Jack McKay sends: DivX, Inc. (DIVX) is a digital media company that develops the DivX codec and related software. DivX licenses its technology to manufacturers of DVD players and other media devices. DivX shares were slammed by investors after the company disappointed with earnings guidance in their fourth quarter 2007 conference call. However, DivX’s revenue growth remains strong and the company has over $140 million in cash. With a market cap of only $260 million, DivX’s punishment has been overkill.

DivX Technology
The DivX codec (codec = compression, decompression) has become popular because of the codec’s ability to compress lengthy, high resolution video into small file sizes while not significantly degrading visual quality. From a technical standpoint, the DivX codec is an implementation of the lossy MPEG-4 Part 2 (also known as MPEG-4 ASP) compression standard. Commercial competitors in the video compression software space include Microsoft’s Windows Media Video (WMV), Apple’s Quicktime, and RealNetwork’s RealVideo series. In addition, the Xvid codec (DivX backwards) is a free and open source equivalent to the DivX codec (Xvid also is based on MPEG-4 Part 2), and videophiles claim that use of the Xvid codec produces slightly better video quality than use of the DivX codec.

H.264 Standard is the Future
An alternative compression standard developed by the Moving Pictures Expert Group (MPEG) is named H.264 (or MPEG-4 AVC, or MPEG-4 Part 10) and has given rise to several new codecs (implementations of the standard). In general, compared with codecs based on the Part 2 standard (like the DivX codec), codecs based on the H.264 standard contain advanced features that support slightly higher video quality, but decoding is more CPU intensive. H.264 is growing in popularity, and is predicted to be the future standard for digital video.
In several years, the DivX codec may be a legacy technology. In order to preserve market share, DivX must leverage its existing popularity to succeed in the H.264 space. In 2007, realizing H.264’s expected growth trajectory and seeking to gain a foothold in the space, DivX purchased MainConcept, a private company that developed a H.264-based codec that is licensed by Adobe, Panasonic, and Sony, among others. DivX is using MainConcept’s technology to produce a DivX-branded H.264 codec.

Popularity
Encoding video with the DivX codec produces DivX video files. In particular, DivX video files are often created to minimize file size to ease file exchange using BitTorrent and peer-to-peer downloading services. As such, downloaders have amassed large libraries of videos, including movies, in the DivX, or more frequently, the Xvid format. Playback of these videos requires MPEG-4 Part 2 support. For DVD player manufacturers, support for MPEG-4 Part 2 video has usually been achieved by gaining DivX compatibility or certification. Hence, DivX has benefited from the emergence of both DivX and Xvid encoding.
Buoyed by the increasing availability and adoption of high speed internet connections, BitTorrent and peer-to-peer traffic growth continues to be tremendous. Thus, an increasing number of videos are being swapped online in file formats that increase demand for products possessing DivX certification. However, H.264 is beginning to be used more frequently for distribution of pirated video (x264 is the most popular H.264-based codec for pirated content). DivX market share could be harmed if a non-DivX H.264-based codec becomes the de facto standard for pirated distribution.

Clever Math, Flimsy Moat?
If the popularity of the DivX codecs was tied to the superiority of the technology then DivX would have a flimsy moat. However, as is seen in many other examples in the business world, technological superiority does not equal success. For DivX, this is a positive. The DivX 6 codec is not the visual quality leader, but the established base of DivX video and strong DivX brand presence hinder adoption of new codecs by video distributors. Publishers want video to be easily consumed even by non-technical users, and this means that the popularity and transparency of the codec chosen for encoding often is a larger consideration than the codec’s mathematical ingenuity. Thus, DivX’s moat is the not its technology, but rather the significant quantity of existing DivX video, as well as the DivX brand. In this way, the lack of an established video base serves as a adoption barrier for new codecs. Importantly, this means that DivX’s moat cannot be quickly undone by clever math.

High Level Trends and Factors
The discussion of codecs and video technology is best summarized with a statement of the most important high level trends and factors evident in the digital video technology industry.
First, the movement to H.264 allows for a shakeup in the landscape of the codec market. The market share of popular MPEG-4 Part 2 codecs will be eroded by the standard transition, and the market share will be absorbed by a new breed of H.264 codecs. The success of a MPEG-4 Part 2 codec will only help its author (or the company that developed the codec) preserve market share to the extent that the author or company can leverage the old codec’s popularity to create a similarly successful H.264 codec. Relevance of H.264 codecs will depend on popularity with content uploaders on peer-to-peer and BitTorrent networks and adoption (licensing) by major media content holders and distributors. DivX’s development of a popular H.264 codec is critical to the company’s future.
Second, the emergence of direct-to-consumer online video distribution will also have an effect on codec market share and popularity. Currently, codec market share (mostly) hinges on codec usage in video distributed in peer-to-peer and BitTorrent networks. While the build-out of online video distribution infrastructures and subsequent consumer acceptance will take longer than most predict, at some point in the future legal video distribution will not be an insignificant portion of total distributed video, and thus legal video distribution also threatens to determine the winners and losers of the digital video industry.
Third, codec technology has progressed to the point where improved codecs can only realize incremental video quality improvements over other codecs based on the same standard, when holding fixed the file size of the encoded video. It is unlikely that a new encoding technology will revolutionize the video industry. Also, as discussed previously, codecs that only provide an incremental improvement in video quality are subject to significant barriers to entry because of the lack of an established video base.
Finally, consumers and other third-party video industry participants have an interest in the adoption of a limited number of codecs for industry standardization and simplification. If the digital video industry consolidates like the digital audio industry (mp3 for computer audio, Dolby or DTS standards for disc audio), then a limited number of market participants stand to benefit in a big way.

Stage 6 Background
Just before DivX went public in late 2006, the company launched Stage6, a video site in the YouTube mold, in order to demonstrate the high quality video capable of the DivX codec. As such, DivX did not seriously promote the site - the company’s goal was only to provide a demonstration of the codec’s capabilities. Still, Stage6 quickly grew in popularity - by the middle of 2007, the site was receiving over 10 million page views per month. Most attributed the site’s user growth to the demand for high quality online video. However, in late 2007, the DivX board decided not to sell or spin off the asset, as had been previously planned. In response to the decision, certain DivX co-founders, who would have led the new Stage6 entity, resigned. Stage6 was shut down in February 2008. The company cited spiraling operating costs, although potential legal liability may also have been a factor.

Third Quarter Earnings Surprise
DivX released their Q3 2007 earnings on November 5, 2007. Non-GAAP profit was $6 million, while free cash flow was $9.5 million. Revenue was a record $21.9 million. In the third quarter, DivX announced their first partner for the DivX Connected platform (D-Link). DivX signed an agreement with Qualcomm to enable DivX technology to be used in Qualcomm’s video chipsets, allowing consumers to access DivX video on various mobile devices. DivX reached an agreement with Yahoo to switch their bundled toolbar advertising to the Yahoo Toolbar from the Google Toolbar. Finally, DivX expanded their relationship with LG Electronics, allowing a wide range of LG products to be DivX compatible. DivX CEO Kevin Hell summarized the quarter’s developments in the third quarter conference call:
We announced our first partner for DivX Connected to D-Link. We’ll begin shipping products shortly. We entered into a very exciting new partnership with Qualcomm. We signed a multiyear software distribution agreement with Yahoo. We increased our market share in the U.S. and global DVD player space, and finally we entered in to an expanded relationship with LG Electronics, covering digital televisions, a new mobile handsets and a multiyear contract renewal.
CEO Kevin Hell also reiterated DIVX’s focus on the emergence mobile segment, stating that the mobile market is over seven times larger than the DVD player category in terms of total unit volume. He claimed that the signing of the Qualcomm agreement, in addition to the announcement of DivX certification for the LG Prada and Samsung F500 phones, showed “further traction in the mobile space.”
In DivX’s native DVD market, the company showed stronger market penetration. In the third quarter in the U.S., DivX-compatible DVD player shipments grew to 31 percent of total DVD player shipments, which was a 53 percent increase over the same quarter in the previous year. DivX CEO Kevin Hell added “In Q3, our top 5 OEM partners, taken as a group, increased unit shipments of DivX certified products by 55 percent relative to the same period last year.”
The third quarter conference call also clarified the company’s DivX Connected initiative: “DivX Connected is an open platform that enables users to easily access content and services from the PC or the Internet on a variety of consumer electronic devices.”
Financial commentary on the conference call revealed that technology licensing revenue was $17.1 million (37 percent year over year increase). Technology licensing revenue from hardware manufacturers was roughly ten times licensing revenue from software designers. Google’s toolbar revenue accounted for the remaining $4.8 million in revenue (although the company signed an agreement to distribute the Yahoo toolbar going forward, as mentioned above). Selling, general, and administrative (SGA) expenses grew to $15.1 million (69 percent of revenue) from $6.7 million (43 percent of revenue) the same quarter the previous year. However, a large portion of the increase was attributable to Stage6 (DivX’s online video service - since shut down). Indeed, SGA costs for the core DivX business was $9.5 million or 43% of revenue, the same percentage as the previous year. Research and development costs were $4.3 million, or 20 percent of revenues.
Within several days of the third quarter earnings release, the stock jumped fifty percent to $18 per share as investors focused on DivX’s revenue beat and better than expected DVD market penetration.

Turbulent Fourth Quarter: Management Turnover and Legal Woes
In late July 2007, company co-founder Jordan Greenhall stepped down as CEO. DivX said that their Stage6 video service would be spun off, and Greenhall would lead the divestment process, and become chief executive of the new Stage6 company. However, by December 2007, the Stage6 divestment had stalled and DivX management was tight-lipped regarding the asset. Investors, having overcome the third quarter earnings euphoria, seized on Stage6’s uncertain future and DivX’s lack of strategic transparency.
Then Jordan Greenhall and other company co-founders abruptly resigned in December. The company announced on December 20, 2007 that it “expects to take additional time to consider the alternatives available to the Company related to the future of the Stage6 service.” DivX stock declined from $17 to $14 in December.
In early February, Stage6 suffered another setback. DivX’s request to declare Stage6 protected by the DMCA’s Safe Harbor provision was rejected. The decision left Stage6 vulnerable to Universal Music Group’s (UMG) already-filed lawsuit, which accused DivX of being responsible for users’ piracy of UMG content. For information related to this ruling, read this analysis.

Stage6 Shutdown
On February 25, 2008, DivX announced that Stage6 would be shut down. Even though most commentators agreed that the market was assigning a negative value to Stage6, given the legal liability and rising bandwidth costs incurred by continued operation, the market reacted negatively - shares declined from $12 to $10 over the next week.
After the shutdown of Stage6, industry analysts were able to shed light on rumored behind-the-scenes developments that contributed to the departure of company co-founders, including Jordan Greenhall, as well as the shut down of Stage6. The DivX board was rumored to have rejected a planned $27 million spin off - a deal that would have left DivX with 20 percent of the new entity, no operating cost liability, and most of Stage6’s 2008 revenues. After the board made their decision in late November, Jordan Greenhall, who would have led the new Stage6 entity, and a rumored 20-some company co-founders left the company. However, whatever alternative plans DivX had for Stage6 fell through, as DivX subsequently shut down Stage6. By making this decision, DivX escapes bandwidth costs and legal liability, but also receives no more Stage6 Yahoo Toolbar revenue (installing DivX software to watch DivX videos on Stage6 optionally installs Yahoo’s toolbar) and decreases distribution of DivX videos, which may reduce demand for DivX compatible products and diminish DivX’s market presence.
Given these tradeoffs, it’s easy to see why DivX management was not single-minded with regard to Stage6. Still, the management scuffle should be concerning to investors, as it speaks volumes about the general managerial environment at DivX.
Regardless of reason, the shutdown of Stage6 determines the future business model for DivX. From one perspective, DivX sacrifices its own DivX video platform in order to focus on enabling third party platforms. In effect, DivX is saying “If we were going to have to make this work by ourselves, it was never going to work anyway.”
In eliminating direct distribution of DivX files, DivX is relying on users to distribute and download DivX files using alternative platforms. In the short term, this mostly equates to distribution using BitTorrent and peer-to-peer technologies. However, this is much tougher for the average computer user, and DivX file distribution will be severely impacted. In the long term, DivX’s decision to shut down Stage6 may open up Internet distribution licensing opportunities with third-party content holders.
Historically, content holders have been loath to work with DivX, because of the company’s association with and reliance on distribution of copyrighted material over peer to peer networks as well as Stage6. However, it may not be a coincidence that shortly before announcing the shutdown of Stage6, DivX was able to convince Sony to allow encoding of their content in DivX format. It is DivX’s goal to convince other content holders to distribute material in DivX format. In several years, as direct-to-consumer Internet video distribution takes off (for example: you pay Sony $10 to download a movie online), DivX compression may become commonplace. If DivX compression becomes popular for online distribution by major content holders (major movie studios, especially) and this is in no small part attributable to DivX’s move to a more righteous existence (ending Stage6 piracy), then the Stage6 decision will have been well worth it.
However, the closure of Stage6 should be viewed as a negative, even if considered independent from what was learned about DivX management from the events that unfolded. DivX has more than enough cash to keep paying the Stage6 bills for a long time, so the fact that Stage6 was responsible for more costs than revenues was not material to DivX’s financial legitimacy. The potential liability from the UMG lawsuit also does not disappear by a Stage6 shutdown. Furthermore, if DivX were to keep Stage6 open, DivX video would continue to gain market share, and it is likely that major content holders would come around to the idea of distribution using DivX due to consumer demand (codec popularity). Ultimately, DivX will succeed or fail based on the popularity of its technology, and keeping Stage6 open would have helped its popularity in the long run as well as the short run.

See Why DIVX Holds Promise for Investors

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