DivX Unmuzzled, Quiet Period Ends

Over the past few months I have become increasingly obsessed with a company that I have followed for a very long time. For most people, today was like any other Monday. They went to work, talked about their weekend and couldn’t wait for it to be over, but for me I spent the day waiting in anticipation of something that I’ve been looking forward to for several months now.

For the first time ever, I had the opportunity to listen to DivX publically comment on their business plan and their execution over the last few months. In the past, I’ve followed DivX as closely as any other tech enthusiast and while I understood that the quality of their codec and the underground roots that set them apart, very little information was leaked out about this private company based in San Diego California. While many have either never heard of DivX or have no idea of what the company does, over the years, I’ve formed a fond appreciation for their technology and their inexplicable ability to survive regardless of the competitive landscape.

When I found out that the company was going public, I was very excited, in part, because I wanted to see DivX succeed, but also in part because it meant that going forward they had to a legal obligation to share intimate details about their business on a quarterly basis. While I never had the opportunity to see DivX’s roadshow prior to their going public, you can bet that I wasn’t going to miss their first conference call and in retrospect, I’m glad that I tuned in.

From a bottom line perspective, DivX realized another quarter of strong growth. During the last three months, they took in $15.4 million in revenue, which represented an 83% increase over a year ago. They also realized a mind blowing 94% gross profit margin on those revenues, which was an improvement on the 92% margins that they saw earlier this year.

After paying compensation and administrative costs, the company was left with $3.1 million in net income for the quarter. This compared to approximately $750,000 in net income from the year before. DivX also reported that over the quarter they had seen their 50th million DivX certified device shipped and promised to update investors as they hit the 60th, 70th and 80th million milestones. While the earnings growth was impressive, in the grand scheme of things, it is only a small part of the DivX story. With the conference call being the first time that DivX was allowed to unmuzzle their executives, management took advantage of the opportunity by helping to better educate less tech saavy investors on what exactly DivX is, and what their growth strategy would be going forward.

In very direct comments, DivX CEO Jordan Greenhall told investors that “for those of you who are new to the DivX story, our goal is simple, we want to make media better through the use of technology and community. We do this by providing technology that makes creating and sharing media easier. Our video technology has been downloaded hundreds of millions of times and licensed to consumer electronic companies like Samsung and Philips for inclusion on millions of devices like DVD players. We are growing our business with our partners both by adding new devices like digital cameras and by extending to new geographies. Underlying this success is a community of millions of consumers who want to share their experiences through media.”

While it’s hard to nail down DivX to a single statement, Greenhall’s statement speaks directly to DivX’s core focus and the company’s mission in their quest for growth. During the call, Greenhall stressed that the company was intent on going after growth, but only in a responsible and profitable way. With their software having now been downloaded over 180 million times and with 50 million of those downloads in the last 12 months, management was clearly eager to show investors how they plan to leverage their superior codec advantage to create opportunities for their business.

Greenhall was reluctant to give up too many details during the call, but he did say that the company is planning on growing their revenue in the fourth quarter from $15.4 million, to $15.5 – $17.5 million next quarter. He also warned that they would likely experience a decline in net earnings as a result of the higher costs associated with being a public company.

While based on the aftermarket performance, investors clearly weren’t pleased with the guidance, analysts did not seem overly concerned and focused most of their questions about DivX’s Stage 6 expansion plans.

Stage 6, in it’s purest form is a high quality version of YouTube. The site leverages the strength of the DivX codec with content from a variety of publishers. While DivX did not include any Stage 6 revenue assumptions in their guidance for the fourth quarter, it’s an important aspect to their business plan nonetheless.

While DivX was very guarded over the metrics behind their Stage 6 property, they did tell investors that Stage 6 has seen several hundreds of thousands users register for the site and that traffic was up nearly 100% over the last month. While it’s far too early to judge the success or failure of Stage 6, it’s an obvious positive sign when the company has already surpassed their own internal expectations for the growth of the site. Specifically, they pointed to higher adoption of Stage 6 in Japan, where consumers have historically had a greater exposure to DivX then in the US.

As an online video enthusiast I’ve played around quite a bit with Stage 6 and while I’m not convinced that it offers a compelling enough solution for me to give up the community of YouTube, undoubtably, the video quality is superior to YouTube. During the call, Greenhall was asked how Stage 6 was differentiating itself from YouTube and he gave a great response when he said that “the technology platform that they use, the flash platform, is extrodinarily good for delivering relatively low quality short form content for consumption on the PC, but is uniquely poorly suited for delivering long form high quality content to the living room.”

In a nut shell, this is the major advantage that DivX has over YouTube. Not only does the quality of their downloads look light years better then the low res movies that competing formats offer, but their relationships with the consumer electronic firms give consumers the ability to burn and watch those downloads on DivX certified DVD players.

This digital footprint, gives DivX a solution to the 10 foot problem that many companies are still trying to solve. This also makes it all that much more essential that DivX is able to continue to renegotiate their relatively short term contracts with CES manufactuers though and is perhaps the greatest risk to their business model as well.

Over the last several years, DivX has seen their codec become an industry standard in large part because of the underground P2P movement. Online pirates quickly realized that the DivX codec was a superior file format for downloading and distribution over the internet and they practically forced consumer electronic manufacturers to support DivX. As the industry has evolved, it’s clear that DivX faces a real challenge in becoming a viable mainstream alternative, yet without significant content, they risk becoming irrelevant to the CES manufacturers if they stray too far from their less reputable content sources.

To help solve this dilemma, the company spelled out a three prong strategy to grow their business. The first relates to CES licensing arrangements that they’ve previously negotiated, the second is to develop Stage 6 and other relationships with online video sites to help spread the adoption of their codec by consumers, and the final piece of this strategy is to pursue partnerships with the video camera manufacturers, so that consumers can start easily creating DivX content without having to convert their files.

During the call, management said that they’ve been working with two video camera manufacturers, but that there are some technical limitations to the adoption of DivX in video cameras. They also emphasized that they remain committed to the online video sites, as evidenced by their recent partnership with the photo and video sharing site, Photobucket.

While analysts clearly walked away from the call with answers to the questions that they had posed, I was still left feeling hungry by several issues that they I believe that they had failed to bring up.

In looking at the licensing opportunities over the near term, I believe that analysts failed to get clarification on two major opportunities for the company. The first is support for the PlayStation 3 and the second is support for the Xbox 360.

Playstation has already announced that they will be supporting the mpeg 4 codec, which means that both DivX and XviD files will be compatible from the get go on the PS3, yet for the life of me, I still can’t determine whether or not this means that DivX will actually receive royalties or not. While the PS3 fan sites have been abuzz over the news, I’ve heard very little from either Sony or DivX on what this support means and I would have liked to have heard them clarify whether or not DivX will in fact be earning revenue from Sony. At $1 – $2 per PS3 shipped, this revenue could be very lucrative and more importantly would be an important weapon in forcing Microsoft into a partnership that they may otherwise be hesitant to consider.

In regards to the Xbox 360, I’ve seen several rumors now, that Microsoft intends to bring DivX support to the Xbox 360. The rumors started after a blog in the Netherlands attended a video game conference where a Microsoft employee suggested that they were going to support DivX technology before the PS3 launch. While officially (and unofficially) Microsoft has said no comment, several of the Microsoft employee blogs that I read regularly have offered very cagey responses, that I can’t help but interprete as a sign that future support for the Xbox 360 is likely to be forthcoming.

Normally, I wouldn’t put all that much stock behind such rumors, but while surfing the beta version of Microsoft’s new Soapbox video sharing site, I discovered that Microsoft was allowing users to upload DivX videos to their site and it’s hard for me to believe that they would allow this without an agreement in place.

At this point, this is only speculation on my part, but I believe that Microsoft would be very foolish to allow the PS3 to move forward with DivX support and then to not offer the codec to their own customers. While the average American consumer isn’t demanding that the consumer electronic companies support DivX, the hardcore gamers certainly are. Microsoft may be reluctant to license the technology because it conflicts with their media center .wma strategy, but they would be foolish to ignore the core gamers who are demanding the ability to watch their pirated DivX movies on the Xbox 360.

To say that I was disappointed to not get an update on this development is an understatement. If a deal is in the works, I can understand why DivX would have remained silent over this issue, but considering that Sony is a little over a month away from their PS3 launch, DivX should have used their first earnings call to either highlight one of the most promising growth areas for the company or to place public pressure on Microsoft to license their technology. While most earnings calls would have gone unnoticed by the blogs, I can assure you that gamer sites would have been whipped into a frenzy, if they knew that Microsoft was either going to be issuing support for the codec or if they knew that Microsoft was refusing to license it.

While my gut tells me that we will still see DivX support before the PS3 launch, the failure of the company to bring it up and the failure of the analysts to ask about it, clearly demonstrates that Wall Street still doesn’t fully understand the true potential of DivX’s business model.

I was also disappointed that DivX didn’t better leverage their first earnings call to better explain what their plans were with the war chest that they’ve accumulated by going public. Between the $110 million in IPO proceeds, the $3.5 million in cash that they earned during the quarter and the existing stockpile of cash, DivX now has an impressive $146 million in cash.

While the company did mention that they planned on beefing up their sales force, they never addressed what their longer term plans were for the money. Certainly part of the cash will need to remain as working capital, but I would like to see DivX make better use of their IPO proceeds by either investing more heavily in research or by acquiring other companies that would compliment the core components of their business.

Overall, I walked away feeling as confident as ever that DivX has a bright future ahead of them, but I also walked away wanting quite a bit more. While I understand the need for the company to keep their trade secrets, as a public company, DivX now has a responsibility to their shareholders to provide them with clear and measurable guidance, on how they plan to grow their business. I have no doubt that DivX management is hard at work adjusting to their new public role, but in the meantime, it would have been nice to see them offer more bite then bark, now that the quiet period has ended and their executives have been unmuzzled.

Davis Freeberg is a technology enthusiast living in the Bay Area. He enjoys writing about movies, music & and the impact that digital technology is having on traditional media. You can read more of his coverage on technology at www.davisfreeberg.com.