutting their store hours by three hours per day.

Most notably, they’ve been trying to strike agreements with studios to delay when they offer new release DVD rentals to their customers. In exchange for lower prices, they’ve agreed to put all of the new movies by Warner Brothers on very long wait status for their customers. In exchange, they get lower prices that will help them to drive brick and mortar competitors out of business. So far most studios are only watching these experiments from the sidelines, but Warner Brothers has embraced this scheme with gusto and has followed up their agreement with Netflix by striking a similar deal with Redbox.

Ironically, Redbox actually dismissed an anti-trust claim against Warner Brothers, in exchange for being invited into this exclusive club. Now some will argue that the beauty of Netflix is their deep archived content and while 487 or the 488 movies in my queue currently show availability of now, they’re customers who do like to rent new releases. By making them wait, Netflix is creating an artificial rental window that allows Warner Brothers to charge higher prices for new release DVDs and causes the price for rentals to rise at rental firms like Blockbuster. In fact since striking these agreements, Blockbuster has raised prices on their DVD by mail program and reinstated late fees to their customers. This is a reversal of the price wars that consumers enjoyed over the last decade.

While Netflix and Redbox haven’t seen much in the way of customer defections from implementing this hostile policy, they may find their activities under closer scrutiny thanks to Susan Uman from Manhattan. In a lawsuit against Netflix, she argues that this latest rental window is nothing but anti-competitive collusion. Already, Netflix has been sued over a different arrangement with Walmart to carve up the sales and the rental markets, so it will be interesting to see how this one plays out.

According to USLegal.com, “collusion occurs when two persons or representatives of an entity or organization make an agreement to deceive or mislead another. Such agreements are usually secretive, and involve fraud or gaining an unfair advantage over a third party, competitors, consumers or others with whom they are negotiating. The collusion, therefore, makes the bargaining process inherently unfair. Collusion can involve price or wage fixing, kickbacks, or misrepresenting the independence of the relationship betweeen the colluding parties.”

While there is a fine line between collusion and standard industry business agreements, the deal that Netflix made cheats customers out of new releases and I think it crosses that line. They have in effect sold their first sale rights, in exchange for financial terms that give them an economic advantage over smaller competitors in their industry. According to this primer by the Justice Department, collusion tends to occur when we see some of the following conditions.

“-Collusion is more likely to occur if there are few sellers. The fewer the number of sellers, the easier it is for them to get together and agree on prices, bids, customers, or territories. Collusion may also occur when the number of firms is fairly large, but there is a small group of major sellers and the rest are “fringe” sellers who control only a small fraction of the market.

-Bidders who congregate in the same building or town to submit their bids have an easy opportunity for last-minute communications.”

Looking over this list, it would appear that Netflix is very much in a position to abuse their market leadership status. With Movie Gallery in bankruptcy for the 2nd time and Blockbuster getting close to a date with the grim reaper themselves, Netflix and Redbox represent the future of the DVD rental industry. This limited competition has made it easy for them to enter into agreements that wouldn’t have been tolerated by customers five years ago. If Blockbuster had the finances to actually keep new releases in stock, one might argue otherwise, but their company is in survival mode and are now having to pay Warner Brothers more for each new release then their two biggest threats.

While Netflix and Redbox may not have their headquarters located in the same town, both have been aggressively courting Hollywood for access to their movies. Since the studios are largely controlled by a small handful of companies, it gives them the ability to collude with the limited DVD renters that are left.

Prior to their agreement with Warner Brothers, Redbox was on the outside of this club and was being forced to acquire their DVDs from outlets like Walmart because Warner Brothers refused to even do business with them. Now that they’ve stopped sticking up for the consumer, they have access to all the DVDs that they want to buy. If this doesn’t qualify as collusion, I’m not sure what does.

It’s hard to say how much legal merit this lawsuit will have, but from my viewpoint, I believe that Netflix, Redbox and Warner Brothers have created an illegal cartel to try and carve up the DVD market. Warner Brother’s gets to force consumers to buy new release DVDs, instead of being able to rent at lower prices and the rental companies get cheaper supply which helps to boost their profits. While I’m sad that Redbox gave up on fighting for consumers, I am glad that consumers aren’t afraid to fight back. Hopefully, Ms. Uman takes this case all the way, instead of settling at the last minute for a million dollar windfall.

With consumers clearly wanting to access content online, one would think that HBO would be the first in line to embrace this trend, but because of their status quo, they’ve chosen to fight progress instead of helping to usher in the digital age.

Over the last two years, a group of digital and traditional media companies have formed an impressive collective known as the Digital Entertainment Content Ecosystem (DECE). This diverse group of firms includes firms ranging in diversity from Sony to DivX. While each company has their own agenda, the goal of the group is to try and create a media framework that allows consumers to purchase downloadable media and to play it on a wide range of consumer electronic devices.

While I do think that there are some problems with their proposed implementation, I’m also pragmatic enough to see this consortium as our best chance of furthering the internet video revolution. To date, media companies have fought digitization tooth and nail, but this co-op between Hollywood and the Silicon Valley could create an environment where more new release content is made available to the public.

Anyone whose used Netflix’s Watch Instantly program knows that there is a ton of content from the 1980′s, but very few titles from the last decade. One of the biggest reasons for this, is that companies like HBO have used their vast financial resources to outbid them and other digital players for these films. With studios scared to death of upsetting deep pocket partners like HBO, it’s created an environment where consumers must either pirate recent content, set an appointment to see TV or stick to watching it on a disc.

While, HBO has made some of their content available through Comcast’s TV anywhere initiative, it’s only includes their weakest titles and you must be a cable subscriber to get access to the content. Contrast this to Showtime’s digital experiments and it’s clear that HBO is standing in the way of progress.

Like Netflix’s Watch Instantly platform, DECE has proposed a system where consumers can store their media content in the cloud and then stream it whenever (and more importantly wherever) they want to view the film. Yet, according to the industry trade publication, The Wrap (via Inside Redbox), HBO isn’t a fan of this system and is actively trying to block it’s implementation. Since they insist on legal language in their contracts that prevent consumers from accessing digital content while it’s playing on their channel, it’s possible that you could purchase a film and then be blocked from seeing it while it’s playing on HBO.

Imagine paying a steep premium to see a recently released film and then being told that you can’t watch it on certain dates, just because HBO is afraid that you might not subscribe to their channel. Clearly, this isn’t in the interests of consumers and yet HBO is using their financial resources to try and create this very scenario.

“Paying hundreds of millions of dollars a year for output deals with Warner, Fox and Universal, HBO currently restricts these studios from distributing their films digitally during its exclusive pay-TV window. Typically, that window starts six months after a film debuts on DVD and extends for 18 months. It already has presented itself as a challenge for established download sellers including iTunes and Netflix.”

HBO is free to run their business anyway that they like, but I believe that policies that are downright hostile to consumers should not go unpunished. Because of this, I’m asking HBO subscribers to call your cable company and cancel the channel. I know that this may mean giving up some great content, but if HBO starts to feel the sting from a consumer backlash, perhaps they’ll rethink their position and start to embrace the digital revolution. Currently, only 3% of the entertainment industry’s revenue come from online, but if just 3% of HBO’s subscribers were to cancel service, it would have a profound effect on the company’s profitability.

For too long, consumers have been abused by these exclusivity agreements and if you sit back and allow them to walk all over you, then you’re only part of the problem. Instead of rewarding an outdated analog business model, we need to be demanding that studios and their partners join the 21st century and make their content available online.

Ten years ago, Blockbuster video was on top of the world. They didn’t know it at the time, but it was the golden age for the video store. After years of reminders to be kind and rewind, consumers were adopting DVD players en masse and needed a source for their entertainment needs. For better or worse that source was Blockbuster.

With the internet buzz hitting a fevered pitch, Blockbuster was already hard at work creating a digital strategy. Given their dominate position in the video store industry, they even flirted with the idea of buying a small internet start up named Netflix for a mere $50 million.

With the entertainment world seemingly in the palm of their hand, Blockbuster was positioned to make the jump to digital better than anyone, but over the last decade they’ve made a series of blunders that now threatens to bankrupt them today.

Yet, in looking at their rise and fall, it’s easy to make the quick assumption that their problems were a result of technological innovation, but the truth of the matter is that they have no one but themselves to blame for the weak position that they find themselves in today.

Of all their missteps, the biggest blunder was assuming $1 billion in debt, so that Viacom could collect an obscene dividend payment when they sold the company to a naive public. That debt now hangs over them like an albatross across their their neck and has caused them to lose pace with their unencumbered competitors.

With revenues in steep decline, it will only get harder and harder for Blockbuster to continue to meet their obligations under this debt. Without the firepower to compete on a level playing field, their situation will only get worse

With the precariousness of their position becoming increasingly clear, Blockbuster has done everything from paying a high price to refinance their debt to hiring a bankruptcy specialist to help salvage what is left of their business.

Yet, despite the clear and present danger of their situation, Blockbuster has continued to keep their head buried in the sand. Over the years, I’ve offered my fair share of suggestions criticism for how they could improve their business model, but we’re now at a point where a tourniquet won’t save them, they must do massive surgery and Stat!

In an effort to try and preserve a dying part of the entertainment industry, I present to you, my plan to save Blockbuster.

With the future looking pretty bleak for just about any video store, how can a company like Blockbuster save themselves? By sacrificing their media business in exchange for an opportunity to reinvent their retail business.

What I’m proposing would be tricky and the devil really would be in the details, but with the right execution, Blockbuster could shed their legacy of debt, future proof their business and position themselves to take market share, instead of losing it.

Essentially what they’d need to do is create a “good Blockbuster” and a “bad Blockbuster” to isolate their problems.

On one side you would have their DVD by mail program, their DVD kiosks and their digital business. On the other side, you would have Blockbuster’s traditional video store business that so many are quick to write off.

Together, the two businesses are slowly strangling Blockbuster, but split apart, they could free them from the impact of years of stagnation and ineptitude on their part. What I’m proposing is that they spin off their good assets and use that money to pay off their debt.

In the past, Blockbuster tried to launch an aggressive initiative to boost their DVD by mail program, but by doing so, they only ended up cannibalizing their in store customers. As a result, they’ve all but abandoned the program and have allowed their future to slip away.

If an independent Blockbuster.com doesn’t have to worry about that cannibalization, they could focus on going head to head against Netflix. They could create a subscription program for their kiosks that could offer value that Redbox couldn’t match. They could be price competitive without having to worry about their legacy stores. The result would be a smaller Blockbuster with less meaningful revenue, but it would represent profitable revenue instead of losses.

Neither Netflix nor Redbox would be able to offer DVD exchanges at the kiosk level and through the mail, but Blockbuster could capitalize on both strengths. Yes, the company would be a mere sapling in the larger entertainment industry, but Netflix was once a sapling and they’ve been able to grow into a very large oak.

From the video store side of the equation, Blockbuster could focus on what they do best, maximize cash flow while transitioning their stores into a new business. Whether that means turning their stores into modern day Starbucks or a replacement for the now defunct Circuit City, there are still plenty of opportunities for smart and nimble retailers.

To date, Blockbuster CEO Jim Keyes has made this transition a priority for the company, but when they are forced to forgo tens of millions in capital expenditures, just so that they can service their debt, it limits how quickly they can make this jump. As a result, they continue to face pressure to close stores instead of turning them into cash flow producing machines.

Given all of the negative media attention, it may be hard to believe, but Blockbuster still does a ton of business. For the first 9 months of 2009, Blockbuster brought in over $1.9 BILLION in revenue. By comparison, Netflix brought in $1.22 billion during the same period. Yet, when you look at the differences in market capitalization, Netflix is over 20 times more valuable than Blockbuster.

Perhaps even more surprising is that Blockbuster would have turned a profit of $38.4 million during that 9 month period, had they been able to ignore their debt. Instead, that $38.4 million profit turned into a loss of $131.6 million for the company. Now you don’t need to have a Phd in math to know that losing over $100+ million per year starts to get expensive fast and perhaps even more damaging than the loss of the cash is the effect that these interest payments are having on their competitive ability.

Instead of being able to invest in their future, they’ve been forced to make cut backs. Instead of retrofitting their stores, they’ve been closing them instead. Instead of stepping up the marketing, they’ve been forced to dial back. The result is that more revenue shifts to Redbox and Netflix and their cost to acquire customers has plummeted. If this trend continues, you don’t need Dr. Doom to tell you that it will be curtains for Blockbuster. They must stop the bleeding and they must stop it now.

Now I know what you are thinking, if Blockbuster is a penny stock today, how are they going to come up with $1.6 billion to pay off their long and short term debt. Part of it comes from the assets that they are holding today. With $980 million in current assets, they should be able to keep a good chunk of their leverage in check. The remaining $620 million worth of debt would be paid off by spinning off their new media divisions.

According to the most recent data, Blockbuster currently has 1.6 million online subscribers. As of last September, they had deployed 1,000 kiosks, but were anticipating that they would have over 10,000 deployed by the end of 2010. While Blockbuster doesn’t break down their digital revenues, I think that it’s reasonable to suggest that this division would be worth anywhere between $25 – $75 million based on their market position and intellectual assets.

If you look at Netflix’s current valuation, it works out to be approximately $255 per subscriber. Assuming that you discount Blockbuster subscribers by 30%, it would value Blockbuster’s DVD by mail business at $285 million.

In February of 09′ Coinstar completed their purchase of Redbox at a valuation of approximately $350 million. At the time, Redbox had 12,500 kiosks suggesting a value of approximately $28,000 per kiosk. Assuming that Blockbuster can get to 10,000 kiosks, even at a 50% discount to what Coinstar paid at the bottom of the market, one could assume that this stake would be worth approximately $140 million without Blockbuster’s legacy stores or debt.

What these numbers suggest is that if Blockbuster were to do a spinoff, it’s easily conceivable that they could raise at least $500 million in the offering. Assuming that they start to market their DVD by mail and get it up to 2.5 million subscribers, it would value their new media business at approximately $660 million.

If they did the spin off in the form of a convertible bond, I believe that this number goes even higher, because bond investors could be given the option to return to their current position, if the spin off flopped.

While this sort of transaction would create a new competitor for Blockbuster Video, by getting rid of their debt, it would enable their stores to become profitable once again, which in turn would make it easier for Mr. Keyes to raise money for the marketing and store improvements that Blockbuster so desperately needs.

While I believe that this rescue plan could make Blockbuster competitive again, I don’t believe that their current management is willing to sell off their future, even if it means saving themselves. Despite all evidence of a dying industry, Keyes continues to insist that the video store is the cornerstone of what they do and has consistently defined Blockbuster’s competitive advantage as being able to offer entertainment across multiple channels. While it’s easy to point to Netflix and Redbox as the source of Blockbuster’s kryptonite, I believe that it is their own unwillingness to let go of the past that is preventing them from being a video superhero of the future. Only time will tell how indestructible they really are, but if they continue down the same path, they’ll end up as a mere footnote in the history of the entertainment industry.

Recently, Paramount announced that they were going to be distributing content on USB sticks. At the time, they didn’t say what format it would be in and even on DivX’s conference call there was no mention of this realization of their strategic vision, but Electric Pig is reporting that the Paramount movies will in fact be encoded in DivX.

With only 20,000 memory sticks for sale and at a price of approximately $33 US, Paramount is still clearly in the testing phase, but the fact that they choose DivX demonstrates the clear advantage that DivX has over all of their other digital competitors. They have the only real solution for brick and mortar retailers.

If Paramount tried to do this with a proprietary solution, it wouldn’t work because it wouldn’t give them a way to get that movie to the television. They could try to do it with Apple, but Apple doesn’t have the same reach to the TV, especially in Europe where this is being launched.

To date, most of my thoughts on DivX’s courtship of Hollywood have centered on the futility of trying to win enough support, so that online retailers could adopt their technology for digital distribution. If you can’t get a Disney or UMG to license DivX’s format, it makes it tough for someone like Netflix or Blockbuster to use their codec even with the other 80% of the content owners on board.

The beauty of the USB distribution strategy is that they won’t need 100% industry support in order to move their plans forward. Shelf space is limited as is, all they need is for a single studio to want to take advantage of this and there will be more than enough titles to tempt you with while you are waiting in line at the cash register.

Now I know what many of you are thinking, movies on USB are pretty lame. When Paramount made their announcement, there were more than a few commenters who zinged them for being out of touch with current trends. While there’s no doubt that the world will go digital, I also realize that the major studios aren’t going to abandon the retail partners that deliver the majority of their profits each and every year. It may end up becoming super easy to buy movies straight from your home, but if you have millions of consumers visiting a store each day, you can bet that the studios will want to reach those customers where they are hanging out. The shelf space is too valuable to be abandoned.

DivX on USB also opens up new business models for the studios. Instead of selling three DVDs, they could package all the Godfather films on one stick to justify a higher price tag or they could offer an entire season of television on an 8GB stick instead. If a retailer can sell something for twice the price, they will take smaller margins from the studios for the larger transaction. With the studios under pressure to develop new revenue streams, this will be too tempting for them not to exploit.

There’s no doubt that DVD is moving to Blu-Ray, but DivX memory sticks allow their Hollywood partners to reach consumers who may not have upgraded to high def just yet. With the industry in a state of flux, being able to sell a device that can be read by any computer and over 200 million devices gives DivX broad reach when it comes to the world of disconnected playback.

Paramount may be approaching this market cautiously, but I think people have greatly underestimated the size and the impact that USB films will have. It may not be cutting edge technology, but there are too many powerful companies who need it to succeed for it to fail. At the birth of this industry, it’s encouraging to see Paramount actively supporting their partnership with DivX, instead of just taking a licensing payment and then ignoring what their technology can offer.

USB movies won’t necessarily solve DivX problems with their shifting business model, but it does underscore the significance of the platform that DivX has built. As much as DivX is threatened by the obsolescence of the DVD, they can also benefit from the format shift. So far, they haven’t done a very good job of managing this transition, but this deal proves that even an old dog can learn new tricks. If retailers start asking for DivX as a weapon against Blockbuster and Netflix, other studios might also understand the benefits of using open and popular technology to make more money.

Just in case you think Blockbuster’s problems are isolated to a declining video store industry, I’d encourage you to take a closer look at their latest 10-Q filing. Despite there being clear growth in the DVD by mail category, Blockbuster is hemorrhaging subscribers. In fact, the percentage of people giving up on their by mail service is almost as high as the percentage of people giving up on their video stores. According to their 10-Q,

“Rental revenues decreased mainly as a result of: a $76.3 million decrease in by-mail revenues driven by a 30% average decline in by-mail subscribers, which was more than offset by related cost reductions described below under “Domestic—Gross profit;”

At one point in early 2007, Blockbuster had the pedal on the metal and was boasting of having close to 3 million subscribers. Since then, they’ve been understandably quiet, but I had no idea things were this bad until I read their most recent filing.

After piecing through other filings, I was able to come up with an estimate of 1 – 1.25 million current subs.

Here’s the math for those playing at home.

At the end of 2006, Blockbuster had 2.2 million subscribers and had brought in approximately $250 million in revenue. By the end of 07′, they were flirting with 3 million subs and had $525 million in DVD-by-mail revenue.

From a historical standpoint, this tells us that Blockbuster’s subscribers tend to average between $9.49 – $14.60 per month, but these figures are a bit skewed by their total access efforts. Since most of their subscriber gains were added at the end of 06′ and the beginning of 07′, it pushes both numbers to an extreme. Their actual monthly average is probably closer to somewhere in the middle.

By comparison, Netflix subscribers were averaging $12.84 per month as of their most recent quarter.

The information that Blockbuster discloses doesn’t allow us to get at an exact figure, but if we also dig through past filings, there is more than enough info to extrapolate a reasonable estimate for their current number of subs.

In December of 2006, they had just passed 2.2 million subscribers. Two months later, they were predicting that they’d be at 3 million subscribers by March 07′

A year later the first sign of trouble shows up when they disclosed that they saw “significant” subscriber losses after pulling total access in 07′. If we assume that 20% of their subscribers left after they cancelled the free in-store exchanges, it would bring you to an estimate of 2.4 million subscribers for midway through 07′.

By Oct 08′, Blockbuster admits that their by mail revenues decreased another 21.5%, so if you subtract another 500,000 subs you get a total of 1.9 million from 9 months ago.

Since we know that they’ve lost 30% of their subscribers over the last 12 months, it gives us an estimate of 1.3 million subscribers today. With some of these number being moving targets, I wanted to check to my math to see how reasonable this guess was and I actually think it’s a tad high. If you take a look at their most recent by-mail revenue number, it suggests that the total is slightly lower.

Since Blockbuster has plans that range from $9 – $17 per month, it gives us a range to consider. If a decline of $76 million represents 30%, it would suggest that they are currently earning $14.8 million per month from by mail subscribers.

If we assume that 100% of them were $9 per months subs, it would mean that the maximum number of subscribers that they could have at this point would be 1.64 million and if 100% of the subscribers were paying $17 per month, it would peg the minimum size of their subscriber base at 870,000.

Since $12 – $14 is a more reasonable estimate for what the average Blockbuster by mail subscriber pays each month, it gives us a ball park range of 1 – 1.25 million current subscribers.

I wasn’t surprised to see a drop in subscribers right after Blockbuster abandoned their total access plans, but to see them drop below TA levels has to be concerning for Blockbuster Execs. This is the one part of the company that should be firing on all cylinders, but clearly Netflix’s Watch Now service has been poaching their members.

Blockbuster may have put up a good fight in the DVD wars, but with nearly 10 times the number subscribers, Netflix is now threatening to do to them, what they did to Wal-mart’s DVD by mail program.

The smaller membership gets, the harder and harder it will become for Blockbuster to run their by-mail program at a profit. They could always raise prices, but that would only lead to additional defections. With Blockbuster on the ropes, don’t be surprised to see Netflix maintain the price war for another 12 months while they wait for Blockbuster’s bond owners to take control of the company.

In the meantime, this data only highlights the fact that Blockbuster’s problems aren’t because of a lack of opportunities, it’s an issue with their execution.

Over the last few years, Redbox has been able to build an impressive DVD rental network by being innovative and flexible while their competitors were still laughing at the concept of kiosk rentals. Over time they’ve added features to the Redbox website that allow customers to browse and reserve titles online. They’ve linked their kiosks together so that unlike competitors (ahem: Blockbuster), you can actually rent a movie from one location and return it at another. Redbox’s core business may ultimately be, plain old boring DVD rentals, but there’s no denying that they’ve been an innovator in their industry. This is why I am so perplexed by their most recent decision to go hostile against iPhone owners.

Given the company’s reputation for thinking progressively, I was disappointed to learn that they’ve decided to take a technological step backwards by putting pressure on the Inside Redbox blog, to kill their Inside Redbox iPhone application.

I haven’t jumped on the iPhone bandwagon myself yet, but I can understand why some people think of their phones as an extra appendage. The apps store was a brilliant move by Apple and has created all kinds of interesting software programs that wouldn’t have existed if people had to rely on big companies to build them.

By taking advantage of the GPS features inside the phone, Inside Redbox was able to give iPhone customers the ability to look up which Redbox was closest to them at any given moment. It also allowed customers to find out whether a specific title was available before wasting time visiting the kiosk in person.

The best part about the application though, was it’s ability to reserve movies directly from the iPhone. This means that if you’re standing in line at a Redbox and the person ahead of you is taking too much time selecting a movie, you could theoretically use your iPhone to digitally cut in line and reserve the last copy of Harold and Kumar instead of having to wait impatiently.

When you consider that one of the biggest customer service complaints about Redbox are the long lines when customers try to return DVDs, it blows my mind that Redbox would discourage consumers from using their own mobile device by having them monopolize a kiosk instead.

Whether a customer prefers to order their movies from the internet, a kiosk or the middle of the store while shopping for groceries shouldn’t make a difference to Redbox. No matter what, they are still making a sale, even if they don’t have 100% control over the purchase.

Inside Redbox is mum on details and calls to Redbox’s PR agency didn’t shed any light on the situation, but the two most “controversial” features included in the app is a list of codes for free Redbox movies and the fact that the app relies on Redbox’s website for most of the content.

One theory for why Redbox doesn’t seem to care about iPhone customers is that while they’ve been able to get a lot of buzz using their free movie offers online, consumers haven’t been all that aggressive about redeeming the promotions. Since iPhone customers have access to the most recent free offers while they are actually standing in front of the Redbox kiosk, it makes it easier for customers to take advantage of their specials.

If this is the reason why Redbox killed the application, my response would be that Redbox hasn’t solved their problem, they’ve just made it more difficult to work out a reasonable compromise with their customers. It won’t take consumers very long to figure out that they can bookmark Inside Redbox’s list of free codes or RedboxCodes.com on their iPhones and still have access to the same information.

Rather then fighting progress, Redbox should be using the relationships formed through the application to streamline their movie promotions. They already restrict some of their offers to new customers only, so why can’t they work out a deal for iPhone promotions? Wouldn’t it be better for Inside Redbox iPhone users to have a 10% chance at “winning” a free movie instead of killing the app and forcing these customers underground? By trying to lower the wham hammer on this neat little application, they’ll only end up upsetting customers instead of addressing a weakness in how they’ve choosen to promote their service. Just because the iPhone app doesn’t fit into their mold of what marketing should be, doesn’t mean that killing it is the best solution.

A second theory for why Redbox may have requested that the app be pulled is that Inside Redbox uses Redbox.com’s website for a healthy chunk of their content. Some businesses may object to this and want to have 100% control over how their customers are “allowed” to use their product, but smart companies see the benefits of being open. In fact open API’s are becoming increasingly common in the tech industry. By allowing third parties to mashup and repurpose your data, entirely new creations are possible. This is why some of the most successful companies have business models that encourage outsiders to partner with them. The Inside Redbox app may repackage content from Redbox’s website, but when push comes to shove, it’s really no different than an internet browser. Is it really better for Redbox to force their customers to have a subpar experience using the Redbox.com website on the iPhone instead of an app that is specifically designed to be viewed on the small screen? I don’t think so.

Asking Inside Redbox to pull their program is a bit like asking Microsoft to not allow Redbox’s website to be shown on Internet Explorer. If Redbox really objects to how their content is being used, they have the power to change it. Instead of trying to kill the third party programs that tap into what they’ve already created, they should be encouraging their fans to mix, mash and experiment to create new experiences for their customers.

To date, Redbox has managed to stay ahead of the competition by being nimble and by nurturing a passionate and dedicated fan base. Their decision to now turn on the very fans who cared about them long before their mainstream momentum, says a lot about how fickle their business decisions really are. Instead of acting like the innovator that I know they are, they are acting like a big media company. Hopefully, Redbox comes to their senses and “authorizes” the use of an app that only makes their service more valuable to their customers.

The last couple of years may have felt like a bad dream to most investors, but for DivX shareholders it’s been nothing short of a nightmare. They don’t hand out Oscars for businesses, but if they did DivX would have won hands down for best horror flick.

When the company first went public, expectations were high. YouTube had just been sold for $1.6 billion, DivX was demonstrating 75% gains in their high margin core licensing business, and their unique business model looked like it offered a very strong moat from competitors like Apple and Microsoft.

At one point DivX’s market cap exceeded $750 million, today it barely closed above $150 million. Over $600 million dollars in capitalization wiped out by one misstep after another. Admitedly, the tough economic environment can be partially blamed for DivX collapse, but the sad truth is that much of the value destruction could have been avoided.

Suicide Kings

Shortly after DivX went public, Jeran Wittenstein wrote “DivX was founded just before the dotcom bust in February 2000 after Greenhall managed to convince Jerome Rota — a French software engineer who created DivX’s founding technology — to join him in building a company. Including Greenhall and Rota, eventually there would be five co-founders, all of whom are younger than Greenhall and still with the company.” (Note: bold print added by me)

They may have been able to survive the dot com collapse, but DivX’s founders weren’t able to survive the success of going public. In December 2007, Jordan Greenhall, Darius Thompson, & Tay Nguyen all left the company after DivX’s board of Directors made the inexplicable decision to cancel their spin off of Stage6. Joe Bezdek officially left the company 10 months later and now I hear that Jerome Rota, DivX’s original creator, resigned from the company on February 6th of this year.

While Rota remains on the DivX board of Directors, the loss of his day to day influence can’t be understated. I only had the opportunity to meet him once, but was impressed by his remarkable vision. These five individuals may not have had the spit and polish that Wall St. expects from traditional executives, but they weren’t afraid to take risks and knew how to motivate the troops beneath them. The impact from the loss of these employees goes well beyond their individual contributions and investors have already seen shockwaves from these loses ripple through DivX’s employee base.

Two and a half years later, investors have voted with their feet, all five of the founders have now left the company, cracks are beginning to form in their moat and their franchise is very much in danger. The company has gone from being an innovative risk taker to a zombie of her former self. DivX now stands at a crucial crossroad. Are they willing to risk potential annihilation to save consumers from their zombie masters or do investors have Dawn of the DivX in store for a sequel?

“Affliction comes to us all, not to make us sad, but sober; not to make us sorry, but to make us wise; not to make us despondent, but by its darkness to refresh us as the night refreshes the day; not to impoverish, but to enrich us.” – Henry Ward Beecher

There are many instances where management has stumbled, but the end result all comes down to a loss of confidence. They’ve lost the confidence of their shareholders, the analysts, their employees and most importantly, the consumers who drive demand for their products.

Without a dramatic turnaround, I fear that this lack of confidence will spread to their manufacturing partners and we’ll see DivX lose their digital video franchise. While there is still plenty of cash flow left to milk from the DVD market, without aggressively expanding their market position, DivX’s influence will be over before they have a chance to finish the revolution they started.

Barbarians at the gate

When DivX went public, investors were willing to pay a premium to get exposure to the stock. At one point investors were paying more then 10 times sales, a P/E over 30 and over five times DivX’s book value. Based on the midpoint of DivX’s 2008 guidance, DivX is now valued at 1.15 times book, 1.66 times sales and a p/e ratio of 9.5. When you consider that DivX is holding $120 million in cash and short term investments, investors are pricing them more like a blank check IPO, then a strong growing company. You can argue that this is a result of the poor financial markets, but I think it speaks volumes about the lack of confidence that shareholders seem to have in management.

DivX’s response to their problems has been to try and slash and burn their way out of it. When they closed Stage6, they also layed off approximately, 10% of their staff. After Yahoo! backed out of their toolbar arrangement, DivX fired another 10% of their staff. If DivX was struggling to get by, I could accept these types of sacrifices, but the reality is that these cuts are only designed to boost earnings for the company.

I believe that DivX’s management is under the impression, that if they can increase earnings enough, investors will reward them by returning to their stock. The problem with this strategy is that it may be easy for DivX to position themselves to feed off of years of hard work, but without continuing to invest in the business, they have little chance of realizing meaningful growth. When DivX presents their 2008 earnings in early March, I believe that their focus will be on strong earnings results. This may look impressive from a distance, but don’t be distracted unless it’s accompanied by strong revenue growth. Earnings are certainly nice for investors, but if DivX has stopped growing, then investors won’t pay a very high multiple.

When DivX presented at the Thomas Weisel technology conference earlier this month, they used the following graph to illustrate their past growth. On the surface, it’s hard to criticize the progress they’ve made.

While there’s no doubt that DivX has accomplished a lot in a very short time, where they are going is more important then where they’ve been. Sadly, over the last year they’ve seen their progress come to a screeching halt. Another way to illustrate, the same information that DivX used in their Thomas Weisel presentation, is to graph the percentage that revenue has grown each year. Even if we exclude things like the Yahoo! toolbar fiasco, the trend for DivX’s core business doesn’t offer a lot to get excited by.

In 2003, DivX grew their core licensing business over 700%, in 04′ they saw 184% growth, in 05′ they saw 84% gains, in 06′ they almost experienced a 76% increase in growth. In 07′ signs of danger started to appear, but they still realized 40% growth from their core business. If we use the midpoint of their guidance for 08′ revenue, DivX should see a 13% increase in core revenue for 08′.

As DivX’s business has grown, there is an expectation that the law of large numbers will start to kick in, but if current trends continue, it would appear that DivX’s core licensing revenue will hit near term maturation sometime this year.

Jordan Greenhall said that 2007 would be a building year for DivX, Kevin Hell said the same thing about 08′. With the company in self destruct mode, how optimistic should investors be for 2009?

Trouble In Never Never Land

Some investors may cheer the savings in earnings, but make no mistake, it has had a tremendous cost. The coup to get rid of Greenhall, the divisive nature of current management and the layoffs have all had a tremendous impact on employee morale. DivX may claim that their employee relations are normal in their SEC filings, but there is too much evidence to suggest that DivX now suffers from Yahooitis! These creative individuals are the soul of the company. If DivX continues in their zombie state, more and more employees will leave, feelings will become even more bitter and the company’s progress will be stalled.

If you want to see proof of how bad employee relations have become, take a look at DivX’s reviews on Glassdoor.com. Kevin Hell’s current approval rating is 15%. That’s worse then GW’s numbers, when he left office. To put this into perspective, Hell’s ranking gives him the dubious distinction of being the 18th worst CEO of the 7,185 companies that Glassdoor is tracking.

If you read the comments on the site, it’s very revealing about what’s going on behind the glass curtain.

“It’s party time…if you are a VP or above…”
Pros
It’s a fun atmosphere and very social if you are of the right mindset. Lot’s of cool people and talent…
Cons
Watch your back…I didn’t trust any of the management at all after seeing my boss’ team cut without her knowing beforehand. Very closed, “open environment”… If you are looking to complete a project to add to your portfolio…think again…my projects changed scope every 3 weeks. The strategic direction changes everytime the wind blows.
Advice to Senior Management
Hire new management that cares more about the company’s success than their cushy compensation packages… Layoffs in 2008 were taking place while senior management was cashing in on millions of $$ in stock…even at very low strike prices….Something very fishy is happening here…”

or this one from a current employee who goes by the name anonymous

Anonymous in San Diego, CA: (Current Employee)
“Great company, TERRIBLE management.”
Pros
You get a chance to work with a lot of cool, talented people.
Cons
All the cool, talented people are getting laid off/fired/quitting.
Advice to Senior Management
DivX had so much energy and drive but the management seems to have succeeded in beating that out of the company almost completely.

Here’s one that calls out DivX CFO Dan Halvorson

Developer in San Diego, CA: (Past Employee – 2008)
“DivX was a fun place to work…. at one time”
Pros
DivX has a wonderful group of bright engineers. The camaraderie in my team was superb and we made the best of the otherwise dismal situation. The HR department is better than most in that they truly seem to care about the needs of the employees. There is an opportunity to do something big, and that can be exciting as well.
Cons
I’m not sure where to start! The CFO Dan Halvorson has a reputation for layoffs and cash-outs. He was rumored to have said, “I love it when people quit”. It’s gotten to the point where Halvorson avoids the office and never sticks around at company events. I suppose he knows he isn’t welcome. The constant layoffs and lack of openness to employees gives people an sense of uneasiness and all you can really do is speculate what they’re upto. At least with Jordan, he would be straight with you. The Hell regime seems pretty secretive and sometimes dishonest most times. The Stage 6 debacle was a train wreck. So much of the company’s resources were thrown at this pig and look what came of it? Nothing. A number of long time employees left around this time? Coincidence? Maybe, but not likely. I am guessing the founders got tired of the games and politics.
Advice to Senior Management
Get rid of Halvorson, he is dragging morale down all on his own. No one likes him or wants him there. Be more honest and forthcoming with employees.

The most accurate of them all though, is the bittersweet summary of DivX’s short history.

Anonymous in San Diego, CA: (Past Employee – 2007)
“Good While It Lasted”
Pros
The culture, when it first started was remarkable. There was a great vibe in the office and you constantly felt that you were being challenged and motivated.
Cons
After they went public, and Stage 6 launched, there was a massive series of mistakes that killed morale.
Advice to Senior Management
Listen to your employees.

It may be tempting to write off comments like these as disgruntled employees, but there’s obviously friction between labor and management. Shareholders may not want to acknowledge it, but they would be foolish to ignore it.

If DivX’s reign of Hell is allowed to continue, labor problems will only get worse. Lower payroll may be good for the bottom line, but it does nothing to boost their revenue, long term potential or the health of the underlying business. Going into zombie mode may be the safest way for management to keep their jobs, but zombies move slow and now is the time for action, not caution.

DivX’s digital eco-system is shifting like quicksand beneath them

Like the DVD, DivX’s codec is being made obsolete by high definition. To DivX’s credit, they saw this trend earlier than most and had the foresight to buy MainConcept to help manage this shift, but even there we’ve seen talented defections.

Support for H.264 doesn’t automatically mean that their codec won’t be skipped over in lieu of generic HD certification. The biggest threat to DivX’s business model is that CE makers will use the DivX to HD transition as a way to build support for generic certification. If consumers aren’t demanding DivX support, it will make it easy for them to cut DivX out of the equation. Managing this change to their eco-system, should be the company’s top priority. If DivX can’t convince device makers, that consumers really want their product, more and more manufacturers will leave DivX for cheaper alternatives, creating a downward spiral on their licensing business.

Winbox COO, Niklas Samios shares his rationale for choosing to skip DivX certification

Since Hell took the helm of the company, DivX has been focused on licensing premium content from the major studios. They have scored agreements with Sony and Time Warner, but between their P2P reputation and their Stage6 experiment, one can understand why some of the studios would be reluctant to dance with them.

Last August, they announced a partnership with Cinema Now for showcasing DivX content. While it’s unclear as to when their collaboration will start, it sounds like they are working on creating some kind of new entertainment destination.

According to CEO Kevin Hell DivX is “actively working with retailers to launch sites that can sell content leveraging our DRM in the marketplace. We announced Cinema Now last year and we are actively working to launch a retail offering with Cinema Now and other parties that are out there. The whole idea being that we want to bring content and allow that content to move to all the different devices out there that have our DRM inside.” (Note: Bold added by me)

While I’m of the belief that there can never be too many internet video sites, I did find it curious that Hell used the word “launch” to describe their initiative. When you consider how difficult it’s been for businesses to gain traction in the online video space, it’s a little surprising that DivX wouldn’t be using Cinema Now’s own flagship website as their distribution system.

What the need for a brand new site reveals about DivX content initiatives is a fatal flaw in their Hollywood ambitions. Even with a third tier internet video provider, they can’t convince Cinema Now to incorporate DivX into their main site, because they’ll never be able to get a license from all of the content providers.

Even if they could get a couple more studios on board, their lawsuit with UMG will effectively torpedo any hope of them ever being able to offer a comprehensive catalog to consumers. If you think UMG has any intention of backing down on this one, take another look. Read through DivX’s latest dust up over whether or not UMG should be allowed to use Audible Magic on Stage6′s 60 terrabyte database and form your own conclusions as to how far UMG seems willing to take this.

In the past, DivX management has argued that access to premium content was a key component to their growth, but at the Thomas Weisel investor conference, Hell backed away from previous comments.

“this space does I think take some time to play out, I think that there’s a lot of interesting opportunities out there right now in the premium space, but they’re taking time to really play out, so we’re making sure to pace ourselves in this space and not get ahead of the market”

Going after the studio content is a mistake in my opinion, it’s like ditching the girl you took to the prom for the cheerleader that all the jocks are already trying to make a move on. If DivX had a clean record and was bulging with cash, they might have a shot at some of that hot mainstream content, but when their P2P ex-girlfriend is more horrifying then Carrie to the content providers, it seems foolish not to stick with the girl you took to the dance.

DivX doesn’t need Hollywood content, they need consumers to DEMAND support for DivX in their consumer electronics. Supporting the dark side of the content business wouldn’t earn them any friends in Hollywood, but it would win them the hearts of consumers and would rebuild their moat in high definition.

One of the biggest challenges that Blu-Ray players have faced, isn’t so much the high cost of the hardware device, but the extra money that studios are insisting for Blu-Ray content. DivX could turn themselves into a recession play if they’d be more vocal about advertising the “free” content that people can use on their devices. As Paul Sweeting so aptly put it earlier this year, “hardware makers are adding all sorts of other gimmicks to their Blu-ray players, too, from wireless connectivity, to portability, to, wait for it…VHS playback. Yep, anything to try to avoid slashing the price of players. And anything to try to give consumers options beyond paying $30 for Blu-ray movies.”

Instead of promoting their latest licensing scheme as an H.264 solution, DivX should be pointing out that DivX Plus certification offers “Blu-Ray quality” high definition without this $30 cost. Again, it wouldn’t help their content negotiations, but it would help drive consumer demand back to DivX Plus devices, which is what ultimately drives CE interest and powers DivX’s business.

Content deals make sense as a way to extend their eco-system, but only if it’s on DivX terms. Instead of begging studios for access, DivX should be developing their consumer pipeline and rewarding the content companies who recognize the benefit of being able to access millions of consumers at their television sets. DivX greatest opportunity is the caos caused by Hollywood’s licensing terms. If they go through official channels, it will be years before they can reach their core fans, but if they fight against the system, they will be the only international solution for a very long time.

How much buzz could DivX get, if they actually spoke out about their lawsuit against UMG or if they ran some kind of “pirate” friendly promotion like giving free ISOhunt toolbar installations, while trying to find a replacement for Yahoo! These moves wouldn’t make them any money, but it would be a clear signal about who their end customer really is. DivX does almost zero marketing because their consumers have built their brand. By going hostile against Hollywood, DivX would magnify the strength of their signal. When consumers show passsion for the DivX brand, CE companies will quickly fill the void.

Fat Tube and little DivX

DivX other big “growth” initiative has also turned out to be a flop. Despite two years of pitching the concept, DivX has yet to see Connected integrated into other consumer electronics. The sad part is, that I believe Connected could radically transform DivX’s value proposition.

Currently, if you want to play a DivX movie on a DVD player, consumers must find the content, transfer it to a portable storage device (i.e. burn a DVD or move the file onto a memory stick) and then physically transport the media to their DVD player. If you’re a hard core fan, it’s worth going through all this trouble to get access to your media, but I’d be shocked if more than 5% of users were taking advantage of this feature.

The beauty of the Connected business model is that it dramatically simplifies the process. If consumers buy a TV that is powered by DivX Connected, they’ll get curious as to how to take advantage of the functionality. Not everyone will adopt DivX, but if even 25% of those customers plug their television into the internet, it would drive mass adoption for DivX content.

Compared to their DVD licensing, DivX Connected could have an atomic impact on the content industry. Make no mistake about it, if Connected takes off, it will be a weapon of mass piracy from the studio perspective. Because Connected makes it so easy to access your content, it has the potential to turn mainstream customers into rabid file sharing animals. Why it hasn’t already taken off remains a mystery to me, but it could have a serious impact on the demand for DivX, if they can ever get it released into the wild.

Last fall, I had the opportunity to meet Hell in person and I asked him whether or not he felt that the premium they were asking for Connected had anything to do with manufacturer resistance.

His response was “I wouldn’t attribute it to the pricing, I think it’s more an issue of implementation and the fact that a lot of these guys are still trying to figure out what they’re doing there. They either have their own initiatives or they’re confused about it, they want to try X, they want to try Y, anything that’s out there to figure out what it’s all about and in my mind it’s a lack of coherent focus and understanding by the CE partners.”

Since then, CES has come and gone, but it looked pretty clear to me that the CE industry isn’t all that confused about their connected television plans. The fact that DivX hasn’t been able to get their product in the door may or may not have something to do with their pricing, but deep discounting may be their best option for jump starting the program again.

In 2002, DivX was struggling to convert their company into a licensing business. Manufacturers were skeptical that consumers would pay extra for the support. To prove the value of DivX certification, DivX signed a licensing agreement with a little know third tier DVD maker known as KISS. It was officially certified in August 2003. The product, immediately began to pick up buzz and less than six months later, Phillips signed on to have DivX included in their own DVD players as well. After Phillips made their move, other CE companies were forced to follow and by mid 2004, DivX DVD players were pretty much available anywhere on the globe. To this day, the Phillip’s DVP642 remains one of the most reviewed DVD players on Amazon.

A couple years after DivX helped to put Kiss on the map, Cisco bought them out for over $60 million. I would argue that there are many similarities between Divx’s initial efforts to convince DVD player manufacturers to licensing their technology and their current struggles in the Connected market. Rather then continuing to hold out for a premier deal, DivX would be well served in signing a teaser deal with a small television provider. When large CE companies see proof that DivX Connected can move TV sets, they’ll quickly begin signing contracts to ensure that they remain competitive. While heavy discounting is less than desirable from Divx’s perspective, getting more Connected devices in the wild, would at least give them an opportunity to prove that there’s still value in the DivX brand.

Death of a Salesman

While I support discounting when it helps to secure DivX’s moat, it’s hard to be encouraged by the cracks that we’re seeing in their value proposition.

To help take a closer look at DivX’s pricing erosion, I reached out to Jack Wetherill from Futuresource Consulting for data on global DVD player sales. According to Mr. Wetherill, “DVD players in their broadest sense (ie set-top players, recorders, integrated home theatres, DVD/VHS combos and portable DVD players) totaled 122m in 2006 and 127m in 2007. We expect the market to level off at 127m in 2008, although year end numbers are still being finalised.”

When DivX first went public, the company said that they had a 25% penetration rate in the DVD player market. This translated into approximately $47 million in core licensing revenue for 2006 or approximately $1.54 per DivX certified device.

In 2007, DivX grew their global DVD player market share to 37%, which translated into approximately $66 million in core licensing revenue or $1.40 per unit.

At the Thomas Weisel Technology conference, DivX said that they’ve now captured 50% of the DVD player market, but according to their own projections they are only expected to grow their core licensing business by 13% in 2008. With core revenues around $75 million, this would suggest that DivX is now earning a unit licensing fee of $1.18 per certified device. A decline of approximately 23% in pricing power since the company went public.

When you consider that consumer trends have been much kinder to upscaling DVD players (where you almost always find DivX) vs. traditional DVD players and when you consider that DivX’s core revenue numbers include other electronic categories and Main Concept revenue, one could argue that these calculations are much more conservative then the actual results.

DivX has always said that they provide volume discounts to partners, but with over half the market now captured, it would appear that DivX’s DVD upside is somewhat limited.

Saving Private DivX

Along the way, DivX has made their fair share of mistakes, but they’ve also achieved tremendous wins as a result of the risks that they’ve taken. Compared to the mainstream studios they may only be a tiny mouse, but when you look at affect that their technology has had on the media landscape, it’s clear that they’ve been able to frighten the Hollywood elephants.

The good news is that it’s not too late to turn DivX around, but without some kind of action, I fear that DivX will remain in cruise control while their franchise continues to lose value. What does DivX need to do in order to return to their glory days of growth? It all comes to restoring confidence in the company.

First and foremost, DivX must put a stop to the bleeding from employees leaving the company. Given their labor issues, I don’t believe that this can be accomplished without replacing their management team, so I believe that new leadership needs to be a top priority.

Once a new team is in place, I would take .25 cents worth of earnings and commit to investing it in DivX’s growth. DivX’s employees are more accustomed to the culture of a start up then a publicly traded company. DivX should be playing to these strengths. Spend $500k per month building out new businesses. Adopt a Google model where employees are encouraged to spend 15% of their time thinking outside the box. Become a technology incubator with the long term goal of spinning off divisions when the markets recover. Start funding a profit sharing contribution to the company’s retirement plan, so that DivX’s success is shared by everyone instead of those lucky enough to get options. Take the time to listen to your employees and address their concerns.

Secondly, DivX must restore faith to their investor base. New leadership could help to accomplish this, but it will likely take more than promises of growth, to soothe the rattled nerves of their investors. Reinforce DivX’s long term commitment to shareholders by paying a .25 cent dividend as a way to reward investors while they wait for evidence of a turnaround. Taxes on a dividend would be better avoided through a buyback, but further buybacks would only reward short term shareholders and would increase volatility by reducing an already low share count. With a 5% yield, a dividend should help to establish a floor on DivX’s share price until earnings multiples expand back to growth levels.

Finally, restore confidence in your consumer base by speaking out for consumer rights. Use the UMG trial as a way to create passion in your fans and to drum up support for digital rights. Squeezing marketing leverage from the lawsuit would at least help to justify the costs involved with going to trial. Focus on Divx Plus’ quality advantage for HDTV consumers. Instead of throwing good money after bad, abandon your content plans until you have better leverage. Use small independent content providers to show how powerful DivX user base can be to progressive studios. Sign a sweetheart deal with a small CE television manufacturer to put pressure on the rest of the market.

If investors do nothing, DivX won’t necessarily go bankrupt, but it will torpedo their brand and market position. DivX CFO Dan Halverson said that their #1 goal in 09′ is to protect the balance sheet. This may seem prudent during such difficult economic times, but sleepwalking through a format change won’t position DivX for the long term. There will be a time for Divx to cash in on all of their hard work, but to try and do so at such a crucial point in the digital transition seems foolish and short sighted.

Over the last few years, it’s been no secret that Netflix has become the dominant force for DVD by mail rentals. There may be plenty of other ways to watch films, but when it comes to renting through the mail, Netflix’s laser like focus has put them in the enviable position of being able to assert a large degree of control over the economics of their market. While there is nothing wrong with a company being so successful that they become the dominant player through skill, there are laws against abusing that power to prevent competition.

A few years ago, Wal-mart created a copycat DVD rental service in order to try and get their own piece of the DVD rental market. Their results were disastrous and despite significant financial and retail advantages, the service never caught on with consumers. Eventually, Wal-Mart realized that it was foolish to spend as much time and money focusing on such a small part of their core business, so they threw in the towel and essentially sold their membership base to Netflix. While we know that the agreement included some cross promotional advertising, the actual terms of the deal weren’t ever publicly revealed.

While some would argue that Netflix’s agreement with Wal-mart was just another example of their business acumen, nearly four years after this transaction took place, Walmart and Netflix both stand accused of engaging in anti-trust behavior over the deal. While Netflix does see its fair share of bogus lawsuits, after reading through the complaint, I think that this case may end up having more teeth to it then most of the frivolous lawsuits that are filed (warning, I’m not an attorney, just my uneducated opinion.)

Because the overall DVD market is so much bigger then the online component that Netflix pwns/operates in, I think they’ll end up getting past this, but the complaint which was filed by Andrea Resnick, does do a good job of framing the debate and raises some prickly questions for Netflix/Walmart. Had Resnick tried to seek an injunction blocking the transaction back in 2005, most courts would have brushed aside any anti-trust arguments in a heartbeat, but by shifting the focus of their complaint beyond Netflix’s control over the DVD by mail category to Wal-Mart’s domination of the DVD sell through space, Resnick does a decent job of making his case.

According to the complant, “Prior to and at the time of the agreement, Netflix and Walmart.com were actual competitors in the Online DVD Rental Market. In addition, Netflix, on the one hand, and Wal-Mart Stores and Walmart.com were actual participants and Netflix was a potential participant, with the means and economic incentive to sell new DVDs–in the absence of the Market Division Agreement. Defendants shared a conscious commitment to a common scheme designed to achieve the unlawful objective of dividing the markets for online DVD rentals and new DVD sales. The Market Division Agreement allocated the Online DVD Rental Market to Netflix, with Wal-Mart Stores and Walmart.com agreeing not to compete in that Relevant Market. The agreement also allocated new DVD sales to Wal-Mart stores and Walmart.com, with Netflix agreeing to refrain from selling new DVDs in competition with them. In addition to explicitly or de facto agreeing not to sell new DVDs, Netflix also obtained the Market Division Agreement by providing potentially valuable promotion to Wal-Mart Stores and Walmart.com.”

(Note: bold and italics provided by me)

I don’t know whether or not there was specific language in the agreement preventing Netflix from selling new DVDs to their customers, but I am looking forward to finding out more details during the discovery phase of the trial.

Feel free to read through the complaint yourself, but when push comes to shove, it’s hard for me to believe that the courts will side with Resnick on this one. For one, as Techdirt aptly points out, Netflix doesn’t have a monopoly on the market, they just have the fortunate luck of competing with a neutered Blockbuster for that space. I also would argue that Netflix or Walmart for that matter, doesn’t have the ability to corner the home entertainment market as alleged. If Resnick is successful in arguing that the DVD by mail industry is a unique market they may end up having some luck, but the reality is that the home entertainment market is a helluva lot bigger then DVD rentals via the internet. If the FTC didn’t have problems with Sirius and XM combining to create a single satellite radio company, it’s hard to accept the argument that Netflix’s actions prevented competition on an anti-trust scale.

Since 2005, we’ve seen a radical transformation occur in the VOD and video over the internet markets. During that time, we’ve also seen Redbox install over 10,000 DVD kiosk locations throughout the US, including a large percentage of those in Walmart locations. When you consider that last year, Blockbuster had more then four times as much revenue then Netflix, it begins to illustrate how small Netflix’s slice of the movie rental industry really is.

Only time will tell how far this one will go, but I think it’s worth keeping an eye on. While I’m confident that neither Netflix nor Walmart did anything wrong, the suit isn’t as black and white as I would like. If Netflix does end up having to make compromises as a result of their success, it could have a serious impact on their ability to transition to digital delivery without any turbulence.

While having someone automatically calculate this data is helpful to me, when I first used the service, it didn’t really tell me anything new about how I use Netflix. Since I enjoy number crunching, I had already been tracking this info and knew that I was spending about $3 for every DVD I rented.

What Feedflix did offer me though, was a way to compare how I used the service with other Netflix customers. When it first launched, I didn’t think that Feedflix would have enough members for a legitimate sample size, but with the service growing over the past few months, I wanted to check back and see what it could tell me about how other people are using Netflix.

How Long Do Customers Keep Their Rentals?

Feedflix doesn’t answer this question directly because they break the data into separate groups, but if you do a little bit of math, it’s not too hard to get an estimate on the average rental. What I found surprising about the results was that, even with 75% of the user base returning their DVDs within 10 days, the drag from the other 25% of users brings the average rental period to 9.55 days. In the past, Netflix has said that people who don’t rent as many movies have a tendency to churn at a higher rate, but this data would suggest that they contribute to the lionshare’s of Netflix’s profits before they drop off completely.

How many users subscribe to each plan?

Netflix has never given a breakdown on the number of subscribers in each plan, but Feedflix can give us a reasonable guess as to what this might be. According to Netflix’s latest earnings report, they currently have 8.4 million subscribers. By extrapolating Feedflix’s breakdown of Netflix service plans to the larger subscriber base, we get the following estimates on where customers are spending their money.

1 at a time – 2.1 million subscribers
2 at a time – 2.4 million subscribers
3 at a time – 3.1 million subscribers
4 at a time – 500K subscribers
5 at a time – 168K subscribers
6 at a time – 84K subscribers

To test the data, I multiplied the number of subscribers from each group by the price points on their corresponding plan and came up with an expected 3 month revenue number of $352 million*. The real result from their latest quarter was $337,600,000, so these numbers may be a little bit off, but not entirely unrealistic.

*My results didn’t include any of the 7 or 8 at a time subscribers because Feedflix didn’t have enough data on them. It’s also worth noting that there are rounding errors to take into account. My analysis also assumes that there is a 3:1 ratio between the $4.99 and $8.99, 1 at a time subscribers and makes a weighting adjustment for the difference between the 8.24 million subs at the start of their quarter and the 8.4 million that they finished with.

What is the average cost per rental for Netflix customers as a group?

Getting at this number is a little bit trickier, but if I multiple the breakdown of each plan, by the number of discs that an average Netflix customer is expected to use each month, then my math suggests that Netflix is earning $1.94 in revenue, per DVD rental. At first this number seemed a little low to me, but it would verify Netfix’s claims that they earn a higher profit on 1 at a time subscribers vs. the higher revenue 3 at a time moviehounds. If my estimates are right, it would also mean that Netflix is shipping 1.97 million DVDs per day or nearly 60 million DVDs per month.

It’s worth pointing out that there are a lot of ways that this data and/or my calculations could be wrong so take it with a grain of salt, but if Feedflix’s numbers are representative of the larger Netflix customer base then it would suggest that if you aren’t getting at least $2 per DVD each month, then you are one of the skinny guys at the all can eat buffet.

If you’d like to view my Feedflix account you can find it here.

Even though I’m an HDTV fanatic, it wasn’t until this past weekend, that I finally made the jump to an HD monitor. While I don’t have HDTV tuners on my Media Center, I do have an HD camcorder and it was important for me to be able to edit my high resolution videos.

After doing a little bit of research, I decided to pick up a SyncMasterTM 226BW from Samsung. Between the new monitor and my ATI Radeon HD 2600 XT video card, the resolution looks absolutely stunning. Even my home movies look fantastic in HDTV. I really couldn’t have been happier with the upgrade.

Unfortunately, Hollywood isn’t quite as thrilled about my new HD Media Dream Machine and they’ve decided to punish me by revoking my Watch Now privileges from Netflix.

I first found out about the problem on New Year’s Eve, when I went to log into my account. When I tried to launch a streaming movie, I was greeted with an error message asking me to “reset” my DRM. Luckily, Netflix’s help page on the topic included a link to a DRM reset utility, but when I went to install the program, I stopped dead in my tracks when I saw this warning.

The minute I saw“this will potentially remove playback licenses from your computer, including those from companies other than Netflix or Microsoft” I knew better than to hit continue. Before nuking my entire digital library, I decided to call Netflix’s technical support, to see if I could get to the bottom of my C00D11B1 error message.

When I called them they confirmed my worst fears. In order to access the Watch Now service, I had to give Microsoft’s DRM sniffing program access to all of the files on my hard drive. If the software found any non-Netflix video files, it would revoke my rights to the content and invalidate the DRM. This means that I would lose all the movies that I’ve purchased from Amazon’s Unbox, just to troubleshoot the issue.

Technically, there is a way to back up the licenses before doing a DRM reset, but it’s a pretty complex process, even by my standards. When I asked Netflix for more details, they referred me to Amazon for assistance.

Perhaps even worse than having to choose between having access to Netflix or giving up my Unbox movies was the realization that my real problems were actually tied to the shiny new monitor that I’ve already grown fond of.

Netflix’s software allows them to look at the video card, cables and the monitor that you are using and when they checked mine out, it was apparently a little too high def to pass their DRM filters.

Because my computer allows me to send an unrestricted HDTV feed to my monitor, Hollywood has decided to revoke my ability to stream 480 resolution video files from Netflix. In order to fix my problem, Netflix recommended that I downgrade to a lower res VGA setup.

As part of their agreement with Hollywood, Netflix uses a program called COPP (Certified Output Protection Protocal). COPP is made by Microsoft and the protocol restricts how you are able to transfer digital files off of your PC. When I ran COPP to identify the error on my machine, it gave me an ominous warning that “the exclusive semaphere is owned by another process.”

My Netflix technician told me that he had never heard of this particular error and thought that it was unique to my setup. When I consulted Microsoft, they suggested that I consult the creator of the program. Since Microsoft wrote the COPP software, I wasn’t sure who to turn to after that.

The irony in all of this, is that the DRM that Hollywood is so much in love with, is really only harming their paying customers. When you do a DRM reset, it’s not your pirated files that get revoked, it’s the ones that you already paid for that are at risk. I’m not allowed to watch low res Netflix files, even though I have the capability to download high def torrents? How does this even make sense? It’s as if the studios want their digital strategies to fail.

While I understand the need for the studios to protect their content, I believe that these measures go too far. It makes little sense to block my ability to copy low res internet movies, when I can always rip the DVD straight from my Netflix discs instead. By blocking access to my Netflix membership, Hollywood is once again punishing their customers by pushing defective DRM.

When Copywrite.org stumbled onto the Belgian DVD company, DVDPost, he noticed something eerily familiar about their website. Over the years, Netflix has inspired their fair share of copycats, but DVDPost had cloned more than just their business model, they completely ripped off Netflix’s website as well.

The similarities between the two sites made Copywrite wonder if Netflix was running a secret European division or if this was just a cheap international counterfeit. While the conspiracy theorist in me desperately wanted to believe that Netflix was using Belgian subsidiaries to expand internationally, deep down inside I knew that this was just another internet knock off. It wasn’t the first time that Netflix’s website had been copied and it probably wouldn’t be the last.

My gut reaction was to start blasting DVDPost as a fake, but luckily I decided to do a little research first. Instead of finding another internet scam, I found a renegade DVD company that has been trying to make a name for themselves, by stirring up controversy in the media.

DVDPost first struck publicity paydirt, when they ran a commercial for a spoof company named Rent-A-Wife. The ad featured a man tying up his wife and trading her for a new one DVDPost claimed that the ads were meant to be light hearted, but critics felt that the company had gone too far with the shock tactics. After local media pressure, DVDPost yanked the Rent-A-Wife website, but followed it up with an equally tasteful ad, featuring Osama Bin Laden as one of their customers.

While it’s possible that DVDPost is trying to fool consumers into thinking that they are somehow related to Netflix, I think its more likely that their recent web redesign is part of a PR campaign. Normally, I try not to fall for this kind of PR bait, but I found their marketing techniques too entertaining, to resist commenting on this latest guerrilla ad campaign.

With access to four tuners and 1.5 terrabytes of storage, I thought that I had the ultimate DVR setup, but after seeing Snapstream’s Enterprise DVR in action, my home entertainment system suddenly seems wimpy. This DVR isn’t meant for the home market, but I can’t help being envious of its capabilities. I don’t know how much Snapstream is charging, but if money grew on trees, I would be all over this in a heartbeat.

With 10 tuners, you won’t need to worry about programming conflicts and with 2 terrabytes of storage, it would mean that you could record 10 different channels, 24 hours a day for at least 8 days before you would have to worry about archiving. Even, if you did need to save old content, the software allows you to back up your videos onto DVD.

While the specs started me drooling, the search capabilities were what I found most impressive. By taking advantage of the closed captioning system, SnapStream is able to search the transcripts of any program you record. This allows you to record a lot of junk and filter it for the information that you care about. Unlike the DVR in your living room, this isn’t limited to one monitor. SnapStream has designed the DVR to act as a server, which allows multiple users to search and stream videos from anywhere connected to the network.

In the video demoing the product, Snapsteam CEO Rakesh Agrawal mentions that they have PR firms, political organizations, schools and pro sport teams as customers. While I could see how all of these organizations could benefit from access to this type of technology, I was surprised to see Wall St. missing from this list. Being able to keep track of when an investment is mentioned in the media, would be a powerful tool for money managers. When you consider that Thomson is booking a billion a year in profits, by selling market data to businesses, you have to imagine that there is a market for searchable video intelligence. SnapStream may be tapping into a niche market, but it can be a lucrative one, if they attract motivated buyers. By helping businesses make better use of DVR technology, they are filling a market void and creating demand for an entirely new DVR product category.

SnapStream’s professional DVR may be well outside of my tax bracket, but it’s still exciting to see the company innovate. Considering the stiff competition in the consumer DVR market, it makes sense for them to diversify into the professional segment. You can read more about SnapStream’s enterprise ambitions in Brent Evans’ recent interview with Agrawal.

“A method wherein contents of DVDs may be restricted based upon purchased certificates is provided. The certificates allow for secured information on playback. Specifically, whenever a DVD is to be played, a certificate is consulted to determine whether the content of the DVD should be played with or without commercial interruptions. If the certificates provide for commercial interruptions, then commercials can be obtained from an online service that renders commercials on demand, or from the DVD itself. In such a case, the content of the DVD may be interspersed with commercials.”

I’m usually a fan of new DVD technology, but I’ve got mixed feelings on this one. Every now and then, I’ll come across a DVD that won’t let me skip past the previews and it drives me absolutely nuts. If I’ve already paid for my content, then should I be forced to watch advertisements? It makes me feel like the studios are double dipping.

On the other hand, I could see plenty of advantages to having ad supported DVDs. There are a lot of people who aren’t willing to pay money, in order to watch a DVD. If they can catch up on a series by dealing with the ads, then this technology could introduce time shifting to an entirely new audience. It could also open up new distribution channels for content providers. For example, if McDonalds included ad supported Disney flicks in their Happy Meals, I’d wager that they would reach more viewers, then Friday nights on ABC.

With advertisers already scared to death of the ad skipping powers of the DVR, I could see studios adopting this as a way of shoring up advertising revenue. I’m certain that the TV producers would prefer live viewers, but if a consumer ends up watching the ads eventually, then why should it matter, when they see the program?

One of the more interesting components to the IBM application, was it’s focus on internet delivered advertising. Whenever I’ve been forced to watch previews on DVDs, it’s typically been for movies that were released a long time ago. While the previews may have been relevant seven years ago, they seem a little outdated today. I don’t think that the free DVD consumer market is going to have the latest internet connected DVD players, but I still found it interesting to learn, that IBM is working on a solution to this problem.

I don’t see this patent making it all the way through the application process, but I do expect that we’ll see more of these types of advertisements in the future. The optimist in me, would love to see this technology used to reach new consumers, but my inner cynic knows that the studios would rather unleash ads on paying viewers, then risk cannibalizing their precious DVD. I don’t fully understand IBM’s motives for filing the patent, but thought that it was an interesting solution for bringing entertainment to the masses.

Over the last few years, I’ve followed the DVD rental industry pretty closely. During that time, I’ve been one of Blockbuster’s biggest critics and have frequently blasted the company for failing to adapt to the digital age. With their core rental business experiencing massive deterioration, I’ve had very few positive things to say about the company.

Their hyper-focus on competing with Netflix, has cost the company dearly and was a huge blunder by Blockbuster’s previous management. In order to try and counteract Netflix’s momentum, Blockbuster ended late fees, started a price war against a well funded innovator with little debt, and they massively cannibalized their higher margin in-store business. All in a desperate attempt, to differentiate their online service. Meanwhile, their executives took home pay packages that were unconscionable, especially when you consider Blockbuster’s dwindling resources and their dismal financial performance.

At the end of the day, their fight against Netflix has cost them at least a half a billion dollars and they still only have 3,000,000 subscribers.

Six months ago, I would have told you that there was nothing that Blockbuster could do to save itself. I had seen Antioco and Co. make too many poor decisions, to believe that they could figure out how to turn the company around. Instead of increasing prices, they were lowering them by offering unlimited total access rentals. While the program proved to be popular with consumers and the Mad Money crowd, it wasn’t an acceptable long term solution for the challenges that Blockbuster faces.

Of all the decisions that I’ve seen the company make, squeezing out Antioco may have been their best one. Ironically, the one move that I think was good for shareholders, turned Mad Money against them and started the spiral towards a new 52 week low today.

With so much going wrong for the company, I had low expectations when they brought in Jim Keyes to takeover at the helm. With the future of rentals being digital, I didn’t immediately appreciate the importance of bringing in a retail specialist.

Over the past few months, I’ve watched as Keyes has taken over and while it will take him time to steer Blockbuster back on course, his immediate move to cut advertising and unlimited rentals was one that made economic sense.

What a lot of people interpreted as Blockbuster refusing to face reality, I saw as an admission that they had lost their focus on their most profitable customers. In the short term, this is a good thing because it helps to stem the losses from the Total Access program, but it’s not a long term solution.

Following Blockbuster’s 3rd quarter earning’s call, I could understand why their shareholders might be nervous, but after listening to Keyes unveil his turnaround strategy at their analyst event, I was shocked to see such a negative market reaction to his ideas. Analysts slammed the event as being big on dreams and light on details and since the event, Blockbuster’s market cap has taken a 20% haircut.

What other’s may have interpreted as bad news, I saw as a stroke of genius. Keyes’ prescription for saving Blockbuster is the exact remedy that they need, in order to remain relevant in a digital age. There is little doubt that there will come a time where we see the end of the DVD rental, but for the first time, Blockbuster is willing to admit this and they laid out a compelling plan for how they will adjust to this transition.

Keyes discussed several initiatives, but at the heart of the strategy was a plan to evolve from a rentailer to a retailer. While the differences may be subtle, the details have tremendous implications on the viability of Blockbuster’s business model.

Dedicate More Square Footage To Retail

While Blockbuster has seen their brutal selloff, shares of Gamestop have caught on fire. The market clearly has no faith in the future of DVD rentals, yet they are still willing to invest in profitable retailers. The rental industry is a tough business and as that stream dries up, Blockbuster needs to be able to replace this with higher profit opportunities.

In order to accomplish this goal, Keyes has worked out an agreement with Sony to provide 2000 PS3 kiosks, in their stores during the holidays. I view this as an an early test for the viability of Blockbuster’s retail approach. I believe that the consoles will sell well among Blockbuster’s customer base and will lead towards more high end consumer electronics.

By focusing on selling higher ticket items, Blockbuster stands a better chance of covering their fixed costs. People are already going to Blockbuster to rent their movies, but if they can start to buy things like computers, cellular phones, HDTV’s and Blu-Ray players, it will give Blockbuster an opportunity to capture some of the money that retailers like Best Buy are able to take in.

If Blockbuster is successful with this transition, they could even get to a point where they could use rentals as a loss leader to drive higher revenue transactions. If you can sell enough HDTV’s, the decline in rental revenues becomes less of an issue. What some might see as the abandonment of the rental market is really Blockbuster pursuing better market opportunities.

Invest In Kiosk Technology

It’s no secret that I believe that burn on demand could save the DVD rental industry. As a tech savvy consumer, I have lots of options for streaming digital content to my television, but most people still prefer the good old fashioned DVD. Even after the digital revolution gains critical mass, there will still be a need for movie rentals. While it’s easy to believe that everyone has a computer and internet access, there is still a large part of the market that VOD and Netflix, can’t get at.

The problem with Blockbuster’s retail initiatives, is that this will eat into the selection and inventory. If half the store is dedicated to selling consumer electronics, it becomes challenging to offer as many choices. Burn on demand can solve this issue for Blockbuster. By taking care of the heavy lifting, Blockbuster can make it easy for consumers to watch an even wider range of content.

Keyes plan to invest in burn on demand technology shows that he understands the savings and impact, that this technology can have. My only reservation about his approach, is his intention to introduce the kiosks at the store level. Kiosks can provide a lot of efficiencies, but they don’t do well with volume. I can see the potential in letting franchisees use the technology in non-video store locations, but believe that Blockbuster needs a different solution at the store level.

Everybody knows how to work a printer at the supermarket, but there is a reason why people still go to Kinkos. They can handle volume like nobody’s business.

Burn on demand kiosks will be good for expanding into supermarkets, coffee shops and fast food restaurants, but Blockbuster will need dedicated servers and lots of burners at the store level, if they want to provide a superior experience at their retail locations. By handling the heavy lifting for consumers, they could bypass a significant technological hurdle in the adoption of burn on demand DVD.

Shifting To More Revenue Sharing Arrangements

One of the biggest weaknesses in Blockbuster’s business model are the high fixed costs that they have to deal with. Blockbuster can’t get rid of the lease payments or all of the employee costs, but they can reduce their leverage by approaching their stuido partners. Whether rental will eventually die or not, the studios want to protect the DVD stream and have an incentive to work with Blockbuster towards ensuring their survival. In order to get less up front costs, Blockbuster will be forced to give up their gross margins, but it will allow them to keep top movies in stock and to offer a burn on demand experience.

Raising Prices and Reinstating Late Fees

Over the past few years, we’ve seen the price of a lot of products go up. Whether it’s higher gas prices or postal rate increases, the cost of living has been increasing. When it comes to rental though, we’ve seen price deteriorate. The DVD price war has taken it’s toll and there is more than enough justification for Netflix and Blockbuster to increase prices. This strategy is probably the most risky, because if Netflix didn’t follow through with their own price increase, there could be a severe reaction against Blockbuster.

One of the things that has always impressed me about Netflix, has been their commitment to testing ideas before implementation. When Blockbuster ended late fees, they took a shotgun approach and hoped that it would pay off. It obviously didn’t.

When Netflix lowered prices it was after they understood the elasticity of the demand curve. By taking their time to react to competitive threats, Netflix was able to make more intelligent decisions in combating Blockbuster. While I’m sure that Blockbuster shareholders would welcome an imediate price increase, I have to admire the fact that Keyes isn’t willing to dive in head first on this one.

As far as the late fees goes, this is clearly a problem. By allowing customers to keep rentals, it’s prevented other people from having access to the inventory. I think it’s fair for Blockbuster to consider this move, but after such a massive no late fee campaign, there could be a strong backlash. One of the problems that I think most people had with Blockbuster’s late charges was the punitive nature of the fees. Instead of having to pay for one more day, you often had to pay for another three day rental.

During the analyst presentation, Keyes expressed admiration for Redbox’s pricing model and pointed out that a $1 a day wasn’t really cheaper then Blockbuster. If Blockbuster had $3 rentals for three days and then a $1 per day afterwards, consumers might accept the return of late fees. Still, after such a massive promotion (and lawsuit settlements), it would be gutsy to try and re-introduce them.

There is no way to know for sure, if any of these initiatives can save Blockbuster, but I do believe that Keyes is making the right moves towards securing the long term future of the company. While I may have written off the video store, I’m not ready to call the end of retail and I’m impressed by Keyes focus on improving revenue per square footage, instead of being distracted by the internet. It’s the right move for Blockbuster to make and one that marks the divergence of the Netflix vs. Blockbuster paradigm. With rental revenues set to eventually expire, Blockbuster is smart in positioning themselves to take on other retailers, where they have an advantage. By making these changes, it shifts the battle to Blockbuster vs. Circuit City, Best Buy and Game Stop and this is a business model that should make more sense to Blockbuster’s investors.

While there is no way for me to know what really motivated Sony, I do have my suspicions.

On a basic level, Sony obviously adopted DivX as a competitive strategy for the console market. Announcing support for a popular codec among hardcore gamers, makes a lot of sense, especially going into the holiday season. Whether or not Microsoft ends up adding DivX to the Xbox 360, Sony’s support for DivX will certainly provide a boost for the console.

On the surface, this explanation seems to make a lot of sense, but the tin-foil hat part of me, can’t help but wonder, if this really had more to do with Blu-Ray.

The current state of the HDTV DVD market is a mess. The Blu-Ray and HD-DVD camps seem to have settled for a stalemate and consumers are getting shafted in the process. By choosing a side in this battle, consumers risk ending up with obsolete technology, but that isn’t the greatest obstacle to adoption. The real reason why consumers are sticking with the standard DVD, is because they can’t get all of their content on either format.

It might be great that you can watch James Bond on Blu-Ray, but it’s a serious weakness when consumers can’t watch Universal, Paramount or Dreamworks content. If Sony was only certifying the PS3, I would dismiss these thoughts as paranoid delusions, but at DivX’s most recent investor presentation, they did say that they hoped to announce the first Blu-Ray/DivX chip before the end of the year.

Now I would never expect Sony to come out and openly endorse piracy, but if you think through the implications of PS3/DivX support, you might understand why I think that they are really engaging in a form of HD-DVD sabotage. By supporting DivX, consumers won’t get the same HD experience, but they will get access to all of the forbidden HD-DVD content and that has huge value to the consumer.

DivX support won’t be enough to end this silly war, but it could prove to be an important band-aid for the Blu-Ray camp. By partnering with DivX, Blu-Ray is now able to offer all content, even if some of that happens to be illegal. I don’t believe that DivX support will change the format war, but it will certainly put pressure on the HD-DVD format. Their advantage so far, has been based on the exclusivity of content and if Blu-Ray consumers are denied the programs that they want, I have no doubt that they’ll turn to DivX as a solution.

Whether Sony adopted DivX to help jump start PS3 sales or to gain a guerrilla advantage in the HD wars will remain a mystery, but either way the move is so shrewd, that I’m surprised to Sony make it. After seeing so many failed attempts at trying to maintain a proprietary system, it is a welcome relief to finally see cracks appearing in the Blu-Ray defenses.

While DivX support on the PS3 isn’t an admission that Blu-Ray has failed, I do think it’s a sign of how far Sony is willing to go, in order to win this battle. If both camps would just agree to cross-license their content, we could end this stupid war, but in the meantime, at least consumers will soon have illegitimate options, to get at the content that the studios don’t seem to want to sell them.

During the quarter, DivX took in $20.9 million in revenue, of which $17.1 was related to their core licensing business. This jump in revenue represents an increase of 44%, over the same period a year ago.

During a conference call discussing the results, DivX estimated that as of June 30th, they had captured 37% of the global DVD player market. This compares to a 25% penetration rate, from a year ago. During the more recent 3rd quarter, they saw their market share for US based DVD players, climb from 20% to 31%, over the past year.

Kevin Hell, DivX’s newly appointed CEO, attributed the growth to top OEMs, reacting favorably to greater consumer demand for DivX products.

“These penetration gains are a direct result of our growing relationships with the key OEM partners, as they react to increasing consumer demand for DivX devices. In Q3, our top 5 OEM partners, taken as a group, increased unit shipments of DivX Certified products by 55% relative to the same period last year. What’s more, we are especially pleased that we have been able to achieve this growth while maintaining our historically strong average royalty rates.”

What I find so fascinating about this aspect of DivX growth, is that they are seeing it come from their existing partners. If new partners were coming on board, it would be easy to dismiss their gains as being driven by OEM competition, but to see 55% growth from your existing customers, would suggest that DivX’s market share is either being driven by consumers directly choosing DivX devices over non-certified products, or from OEMs recognizing the value that DivX adds in a more competitive environment. Whether it’s the chicken or the egg that has been driving demand, these gains represent a strengthening of DivX’s core business and offers further proof, that DivX certification can drive the adoption of consumer electronic devices.

In addition to seeing progress in their core DVD licensing business, DivX also saw key developments in their emerging products category. During the quarter, they successfully launched their DivX Connected platform, they formed a strategic relationship with Qualcomm to help drive DivX mobile, and they signed an important advertising agreement with Yahoo!

On their conference call, DivX didn’t unveil any new customers for their Connected platform, but they did announce that Connected would begin shipping on November 12th. Initially, it will only be available in the UK, Germany and France, but DivX expressed hope that we could see a North American launch sometime in 2008.

One area where DivX continued to struggle, was in securing the rights to premium content. When asked about their progress, Hell said that DivX remained committed to the idea, but that negotiations with studios tend to take a lot of time.

“we continue to aggressively pursue Hollywood content and believe that there is a strong rationale for a deal. Of course, these sort of deals take time, particularly with our open approach, where we’re working across a number of different device types and a number of different brands, but we think that the rationale for the studios and other premium content owners is compelling. We have over 100 million devices out there that are certified. All of those devices have our DRM inside and so ultimately we believe, it’s just a matter of time. Once we do get these folks on board, the studios and other premium content owners, we’ll then be working with other folks like Amazon or Netflix to enable services for distribution in the powered by DivX model.”

There may be strong rationale for a deal, but it appears that DivX is finding out the hard way, that studios don’t always behave rationally. DivX may still be committed to trying to secure the digital rights to content, but you wouldn’t know it by looking at their their legal department. During the quarter, DivX sued Universal music group, in order to help establish the legality of their Stage6 video sharing site. On October 22nd, UMG fired back by filing a copyright complaint against DivX, as well as ten John Does who are accused of uploading infringing content to the Stage6 website.

When asked about whether or not the lack of premium content would impact the popularity of DivX Connected, Hell didn’t seem to feel that it would be an issue.

“I think Connected in its current form and the sense that it has access to all of your music, your photos and, of course, your video, as well as access to Stage6 and other services is a compelling offering and I believe that its something that solves the problem out there, unlike any other platform that’s out there today. That said, of course, I do see Hollywood content as being an accelerator to Connected.”

For most digital media companies, being denied access to premium content would make or break your business, but because DivX’s core customers already have access to premium content, this really isn’t all that significant of an issue. Customers may have to steal their movies off the P2P networks, but DivX consumers have already demonstrated a willingness to take content, especially when legal downloading isn’t an option. Premium content will be an important part of Connected, but it doesn’t necessarily have to be legal content, in order for the platform to succeed.

During the quarter, DivX saw three major developments for their mobile strategy. As part of a new multi-year agreement with LG Electronics, they introduced another DivX certified cell phone, they expanded the global availability of the Samsung F500, and they formed a strategic partnership with Qualcomm.

Of these events, the Qualcomm deal was the most important, because it lays the infrastructure for mass deployment further down the road. Qualcomm is a major player in the cell phone chip market and if DivX can achieve interoperability with their technology, it will accelerate the mass adoption of DivX mobile, once the phone companies finally warm to the technology.

Of all the questions that the analysts raised, I was most surprised by the confusion surrounding their Yahoo! agreement. Over the quarter, DivX reported that they had replaced Google with Yahoo!, as their advertising partner on DivX software downloads. While I can understand why people might be concerned by the end of the Google agreement, I also believe that the move makes perfect sense for Yahoo! and DivX.

Over the last several years, DivX has bundled the Google toolbar as an option, when you download or update their software. Even before, DivX went public, there were concerns that Google’s toolbar would be less effective, as market saturation set in. As more and more people download the Google toolbar, it becomes increasingly harder to find new customers to cross sell to.

From DivX’s perspective, I have to believe that they’ve been experiencing diminishing returns on this revenue stream. By partnering with Yahoo!, they are not only able to cross sell a less saturated product, but Yahoo! will also get a chance to directly steal current Google toolbar customers, every time, someone updates their DivX software. By swapping out advertisers, DivX is able to help keep this revenue stream fresh and relevant, despite their success with the Google software.

When it comes to Stage6, DivX was understandably tight lipped about their progress towards spinning off the asset. For negotiation reasons, they didn’t want to discuss the valuation or the format of the spinoff, but did give some background metrics on the development of the video sharing service.

During the quarter, DivX spent $4.0 million on Stage6. Of this amount, $2.6 million was directly related to bandwidth costs. While this expense was considerably higher then a year ago, it was still less then the $4.5 million that DivX had previously predicted it would spend. DivX CFO Dan Halvorson pointed to infrastructure constraints as a reason for the reduction in spending.

“As we mentioned in the past, the site experienced huge trajectory in 2007, moving from 4 million “uniques” in April to 10 million by July. At the end of October, Stage6 reached 11.7 million unique visitors. Our view is the number of uniques could have been higher, but were limited by infrastructure capacity. To accommodate the increased traffic we have continued to enhance the Stage6 infrastructure.”

Halvorson didn’t elaborate on how they were enhancing the infrastructure, but during the 3rd quarter, DivX did take a $2.2 million charge on their Veatros acquisition from the prior quarter.

While it’s understandable that DivX investors would be worried about the death of the DVD player, DivX’s current results suggest that they will handle this transformation just fine. Unlike the movie studios or print newspapers, DivX should see greater growth from the transition to a digital environment and can still take DVD player market share, even with the industry in decline. As the DVD format begins to disappear, DivX will eventually lose this business, but if they can transfer this licensing revenue into new product categories, they should see a dramatic increase in the demand for DivX devices.

When he was asked to rank the importance of these emerging technologies, Halvorson pointed out that the potential market for DivX devices is 10 times larger then the current DVD opportunity.

“In terms of the ranking of those opportunities, I would say, mobile, given its size obviously, is probably the largest. We are also thus seeing DTVs, HDTVs, set top boxes and gaming consoles all being interested to us over time as well. Cameras, of course, are important not just because it’s a large market, but because it is also a generic content in the DivX format, and as I mentioned, I think the addition of H.264 to our overall media language will allow us to penetrate that more quickly as well.”

The death of the DVD business will happen eventually, but whether it takes five years or twenty, DivX is in a good position to take advantage of this shift. In the near term, OEMs are recognizing the value that DivX brings to a more competitive environment and over the long run, DivX will only need to capture 10% of their market opportunity, in order to replicate their current level of success. As consumers turn away from the DVD, they will need to embrace a digital format and DivX has positioned themselves to directly benefit from this evolution in the digital market.

Disclosure – I am a shareholder of Netflix

From a strategy perspective, things were much more interesting. Lots of exciting news to digest. On the call, DivX addressed their opportunity to gain market share in their core licensing business, the future of DivX connected and how other emerging technologies could fit into that, and perhaps most importantly, the reasoning behind their plans to separate Stage6 from the larger company.

Of all the strategies discussed, there was one that surprised me the most though, DivX has made the decision to try and bury their hatchet with Hollywood, in an attempt to get DivX DRM blessed by the studios. I’m less than optimistic on management’s chances, but if they could pull it off, it would make DivX Connected a pretty compelling solution.

Trapped Between DVD and VOD

The DVD player market continues to account for the majority of DivX’s core licensing revenue. At the end of March, DivX had 32% global penetration of the DVD player market. This was up from 21% from a year earlier. During this quarter, $14.2 million of their revenue represented royalties from their OEM partners. Sony actually accounted for over 10% of their licensing revenue and I still can’t find Sony DivX DVD players in the US.

At this point, DivX has achieved 90% penetration levels in France, Spain and Russia. In the US, the percentage of DVD players that included DivX doubled over a year ago and is now at 28%. In Japan, they still only have an 11% penetration level, but this is up from 5% a year ago. Over the last year, they’ve been able to successfully renew their contracts with their top OEMs and have been able to maintain pricing levels.

By growing their market share for the DVD player market, it has allowed DivX to continue to post impressive year over year growth, even though it’s clear that the DVD has peaked. Right now is an awkward time for DivX because there are so many uncertainties as to how the VOD market will end up shaking out. There are many pundits who are worried that DivX won’t be able to replace their DVD revenue as it tapers off.

To me, this seems a little foolish and is a bit like being afraid of the boogie man. The DVD market will not disappear overnight, it will live longer than the VCR survived. As people migrate to digital TV, DivX is in an excellent position to benefit from that. If their OEM partners see that there is no more demand for DVD players, it will make DivX certification an even greater necessity for them.

The transition to VOD will eventually happen on a mass scale, but it will still take years before the next generation of TV gadgets hits the mainstream.

When Greenhall was asked about how long he thought it would be, before the public started to move from DVD players to connected devices, he told analysts that because DivX’s ecosystem was so dependent on their OEM partners, that it was hard to forecast the transition, but that when it happens, the revenue will come quickly because their partners produce goods for the mass markets.

Emerging Technologies Will Open New Doors

Part of what makes DivX such a question mark, is the sheer size of their addressable market. They’ve established a nice business in the DVD market, but now want to expand DivX to a whole host of devices. During the earnings presentation, Hell listed the following technologies as a few of the markets that are on their hit list; Mobile devices, set top boxes, digital still cameras, game consoles, portable media players and digital televisions.

Of these potential markets, the cell phones have the most potential. Over this quarter, Samsung announced their second DivX enabled phone and will be selling the phone in the Chinese market. Since their first Samsung phone announcement, DivX has seen a lot of interest in working with other cell phone manufacturers.

Their OEM partners are excited about the technology and are coming to them for access. There will be more models announced in the future and while they didn’t give a time line, management seemed optimistic that the announcements would come soon.

On the set top front, during the quarter Divx announed that both St Microelectronics and NXP were both developing chips for a DivX set top box solution.

The box will allow you to plug in an external hard and play DivX files directly on your TV. This helps to solve the problem of getting DivX content to the living room, but still doesn’t help to add to the DivX content eco-sphere. You can’t take the TV off the box, but at least you can bring DivX to it. Hell also said that there was one more set top chip deal that hasn’t been announced.

Hell also included DivX HD as part of the emerging category. HDTV has been one of the hottest growth areas in consumer electronics. Users are starting to revolt. People love the DivX HD teasers on the stage6 website and from (cough) “others sources” on the innerwebs, but they can’t get it to the TV without some kind of a media center.

DivX wants to license their HD technology on top of HD-DVD and Blu-Ray players, but I think that they’d have a much better shot at convincing their OEM partners to sell a low priced DVD player with “DivX HD.” included. With as much as the studios are charging for the next gen players, a box with DivX HD certification and a dirt cheap price point, would appeal to consumers who know better than to try and pick a side in a Hollywood format war.

DivX Connected: Bringing Partners Into The DivX Community

DivX has talked quite a bit about their Connected initiative, but they’ve always left things a little sketchy on the details. Is it a box, is it not a box? Who could really tell, but after launching a prototype of their connected solution for beta testing, the company is now starting to open up on the details. DivX Connected can be a lot of things, but they see it being a similar experience to Apple TV, except minus the high cost and the restrictions on content.

The whole concept is really a lot larger than the prototype box. It’s about bringing a diverse set of partners together, in order to create a seamless experience for consumers. Hell describe their efforts on the program during the call. “We are engaged in a large cross section of partners to implement DivX connected on existing devices. From connected DVD players and digital televisions, essentially any devices that has connectivity and DivX playback ability.”

This philosophy of openness extends even beyond the hardware devices and includes the companies that are trying to sell internet video, as well as the content producers themselves.

“going forward we will focus on a broad range of content solutions through a powered by DivX model, working with a variety of partners to deliver content. In this model Stage6 becomes one of many partners using our technology. To make this happen we are doing two things, First we are increasing our focus on premium content and re-engaging in discussions with major content providers who want to take advantage of our significant footprint. Secondly, we’re building out our existing video on demand product platform so that we can offer out of the box scalable solutions to any distributor of digital content from online retailers to network operators.”

This is a big shift for DivX and one that could have important ramifications. From early on, DivX has bumped heads with the studio fat cats. In the past, DivX has relied on their users to distribute their codec through the P2P networks, but now that the studios are beginning to warm to internet delivery, DivX is seizing on this opportunity, in an attempt to beef up the content that they can offer their own consumers.

Right now, businesses don’t pick their codecs based on quality, they use the ones that the studios tell them they are allowed to use. People like to complain about internet video services not supporting Apple, but that is because Apple refuses to license their codec to anyone. DivX wants to go the other route to try and work with everyone, but until DivX DRM can get Hollywood’s blessing, they’ll be frozen out of the mainstream market.

I’m skeptical that the studios will be particularly eager to work with DivX, but if they could pull it off, it would open plenty of doors for them and would certainly be a game changer for the company. On the call, Hell said that they are trying to go after this opportunity in two ways.

“First we’re going to be focusing on the studios themselves and other providers of premium content to get adoption and format approval from them. In addition, we’ll also be working with other content distributors, folks like Amazon, Netflix, Movielink, etc. so that we can enable their platforms and again we’re moving into a role here where we don’t want to be a storefront, in terms of the DivX Corp business. We’re looking to power other people’s platform.”

It’d be easy for DivX to try and sell content themselves (in fact that’s part of what Stage6 is about), but this is a low margin business and DivX is better off letting others fight over the content. By charging for access, it leaves room for much healthier profit margins. It also gives them a greater exposure to consumers, than anything that they could accomplish independently.

Right now, Apple wants to lock everyone else out of the market, but this is why AppleTV is such a weak platform. Not only do you pay for it, but then you have to buy only their content. DivX wants to see a world where they can bring Blockbuster and Netflix together and let consumers decide which service they want to use. By maintaining their commitment to keeping their platform open, it improves their competitive position over Apple and Microsoft, but none of that matters, until Hollywood agrees to let companies distribute video content in DivX’s format.

A Start-Up Trapped Beneath The Microscope Of Public Scrutiny

Since the launch of Stage6, it’s been an unbelievable hit. The growth has shown no signs of slowing. Since it’s launch, it’s help to push 35 million DivX web player downloads, but hasn’t generated much in the way of direct revenues. For now Greenhall wants to build up the community, before trying to figure out how to make money off of it.

“Like many sites in a similar stage of their life cycle, we’re not actively trying to monetize this user base, yet. We believe that building a community first will enable us to explore a number of different revenue models in the future, but building the community absolutely comes first.”

Since the the site’s launch, the community has responded enthusiastically to the video sharing portal and what started out as a reasonable $1 million marketing expense during the 1st quarter, has now swelled to a $2.4 million bill for this quarter (of which 70% is bandwidth.) Next quarter DivX estimates that they’ll need to spend $4.5 million and another $5.4 million in the fourth quarter. Stage 6 has about 20 -30 DivX employees that work on the site.

With the traffic and the costs starting to add up, it’s no wonder that the company wants to raise outside funds and operate Stage6 as a separate entity. During the call, their CFO, Dan Halvorson gave the reasoning behind the plan,

“Most businesses, at the same point in their life cycle as Stage6, simply wouldn’t be public or part of a public entity. They need to make investments that don’t have immediate tangible ROI or have too strong an impact on a company’s balance sheet to justify. We believe strongly that Stage6 has built a foundation that not merely be sustained, but rather amplified. As such, our board and management, thought it would be best to value our alternatives and one viable option is that Stage6 would be separated out and run as a private company.”

DivX said tat they’d like to finish the break up as close to the end of the year as possible. I’m not sure if this is for tax reasons or strategic purposes, but in the meantime, they are estimating that they’ll need to put another $10 million into the site. Greenhall wasn’t sure, on how they’d end up valuing Stage6, but was open to possibilities and wanted to do what’s best for DivX shareholders.

They may look for a private equity deal or an institutional investment, but they want to keep their options open. After announcing their intent to separate the the two companies, they’ve already received inquiries from financial and “strategic partners” on making an investment.

Overall, DivX didn’t blow anyone’s socks off this quarter, but they did continue to show that their business is healthy and that their business model is valid. They also continued to demonstrate their commitment toward investing in their growth. The extra R&D may end up bothering some shareholders in the short run, but once they break the two companies apart, they’ll have two businesses exposed to the white hot internet video sector, instead of a house divided.

Disclosure: I own stock in Netflix