DivX Well-Positioned To Benefit From Digital Market Evolution

The market for DVD players may be in decline, but you wouldn’t know it by looking at DivX’s (DIVX) latest quarterly results. On a day where the press was reporting a 15% drop in the number of DVD players sold, DivX surprised investors by announcing better than expected revenues, driven largely by gains in the DVD player category.

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 U.S. 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 (QCOM) to help drive DivX mobile, and they signed an important advertising agreement with Yahoo! (YHOO).

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 (AMZN) or Netflix (NFLX) 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 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 it's 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 (GOOG) 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 than 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.

Davis Freeberg

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