Jack McKay sends: DivX (DIVX) is a digital media company that develops the DivX codec and related software. DivX is a popular file format for video that is swapped using BitTorrent and peer-to-peer downloading services. The company licenses its technology to manufacturers of media devices, especially DVD player manufacturers. Over 100 Million DivX certified devices have been shipped. DivX went public in September 2006 and has traded between $8.80 and $23.76 over the past year. Shares currently trade near their all-time low, $9.38.

DivX released their Q3 2007 earnings on November 5, 2007. Within several days, the stock jumped fifty percent to $18 per share on news of better than expected sales and DVD player market penetration.

Since that time, the outlook has only gotten rosier. DivX acquired MainConcept, a company with an “award-winning implementation of H.264″ (-DivX). DivX is penetrating an increasing number of market areas by collaborating with other companies. DivX has made several important agreements with other companies that will spur inclusion on other media platforms (Sony for the PS3, Qualcomm for 3G cell phones, and AMD) as well as reached an agreement with Sony that provides for future distribution of Sony’s library of video content over the Internet in DivX form. The Xbox 360 also indirectly added support for DivX files, but details on their arrangement (if there was one) were not released.

With the acquisition of the H.264 codec used in Blu-Ray discs, DivX can do for the Blu-Ray DVD cycle what they did for the DVD cycle. As confirmation, Panasonic’s new Blu-Ray player is DivX compatible. The PS3 (the most widely owned Blu-Ray player) is also DivX compatible, per the agreement with Sony this past quarter. It’s also worth noting that the Blu-Ray vs. HD DVD competition has been resolved, and we will see total DVD player (DVD plus Blu-ray) spending increasing again, as consumers move off the sideline.

Penetration into new markets is evident by their agreements with AMD and Qualcomm. The new LG Viewty Phone is DivX compatible, and a new D-Link network set-top box supports DivX connected and will start shipping soon in the United States.

More conspicuously (and with much more drama), the company recently announced that their thriving yet cash-burning video service, Stage6, will be shut down at the end of February. First, the market cheered. Then, suddenly, it booed. The reasons behind the Stage6 shutdown have been the subject of much speculation, but it doesn’t matter too much why it happened, we just need to know what it means.

DivX management was not single-minded with regard to Stage6 and it’s easy to see why. Their choices likely would determine their business model for the significant future. Keeping Stage6 up would have forced DivX to pay rising bandwidth costs, which would have overwhelmed gains from licensing in the near future. The advantages to this would be that DivX would keep more revenue from Yahoo for toolbar downloads, and more content would be downloaded in DivX form, increasing demand for DivX products. Alternatively, shutting down Stage6 ceases the increasing drain on bandwidth costs and legal fees while allowing the company to focus entirely on technology development and licensing.

The key insight that I have not seen in any of the news and analysis stories I have read is that DivX’s choice amounts to a choice between keeping with their underground roots (and thus forgoing content provider support) and “going legit.” Content providers and distributors were never going to agree to DivX distribution until their material stopped showing up on Stage6 “illegally”. UMG even sued DivX over Stage6 piracy. We saw DivX sign the Sony distribution deal likely because they were able to convince Sony that if a user downloaded a Sony video in DivX form in the future, the video wouldn’t show up the next day on Stage6. Regardless of what happened in the Sony case, going forward it will be much easier to collaborate with other content holders. I think that focusing on signing deals with content holders (allowing distribution in DivX format) is the correct strategy because if DivX had to be responsible for the hosting of a good portion of DivX content, then the company’s profitability would be significantly restrained.

Digression: I don’t want to talk too much about what “could” have been, because no one really knows all the circumstances regarding the shut down of Stage6 or what options management had. But if DivX could have sold Stage6, it may have been the best of both worlds - they wouldn’t have had to pay the rising bandwidth costs of the site, but the material would be out there in downloadable form, increasing demand for DivX compatible DVD players, personal devices (video players, etc). I wish DivX would have waited however long it took to find a buyer, even if the terms were not very hospitable. The site should have generated interest - its Alexa rankings were increasing fast, and it ranked as the 54th site in the US and about 90th in the world). Of course, Alexa data has to be taken with a grain of salt, but it’s a good ballpark figure. Another X-factor here is that in a spin-off, DivX would still be liable for copyright infringements.

More importantly, consider the amount of good that the Stage6 experiment has done. Many people now know the strength of the DivX codec. Now, there will be significant demand for DivX distribution as pay-for-video downloading ramps up. Also, the name recognition for DivX has increased tremendously, and now many more people have their software installed.

Financials
The stock has dropped from $18 per share three months ago to the current price of $8.80. This is the lowest the company has ever traded. An uninitiated observed would think that the company must be dying, and fast!

This is far from the truth. When DivX reports Q4 2007 earnings on March 11, the company will likely announce that 2007 revenues rose 40 percent compared to 2006, and that 4Q 2007 revenues rose over 30 percent compared with 4Q 2006 revenues.

DivX’s market cap is $325 million, and cash on hand at the end of this quarter will be approximately $150 million (after accounting for the MainConcept purchase). Thus, the enterprise value is approximately $175 million (DivX has negligible debt).

During the 12 previous months, DivX has generated $22 million in cash from operations, while spending under $3 million on capital expenditures. Free Cash Flow over the past 12 months is $20 million, even while being suppressed by rising Stage6 costs (over $7 million last 12 months). Hence, their trailing enterprise value to free cash flow multiple is less than eight, and omitting paid Stage6 costs, it would be lower.

Looking forward, DivX earnings, which had been choked by Stage6, will be as good or better than their earnings before the Stage6 spending ramp began. DivX earned $7.4 million (GAAP) in Q4 2006, and the company has improved its strategic position since that time.

Share price decline and increasingly negative investor sentiment pose a sharp contradiction to DivX’s strong, rising cash flows, increasing brand awareness, and increasing market penetration (both in device licensing, and deals with content distributors). Whether one likes it or not, with Stage6 out of the equation, earnings and cash flows will rise significantly in the coming year and beyond. Even if they don’t, DivX is severely undervalued. The existence of a significant margin of safety is the underpinning for my recommendation to buy shares of DivX at current levels.

DivX management apparently agrees with me that shares are undervalued. They recently announced a $20 million stock repurchase program. They also announced an extended agreement for inclusion on all Philips media devices (including forthcoming Blu-ray players). I’m buying more.

Key Stats:
Market Cap: $325 million
Cash: $150 million (estimate)
Trailing Operating Cash Flow: $22 million
Trailing Free Cash Flow: $20 million
Trailing Earnings: $12 million (GAAP, includes over $7 million Stage6 costs)

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Disclosure: I own shares of DivX.