DivX reported their second quarter earnings yesterday and from a financial perspective, there really weren’t too many surprises. The core business remains strong, but Stage6′s growth is certainly starting to impact earnings. The company ended up beating Non-GAAP expectations by a penny, while revenue came in slightly above the $18 million, that the analysts had anticipated. The company guided toward higher revenue expectations for the 3rd quarter, but reined in analyst expectations for the fourth.

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