DivX, Inc. Q4 2008 Earnings Call Transcript

Mar.10.09 | About: DivX, Inc. (DIVX)

DivX, Inc. (DIVX) Q4 2008 Earnings Call March 9, 2009 4:30 PM ET


Karen Fisher - Vice President, Investor Relations & Compliance

Kevin C. Hell - Chief Executive Officer & Director

Dan L. Halvorson - Chief Financial Officer & Executive Vice President


John Bright – Avondale Partners

Paul Coster – J. P. Morgan

Robert Stone – Cowen & Company

James Goss – Barrington Research

Justin Cable – Global Hunter Securities


Welcome to the DivX fourth quarter and fiscal year 2008 operational and financial results conference call. Today’s conference is being recorded. At this time for opening remarks and introductions I would like to turn the conference over to Miss Karen Fisher.


I am Karen Fisher, Vice President for Investor Relations and Compliance and with me on the call today is Kevin Hell, our Chief Executive Officer and Dan Halvorson, our Executive Vice President and Chief Financial Officer. Before we get started I would like to read a brief Safe Harbor statement and then turn the call over to Kevin Hell.

Statements made during this call that are not strictly historical in nature constitute forward-looking statements. Such statements include but are not limited to the growth and earning potential of the DivX business, the Company's position in the digital media space, its confidence in its growth prospects and its plans to increase shareholder value, uncertainties contributing to the macro economic climate in 2009, the Company's focus for 2009, the Company's plans for expanding its core licensing business, expectations for DivX Connected, plans for extending the Company's content licensing partnerships and the Company's anticipated financial results for its first quarter of 2009.

Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual results to be materially different from those expressed or implied by such forward-looking statements. These factors include but are not limited to the risk that customer use of DivX technology may not grow as anticipated, the risk that anticipated market opportunities may not materialize at expected levels or at all, uncertainties related to the current macro economic condition in 2009, the risk that the Company's activities may not result in the growth of profitable revenue, the risk that the Company's financial performance for its first quarter of 2009 may not meet expectations and other factors discussed in the risk factor section of the Company's most recent reports filed with the Securities and Exchange Commission.

All forward-looking statements are qualified in their entirety by this cautionary statement. DivX is providing this information as of the date of this call and does not undertake any obligation to update any forward-looking statements discussed in this call as a result of new information, future events or otherwise other than as required under applicable securities laws.

For those of you not able to stay on the call today an audio webcast will be archived on our website under Events and Presentations. At this time I’d like to turn the call over to Kevin Hell.

Kevin C. Hell

First let me start by putting the past year in perspective. We just completed a year in which we grew revenue by 11% year-over-year in a tough economy, delivered $19.7 million of non-GAAP net income, posted $0.59 in non-GAAP earnings per share and delivered 34% EBITDA margins. By any business measure 2008 was a solid year for DivX.

Given the many challenges that all of us are facing in the current global economic crisis including a severely depressed market for consumer electronics and for us specifically the loss of Yahoo late in the year I am pleased with our continued strong profitability and cash generation and the greater flexibility it provides during this period of uncertainty.

What’s more during this same profitable period we continued to develop the products and markets that we believe will enable future growth including new device categories such as mobile and digital televisions and an entirely new high definition H.264 hardware and software offering. For me these achievements are notable and I’d like to take a moment to thank and commend our DivX employees for a job very well done in 2008.

As we move into 2009 our overall business remains strong especially our core high margin licensing business which drives our profitability and fuels our strategic investments. The economic headwinds will likely continue, however our overall mission of enabling consumers to enjoy high quality digital video on any device remains relevant and attainable.

Given our strong strategic position and financial condition we feel we are uniquely positioned to deliver on the full promise of digital media where consumers have the freedom to enjoy high quality digital content from any service on any device from any brand.

We possess a unique set of strategic assets including an install base of millions of devices, a massive community of DivX users, a strong global brand, deep relationships with major consumer electronics companies and Hollywood studios and an end to end digital media solution that spans across content, devices and software.

We are a compelling alternative to Apple and Microsoft and we continue to believe strongly in our vision for the future of digital media. With that let me turn to a summary of Q4 and the full year 2008 beginning with our licensing business and then talk about our primary goals for 2009. DVD licensing continues to be our biggest revenue source today and will generate the lion’s share of our licensing revenue in 2009 despite the softening market conditions.

As you predicted last quarter consumer spending has experienced a significant drop off in retail and online sales and there is a definite shift toward less expensive, lower end DVD players with fewer features. Even with this market shift our worldwide penetration held relatively steady at 42% for the 12 months ending September 30th.

However the primary focus for our licensing business last year was to expand our global penetration beyond DVD players into a variety of emerging product categories that consumers are using to enjoy digital video including mobile devices and high definition devices such as Blu-Ray, digital televisions, gaming consoles and set top boxes.

At the start of 2008 our penetration into these new categories was nascent with a handful of devices and IC partners. As you begin 2009 these categories are materializing into meaningful markets for DivX. We have given you a roadmap in the past to help you understand how you can track our progress in these new categories particularly as they moved from initial fee designs to early low volume devices and finally into multiple mass market devices.

I’m pleased to report that we’ve made good progress in moving each of our target product categories through this adoption cycle. Those who saw us at CES got a good glimpse at many of the new devices where DivX is a built in feature. For example Panasonic, Phillips, LG and Samsung all feature DivX Certified digital televisions at CES demonstrating our strong momentum in this category.

Our partners continue to see DivX as a differentiating feature and are aggressively adding DivX to their video products. As a result we expect partner shipments to ramp in these categories and are poised to build on these beachheads moving through 2009. Let’s start with the Blu-Ray category where we are seeing strong momentum.

Today you can find DivX Certified Blu-Ray players from Panasonic, Phillips, JVC, Pioneer, Marantz, Denon, LG and Samsung. We have now certified over 100 Blu-Ray models and expect this number to continue to grow rapidly. We estimate that our Blu-Ray certified partners now account for approximately half of the market for Blu-Ray stand alone DVD players and the DivX penetration in Europe to be approximately 26% for the fourth quarter.

As we had predicted many analysts are now seeing encouraging signs that the Blu-Ray market is growing faster than predicted despite the economic slowdown and we are confident that we are well positioned to benefit from this growth as Blu-Ray replaces traditional red laser DVD players. And of course we can’t overlook the Sony PlayStation 3 which accounts for the majority of Blu-Ray devices on the market today.

If included we estimate that the Sony PlayStation 3 gives us more than 65% of the total market for Blu-Ray devices. Moreover consumers continue to express high demand for DivX playback on gaming consoles including portable gaming devices. We’re also seeing strong momentum in the digital television category where we have certified over 200 models from brands like LG, Samsung, Phillips and Panasonic and over 300 additional models are in the process of being certified.

What’s more we certified over 10 chip sets from Broadcom, Mediatech, MStar and SEMplus all in Q4. The agreement with Samsung the global market leader for digital televisions represents a significant accomplishment for DivX.

In fact with the addition of Samsung our digital television partners now collectively represent 55% of the total digital television market and we expect the demand for DivX in this category to continue to grow through 2009 particularly with the availability of several DivX Certified high definition chip sets.

Over the past two quarters we have seen several IC manufacturers including Panasonic, Broadcom and Mediatech certify embedded platforms that support 1080p high definition DivX playback on a wide range of digital televisions as well as Blu-Ray players, DVD players and more.

In the mobile market we have now certified over 20 mobile handsets from Samsung and LG that are available to global consumers including the first DivX certified mobile phone for the US market the Samsung Omnia. At the Mobile World Congress in Barcelona we announced that Samsung is certifying their newest line of full touch phones.

With a higher resolution video now supported in these phones consumers can easily play DivX videos from their phone directly on their televisions using to the TV out feature. We also launched a new certification program for mobile phones called DivX Mobile Feeder. This certification program guarantees that DivX mobile phones meet certain studio requirements for content protection.

It also guarantees that mobile devices will support higher quality home theater resolution content natively thereby avoiding the need for a lengthy and complex conversion process. We believe this program will expand the value of DivX to mobile consumers and will provide an attractive and differentiated feature for mobile handset OEMs.

One of the exciting indicators of consumer adoption in the mobile segment comes from the demand we are seeing for our DivX Mobile Software Player. As we mentioned in Q3 we offer a version of this mobile player of DivX.com for devices that are not hardware certified and we’ve seen adoption increase dramatically.

Since the launch we’ve seen over 1.1 million downloads of the DivX Mobile Player with mover 300,000 downloads in Q4 alone. These metrics clearly indicate the strong consumer demand for DivX playback on mobile devices and we believe it’s a strong indicator of our long term success in this market.

Turning to the set top box category we are making steady progress in this market as well with the recent certification of an IPTV set top box from ADB. This newly certified device delivers a premium experience for digital entertainment through native playback of high quality DivX video using a standard USB port for home networks.

With the recent ADB announcement together with the flagship launch of Vestel’s European set top box we continue to gain momentum in the set top box market. Our progress in this emerging category once again illustrates our commitment to ensuring a seamless experience for high quality digital video across a broad range of consumer electronic devices.

In addition we continue to see strong interest in DivX technology from major cable and IPTV operators as they define the future requirements and specifications for their set top boxes particularly in Europe. As you can see we have clearly established a presence beyond traditional DVD players that significantly extends the DivX ecosystem.

As mentioned before it’s difficult to exactly predict how the shift to emerging products will unfold but we expect meaningful results here in 2009. One of the key enablers of future growth in the emerging product categories is our new DivX Plus HD certification program which adds support for high definite H.264 base content to the DivX experience.

H264 is an emerging standard for digital video compression particularly suited for high definition and H.264 content on the Internet continues to proliferate rapidly. Our program capitalizes on this trend by bringing reliable playback support for this content to consumer electronics devices particularly high definition devices such as Blu-Ray players, set top boxes and digital televisions.

We launched our certification program in Q4 to our partners and we are seeing good progress towards certifying the first chip sets. In close coordination with DivX Plus we also launched DivX 7 at CES this year in January which adds H.264 support to our popular software bundle including our player and converter. DivX 7 represents a significant new release of our software and the initial reviews by our community and the technology press have been extremely positive.

During the first 50 days software downloads were up 62% and direct sales to consumers were up 41% as compared to the same launch period for DivX 6 our previous major release. Our H.264 initiatives including DivX 7 and DivX Plus HD Certification are critically important to the future of DivX.

As we’ve discussed in the past these initiatives represent a strong step forward toward offering a single unified consumer digital media experience where underlying formats and technologies become transparent to the user. By becoming the consumer face of H.264 on both software and consumer electronics DivX has the potential to become the de facto standard for high definition digital video from the Internet in much the same way that has become synonymous with DVD quality video with MPEG 4.

We are also seeing consistent growth in the broader usage of our software among the DivX community. We averaged over 130 million player and web player sessions per month for the first two months of 2009 which compares with 97 million player and web player sessions per month for the fourth quarter of 2008 an increase of 44%.

These statistics clearly demonstrate the increasing size and engagement of the DivX community and underscore the strong value proposition of DivX software to both consumers and content publishers. Now let me turn to an update on DivX Connected and our premium content initiatives. Let’s start with our DivX Connected initiative.

Connected Solutions as a general category have been slow to materialize over the past several years for a variety of reasons. That said a number of streaming solutions have emerged recently that are getting some initial traction. These solutions are generally linked to a specific service like Netflix or a specific device such as Sony’s Bravia solution or in some cases to both a specific proprietary service and device such as Apple TV or Voodoo.

By contrast our strategy for connected devices is to be neutral platform for both the device makers and service providers. For example we do not expect to compete with Netflix or Panasonic’s [Veracast]. Instead we hope to support a Netflix service or an Amazon service on a Panasonic or Samsung or LG device.

We believe there is power in this neutral approach. It is more open and scales more broadly but it is of course more challenging to coordinate initially since we must work through multiple partners to enable the solution. Our first generation solution DivX Connected is available in the market and has received strong user reviews but it represents just the first step for us.

Based on the feedback we have received from our CE partners and potential service partners we are hard at work on extending and evolving our DivX Connected platform to support streaming content and services from the Internet directly without the need for a PC.

Leveraging our strong relationships with our CE partners and our deep understanding of embedded technologies we believe we are in a unique position to build a compelling neutral and open solution which will support any streaming content source from the Internet on any device from any manufacturer.

While there are flash based video from for example MTV.com or YouTube or a premium video from cinema now our solution is being designed to enable instant access to an unlimited number of virtual content channels from the Internet on connected devices such as connected Blu-Ray players, digital televisions, set top boxes and even mobile phones.

Although it’s unclear when and how Internet distribution of this sort will emerge for today’s broadcast television and other forms of content we think it is inevitable and will bring about a significant and disruptive transformation to today’s media distribution models. It’s the next big evolutionary step for media and we believe we are in a unique position to address it. To wrap up let me address premium Hollywood content

We continue to be committed to our content distribution strategy and believe that supporting all types of content from premium Hollywood major releases to user generated and personal content is key to the growth of the DivX ecosystem. We made solid progress in 2008 through our format approval agreements with Sony and Warner Brothers and our relationship with Cinema Now and intend to build on these partnerships going forward by executing on our powered by strategy.

Although the additional distribution market is in its early stages and we do not expect significant short term revenue from premium content we believe the launch of premium content services all supporting the DivX format will provide significant fuel for our consumer electronics business and will significantly increase DivX’s brand recognition and consumer adoption in certain markets particularly the US.

We are working hard to support the launch of eTailers that will distribute content from Sony, Warner Brothers and others in the DivX format. Since we represent a new platform both to content owners and retail sites we have several hurdles to navigate but we continue to make meaningful progress and remain optimistic on our overall strategy.

So to summarize 2008 we made significant progress in all our key areas of focus from expanding our footprint in key device categories to establishing relationships with major premium content providers and eTailers to developing and releasing new cutting edge video software and tools embraced by our global community of users.

Given the strength of our brand and our profitable business model I am confident we are well positioned to deliver on our vision even in difficult economic times. Now as we move into 2009 let me briefly review our key business objectives with you. First we will continue to aggressively expand into new device categories with more partners and more certified devices.

Second we will build on the successful launch of our new DivX 7 H.264 software. We will also continue to roll out our DivX Plus HD Certification program also supporting H.264. Third we will continue to work on the launch of premium content services with tier one content partners leveraging our studio relationships. Fourth we will continue to drive our DivX Connected initiative and build on our initial product offering.

Next we will expand our worldwide commercial licensing business in collaboration with our European subsidiary MainConcept. Finally we will sign a new software distribution partner to replace Yahoo. I know many of you are eager to get an update on finding a replacement and I can assure that we are making material progress here.

In closing DivX remains keenly focused on the technologies and products that will drive long term success. Our progress to date has been the result of creating value for our broad and diverse community of global constituents including consumers, content creators, software vendors and consumer hardware device manufacturers.

While the current macro economic environment presents challenges for everyone given our strong financial position we have the unique ability to continue investing in areas that will position DivX for future growth and market leadership as conditions improve.

With our industry wide presence, global brand and strong business model we remain confident in our ability to realize our vision of enabling consumers to enjoy high quality video from the Internet on any device and in any location. Before I turn the call over to Dan I’d like to welcome Alex Vieux the publisher and CEO of Red Herring Magazine to the DivX Board of Directors.

Alex’s extensive and global experience on public boards combined with his background as the CEO of one of the leading technology publications will provide valuable perspectives to our already diverse Board. With that let me hand the call to Dan to discuss our financial results in more detail.

Dan L. Halvorson

On today’s call I will provide a summary review of our fourth quarter and year end to help provide some color 2009. I would like to begin by laying out the key principles that drive our operating decisions both in the current economic environment and also important in more stable times. I believe that these principles have been central our successful execution over the past few quarters and will continue to be the foundation of our strategy in the years to come.

We expect the challenges we are all facing to continue until the economy improves highlighting the importance of this approach as we’ve been forced to respond to our business to the rapidly shifting market which we serve. First by maintaining our historically high gross margins we create a meaningful operating margin to develop the products and markets ensuring future growth.

Second we will manage expenses tightly at all times not just when times are tough. This enables us to adjust our business model quickly when necessary so that we can continue to strategically invest resources and dollars into initiatives that will generate the best long term returns for the business.

Third we focus a lot of attention on consistently building strength in our balance sheet which ultimately provides us with the best operational leverage and flexibility to make smart decisions and target he largest market opportunities with the best returns. I believe that our fourth quarter results are a great reflection of how these principles have built the foundation for our success.

As you know in the middle of the quarter we lost a major customer, Yahoo. Our quarterly results include about six weeks’ revenue from Yahoo or $2.6 million. Still even when faced with an unexpected mid quarter event like this we delivered 95% gross margins, managed expenses to deliver EBITDA of $7.9 million or 34% of revenue and increased our cash investment balance by $5 million from the quarter of the third period.

It is results like this that give me confidence that even as we navigate a very uncertain economy with consumer electronics spending under pressure DivX will continue to succeed by sticking to our core principles. With that let me go into the details for the quarter. Revenue for the fourth quarter was $23.2 million a slight decrease over the fourth quarter of last year.

Our GAAP EPS for the quarter was $0.08 per diluted share and our GAAP profit was $2.6 million. Non-GAAP EPS was $0.14 per diluted share and we generated non-GAAP profit of $4.6 million.

Excluded from the non-GAAP EPS and net income are the following, one share based compensation net of taxes of $0.04 per diluted share, two the schedule amortization of purchased intangible assets related to MainConcept net of taxes of $0.01 per diluted share and three a $0.01 per diluted share asset impairment charge which is attributable to write off of certain intangible assets related to the MainConcept acquisition.

Breaking the quarter down further technology licensing revenue for this quarter increased 12% over the same quarter last year to $20.5 million. Technology licensing to hardware manufacturing partners was approximately 70% of total revenues for the quarter. Technology licensing for software which includes the MainConcept revenue was 19% of total revenues for the quarter.

We had one 10% licensing customer that is LG in the quarter who accounted for approximately 13% of revenue. Media and distribution revenue for the quarter declined 57% from the fourth quarter of last year to $2.6 million or 11% of total revenue. This decline is specifically related to not having Yahoo for the final six weeks of the quarter. Revenue from Yahoo Toolbar agreement accounted for approximately 11% of Q4 revenue.

The mix across geographies for the quarter was 67% Asia Pacific, 20% for the Americas and 13% for EMEA. Remember that this geographic revenue mix represents the locations of our licensees who manufacture products not the location into which our products are shipped. Gross margins remain strong at 95% consistent with last quarter.

Looking at the full year revenue in 2008 was $93.9 million compared to $84.9 million in 2007. Our GAAP EPS for the year was $0.30 per diluted share as compared to 2007 EPS of $0.26 per diluted share. Non-GAAP EPS for 2008 was $0.59 per diluted share compared to $0.57 per diluted share for 2007.

Now let me focus my comments on expenses. I will talk about our expenses consistent with the non-GAAP breakout provided in the supplemental earnings table in our press release today detailing share based compensation and other items discussed earlier. Please remember that we closed the MainConcept acquisition in the fourth quarter of 2007.

Consequently our year-over-year comparisons for all of 2008 are impacted by the addition of the MainConcept expenses. Total operating expenses for the fourth of $18.1 million included core operating expenses of $14.8 million or approximately 64% of total revenue, $2.2 million of share based compensation, the scheduled amortization of purchased intangible assets related to MainConcept of $476,000 and an asset impairment charge of $630,000 which is attributable to the write off of certain intangibles at MainConcept.

DivX Q4 operating income excluding share based compensation, the amortization of intangible assets and an asset impairment charge was $7.2 million or 31% of revenue. Including share based compensation, amortization expense and the asset impairment charge we had GAAP operating income of $3.9 million.

Our interest income for the quarter was approximately $800,000 which compares to interest income of approximately $1.9 million during the fourth quarter of last year. The decrease in interest income is primarily due to dramatically lower interest rates and lower average cash balance.

The lower average cash balance is primarily a result of one, cash used to acquisition MainConcept in November of 2007 and two, cash used by DivX to repurchase shares of our common stock during the first and second quarters of this year. For the fourth quarter share based compensation expense net of taxes was approximately $1.3 million or $0.04 per diluted share.

We ended the year with total cash, short and long term investments of approximately $135 million or $4.17 per share. This includes $18 million of auction rate securities which I’ve discussed before. Cash provided by operating activities was approximately $7.6 million during the fourth quarter and more than $23 million for the year.

To put that in perspective while operating in a very difficult economic environment we generated cash from operations equal to approximately 25% of our revenue. We generated $7.6 million from operations during the fourth quarter and key working capital changes which includes a $400,000 decrease in AR balances offset by a decrease of our deferred revenues of approximately $2.2 million.

We did not incur any significant capital expenditures during the quarter. Our GAAP blended tax rate for the quarter was approximately 41.5% which was slightly higher than the overall tax rate for 2008 which was approximately 40%. Our Q4 non-GAAP tax rate was also approximately 40%. Now let me provide a brief update on our auction rate security investments because some of you have expressed an interest.

We have a PAR value of approximately $19 million in auction rate securities. We believe our auction rate portfolio is of high quality. All but one of our holdings carries a AAA credit rating and none of our holdings has a history of default. In addition 100% of these auction rate securities are collateralized by the Federal Educational Lending Program.

Now during the fourth quarter we entered into a commitment with one of our investment firms for the redemption of approximately $14.5 million of these investments at PAR commencing no later than June of 2010. This commitment resulted in an increase of $2.3 million to our long term investment balance offset by a reduction in our unrealized losses which we recorded in 2008.

The remaining balance of the $19 million auction rate securities of $4.5 million has an estimated temporary valuation allowance of approximately $700,000 as of December 31st. This is based on several factors including continued lack of liquidity in the auction market, fluctuations in the interest rate assumptions used to calculate the value of these investments.

We believe this decline in value is temporary based partly on our ability and intent to hold these investments until liquidity returns to the market. Switching to headcount, headcount was approximately 310 as of December 31st which compares to just over 380 at the beginning of the year. Now let me address guidance.

With the release of DivX 7 and DivX Plus Certification Program we continue to be positive on the future growth of the DivX business model as Kevin alluded to in his comments. However as we’ve mentioned several times the outlook for the broad macro economy and more specifically consumer spending is highly uncertain.

Additionally we will be facing tough year-over-year comparisons every quarter from the loss of revenue from Yahoo. Given the decrease in visibility we have decided to provide only one quarter of guidance. We are projecting revenue in the first quarter to range between $17.5 million and $18.5 million with non-GAAP EPS in the range of $0.01 to $0.03 per diluted share.

Technology and licensing revenue will make up substantially all of the revenue in the first quarter. No toolbar revenue is assumed in the first quarter. Gross margins will decline in the first quarter to approximately 85% primarily due to the impact of our H.264 license and costs associated with the release of the DivX 7 software.

We expect licensees for the H.264 license to be approximately $5.7 million for all of fiscal 2009. This license fee will be amortized evenly throughout 2009 to our cost of sales line by approximately $1.4 million per quarter and we view these costs as a sound decision to invest in our ecosystem.

As Kevin indicated earlier with the release of DivX 7 we will drive adoption of DivX Plus HD profiles throughout the community adoption of the DivX encoding tools.

GAAP EPS for the first quarter is expected to be in the range of a loss of $0.02 to $0.04 per diluted share which includes one, the anticipated non-cash share based compensation of approximately $2.3 million or $0.04 per diluted share net of taxes, two the scheduled amortization of purchased assets related debts our acquisition of MainConcept of approximately $550,000 or $0.01 per diluted share net of taxes.

Our weighted average shares outstanding for the first quarter are expected to be approximately 33 million. With that we’ll turn the call over for questions.

Question-And-Answer Session


(Operator Instructions) We’ll go first to John Bright – Avondale Partners.

John Bright – Avondale Partners

Kevin, it sounds like Blu-Ray is going to drive the day for 2009. Correct me if I’m wrong there, but then on the long term strategy is distribution still going to be the most important key to connecting the dots on the long term value particularly where your premium Hollywood content is concerned?

Kevin C. Hell

John, on your first point relative to Blu-Ray, Blu-Ray is emerging rapidly for DivX. We’re getting into a number of devices. As we’ve mentioned we’re in over 100 devices today, approximately 117 to be specific from OEMs like LG, Samsung, JVC, Pioneer, etc. so a very long list of partners and we’re making good progress.

However Blu-Ray is still predicted to be even in 2009 11% of the total market so it’s still a relatively small share of the total optical DVD market in total. That was 4% in 2008 moving to 11% in 2009. It definitely helps in terms of continued growth to offset what’s happening in broader DVD markets but it’s still a relatively small share of the total market.

Now we are seeing as I mentioned before strong growth in DTV and mobile and those two categories will also drive real revenue here in 2009 as well.

John Bright – Avondale Partners

What was the amount of revenue from those two categories in the fourth quarter?

Kevin C. Hell

We have not broken it out yet in terms of the specific revenue at this point in time.

John Bright – Avondale Partners

As far as the connect the dots question?

Kevin C. Hell

In terms of the broader strategy our business model has really relied on looking at the content that’s on the Internet today and that continues to be a large driver of our progress across emerging product categories. That said we do believe that premium Hollywood content available from various eTailers will really put the turbo jets onto our licensing business so we’re actively working on that and we’re making a lot of progress recently.

We’re very optimistic about our ability to get there and we think that’s really going to put the licensing business into overdrive.

John Bright – Avondale Partners

Is distribution then the key you think that still remaining? You’ve gotten a number of studios already. If not distribution, what do you think are the pieces of the pie that you don’t have?

Kevin C. Hell

The pieces of the pie are getting the eTailers launched so we have sites that are selling content in the DivX format and adding additional studios as well but we also of course have our H.264 initiative and DivX Plus. We have the arrival of various HD capable chips that will drive the broader licensing business and we continue to make headway in the connective space as well. So all those things are key growth initiatives for us going forward.

John Bright – Avondale Partners

Shifting to the toolbar discussion maybe you can expand upon how those discussions are going, what the reception has been thus far and whether you think this might be something that occurs in the first half, second half or your general thoughts on the toolbar discussion?

Kevin C. Hell

We are making very good progress on that front. We have talked to a number of interested parties and we continue to believe that our distribution has real value out there in the marketplace. In terms of specific timing, we want to hold off on that until we’re able to talk more specifically about where we are but we’re feeling very, very good about our progress and should have something there relatively shortly.

John Bright – Avondale Partners

Dan, for you on the cost structure side, Q4 you said I think around 310 in headcount. What does that compare to at the end of the third quarter, one? Two, how do you feel about that cost structure as you’re going into 2009?

Dan L. Halvorson

If you compare in the prepared comments a year ago it was around 380. Over the quarter we’re down from around 330. I’ll tell you that the cost structure is fine. We actually have some specific hires that we’re looking for and we’ve talked about this before. Obviously we’re an international company in San Diego, [inaudible] Germany, [inaudible] Russia and there’s open reqs for each geography.

I think the cost structure is fine. It’s the things that we talked about before, the levers that headcount obviously for a business like this is a big point. But I think we’ve got it right sized now as we look at it. Kevin mentioned CES and some of you who were there, a lot of people pulled back but DivX also pulled back.

We still went but not only headcount but the other ways that we’re controlling our costs really our T&E budget. In short I think the cost structure is one we talked about the H.264 investment if you will and the impact on cost of goods as we go forward but we think that’s an investment.

As you move into the operating expenses there’s certain things we can do around our public company costs, some of those are just fixed, they’re not of elastic and as we move into the areas that Kevin talked about the 2.2 just went over, we do need all hands on deck. As far as headcount I think it’s at the right level.

There’s going to be some specific hires and those types of things. We’re feeling pretty good about the cost structure.


We’ll go next to Paul Coster – JP Morgan.

Paul Coster – JP Morgan

Dan, can you just repeat please how we should be modeling out gross margins moving forward and how long this amortization lasts for? Perhaps just explain what it is again?

Dan L. Halvorson

Our historical 95% gross margins are going to be impacted and just like you’ve seen before in the past. With the launch of DivX 7 or H.264 we have the H.264 license, those fees which are public that’s why we’re sharing with you what it is, it’s over $5 million for the fees and you could pay per unit but we’ve had such high downloads basically if you will.

The H.264 is over $5 million which will be an annual fee so as I said in the prepared remarks that’s about $1.4 million per quarter and that impacts our margins somewhere in the 8% to 10% range. The 95% comes down into an 85% over the course of 2009. Of course that’s on revenues as we face the headwinds of revenues.

Of course if revenues were on the right trajectory notwithstanding the headwinds I think we could absorb that extra $5 million and we will absorb it but that’s a way to model the kind of clinical, mechanical but the bigger issue in concern, Paul, is that Kevin and I make sure we articulate the benefits which I think we have, the benefits around H.264.

You saw the demo out at CES as we move forward. But the very clinical answer is about $1.4 million per quarter impact on gross margins.

Paul Coster – JP Morgan

And [inaudible]?

Dan L. Halvorson

There might be other things along the way that may change, but as we think about 2009 it’s in 2009, that’s right.

Kevin C. Hell

It’s really related to the distribution of our software. From our perspective getting the H.264 software out there broadly is of high strategic value. It drives adoption and usage and content creation which in turn drives demand for the devices that can play it back. H.264, as we talked about in the past is really the next generation compression for video and a lot of it chipsets are going in that direction and we’re looking to be the standard for H.264 as we were for MPEG-4. So, to make that happen we believe it’s the right investment now to drive the market, to make that kind of investment and to give away the software for free from our website.

Paul Coster – J. P. Morgan

Now, it’s going to be a fixed amount, it’s not volume dependent and so as you scale up as a percentage of revenue it reduces, is that a correct assumption?

Kevin Hell

That’s right it’s a cap and we expect to exceed that cap. That cap will come in to play because of our distribution goes well beyond so the $5 million will stay fixed.

Paul Coster – J. P. Morgan

Is the royalty rate per Blu-Ray DVD the same as it would be for standard definition DVD?

Dan l. Halvorson

No, it’s actually higher. The H.264 is actually a higher feed, the license is actually higher.

Paul Coster – J. P. Morgan

Well, independent of H.264, just generally?

Kevin Hell

Are you asking for our DivX Plus or?

Paul Coster – J. P. Morgan

I beg your pardon I didn’t indicate I changed the subject, the Blu-Ray royalty rate, how does it compare to standard def?

Kevin Hell

We’re generally seeing slightly higher rates on Blu-Ray relative to standard definition. With DivX Plus and DivX HD certification to get a premium relative to standard DivX certification.

Paul Coster – J. P. Morgan

Kevin, in your prepared remarks you talked about DTV penetration of 55%, what was the context for that please?

Kevin Hell

That’s the presentation of if you look at all the OEMs we currently have signed as partners what percentage of the total volume of the market do they represent. It’s not our attach rate yet, we’re just putting the percentage of the OEMs that we’ve actually got a deal with so we’re up to 55% there on the DTV market. We’re making great progress there. As I mentioned, we have 250 models that have been now certified and 319 more awaiting certification so this area is growing very rapidly. We have Samsung signed up, Panasonic and several others.

Paul Coster – J. P. Morgan

These non-traditional non-SD DVD categories, what percentage of licensing revenues do you think they will represent for the full year calendar year ’09?

Dan l. Halvorson

Yes Paul, we look forward to keeping you updated on that but I’d give you some context that it’s certainly going to track – it depends on we have some things that we think are back end loaded but we think it will start triggering the SEC requirements which depending on if it’s 10% to 20% but I think it certainly will get there. To give you some color, 2008 traction ended up in the 5% range and as we move in to Q1 obviously without the toolbar our revenue is down where it should be but it will be above the 5% is our prediction even in this quarter so it’s going to continue to ramp throughout 2009.

Paul Coster – J. P. Morgan

My last question, second quarter is generally the seasonally weakest quarter, it’s probably going to be the weakest quarter this year isn’t it?

Dan l. Halvorson

I think that’s right. We’re really focused on Q1 but I think the directional – you got it both the industry storms and norms Q2 is our prediction for a couple of things it will be down. The second half is when we think more the emerging products come on so I think that’s right you’re thinking about it in the right manner.


Your next question comes from Robert Stone – Cowen & Company.

Robert Stone – Cowen & Company

Given the fact that it’s fairly late in the quarter, can you just comment on what kind of trends you’re seeing in the CE categories since the end of 2008?

Kevin Hell

Overall obviously we’re seeing softness in the CE category broadly. I think we’re seeing that in a number of consumer oriented categories. The DVD market in particular is down fairly considerably. The Blu-Ray market really I think even though it’s still emerging is a category that is really defying this trend to some degree given the fact that there was some pretty significant price discounting going on and given that the broad availability of titles and the new OEMs that are coming to market, the Blu-Ray market continues to perform fairly well. That said, we are seeing softness in mobile, we’re seeing softness in DVD and of course in the DTV categories as well.

Robert Stone – Cowen & Company

Down DVD, down some of the broader categories, Blu-Ray up it looks like backing out the Yahoo revenue you would be down what a couple of million sequentially? Is that right?

Dan l. Halvorson

Yes, that’s right. I mean if you break out the $2.6 to do an apples-to-apples, the $23 is reported, take out the $2.6 then we’re down – you can think in terms of absolute dollars but I think the other part Rob is think about a percentage and typically it goes the other way Q4 to Q1 is up so you’re thinking about it right. Yes, back out the $2.6 million for Yahoo and you’re at the $21 range down to the guidance.

Robert Stone – Cowen & Company

In the past you had some media distribution revenue other than your toolbar partners with some discs that were bundled with hardware. Did you have any non-toolbar media distribution revenue in Q4?

Dan l. Halvorson

It’s notional.

Kevin Hell

Yes, it’s small.

Robert Stone – Cowen & Company

Just one point of clarification, the H.264 license is [inaudible] this year, next year, forever? What was the duration of it being capped at 5 million?

Dan l. Halvorson

To the extent that we continue to go that way, it’s perpetual based. $5.7 million for there’s a couple of different licenses in it but basically I’d have you model $5.7 million as a go forward until we communicate otherwise.

Kevin Hell



Your next question comes from James Goss – Barrington Research.

James Goss – Barrington Research

A couple of questions, first maybe I can back in to this but if you look at the gross margin issue without the H.264 consideration the fixed variable cost issue in a declining revenue market would your gross margins have declined at least a little bit anyway?

Dan l. Halvorson

They would have as far as running through – just to follow up on the previous analyst Rob Stone, your obvious total revenues are going to come down so a little bit because we’d be running $17.5 to $18 through on with similar cost structure if you backed out the H.264.

James Goss – Barrington Research

What do you need to do to sign additional OEM partners for DivX Connected and what do you need to do to make that more attractive competitor vis-à-vis Apple TV and the others out there.

Kevin Hell

We talked about it some on the prepared remarks. Right now we believe we have a good strong platform, it’s what I’ll call a PC mediated platform meaning it requires a PC to be on which does add some complexity. We continue to get interest from a variety of OEMs across the world on this for categories like DTV and set-top boxes and we’re pursuing those opportunities.

At the same time from the feedback that we’ve received from the market we also believe that having a option of having streaming services where the PC doesn’t need to be on where the device can talk directly to services on the Internet is going to be an important feature for us going forward in this area so we’re hard at work adding that to the feature set so we can continue to pursue opportunities as devices become connected directly to the Internet.

Overall, we’re looking to be the technology bridge between all the various online sources of content and the diverse world of consumer electronics regardless of the format. Today we’re really the world’s leading solution primarily for content downloaded to the PC and what I would call a disconnected model where you burn content on disc or put it on a USB stick and walk it to the device. But, going forward we’re hoping to also be the standard for content that is directly accessed from the Internet from CE devices in a live connected streaming model.

Our core value here is really our deep understanding of media formats and how they translate to embedded solutions in a low cost hardware configuration and doing that in a standard and reliable fashion. That’s really where we’re putting our emphasis and we believe we’re the natural to really put together this kind of platform.

James Goss – Barrington Research

One other thing, and I know you’ve talked about this a little bit too but in terms of professional content and getting eTailers launched in order to make use of that activity, there’s a little bit of a chicken and egg issue but what do you think you need to do to get off the base you’re on right now? Do you need say one more major studio and that might be enough to get the eTailers to create a service around your content or is there something else that you think would be required first?

Kevin Hell

No, we are pursuing additional studios and we’re making good progress there but really to get eTailers launched we’re really navigating a number of issues. We really represent a new platform both for the eTailers and for the content providers. To really navigate through that and to get it launched there are several hurdles we have to cross that are really gating some of the initial releases. We’re making good progress there and we hope to have updates there shortly.


Your next question comes from Justin Cable – Global Hunter Securities.

Justin Cable – Global Hunter Securities

First question is just on you mentioned the software downloads with the new DivX 7 platform out there was 62% which is a great rate trend to see but I suppose it was a missed opportunity since you didn’t have a media distribution partner. First of all, is that correct, is that a correct fair statement? And two, are there some additional downloads or upgrade opportunities that may come about let’s say in the next six months that if you do get a media distribution partner that we can actually monetize that?

Kevin Hell

Sure, the number I quoted were really representing a comparison versus our last major release of DivX 6 looking at the same launch period and they were up pretty considerably which represents I think a fundamental shift in growth in our broader community. In terms of missed opportunity, there are a number of things we have held off on for instance, marketing programs and auto updates through our software that would drive larger usage.

We’re holding off until we have a distribution partner in place so we still believe we’ll be able to also financially benefit from this release as it continues to gain popularity in the marketplace more broadly.

Justin Cable – Global Hunter Securities

In terms of timing, could we say that by the end of Q2 we might be able to see a new partner or two?

Kevin Hell

That would be certainly our hope and we are making very good progress. But again, we hesitate to give specific timing given the partner dependency there but we are making very good progress.

Justin Cable – Global Hunter Securities

Now, when I look at your Q1 revenue guidance it basically assumes that revenues could be down as much as 8%. Can you explain I guess maybe some more granular details on that trend, how much of that decline is from sort of legacy products versus the offset on the contribution from newer products?

Dan l. Halvorson

Without getting too granular I have a couple of thoughts one, it’s not as far down as I think some of the other guidance. I’ve looked at some of the other companies and kind of the macro going to some of the longer term contracts we have but if you link in the other commentary I said that as we execute Q4 ’08 the kind of emerging new products if you will were in the 5% range. That’s going to continue to expand but it’s hard to predict in this market how fast those expand so I think to kind of help you offset. You can do the math, if the emerging continues at that clip, in the let’s say 5% then you can see what the core legacy is doing. But, that’s the visibility we have or I guess I should say we don’t have right now.

But, I think it’s really a mix, we do see our core DVD as Kevin said in the prepared remarks, we’re seeing that come down but we are seeing the emerging tick up which we’re very enthusiastic about.

Justin Cable – Global Hunter Securities

It also sounds like in terms of the emerging market it sounds like you have a lot of products that you don’t expect to get revenues from until later in the year?

Dan l. Halvorson

They’re really back end loaded. If you look at a lot of our press release, and that’s what I don’t know if I’d say frustrating but it’s certainly challenging for ourselves as management and probably for the analysts as well as other investors to really track, we’ve had a lot of press, we’ve had a lot of traction and I think that traction as far as the releases that we’ve had, the press, will return in revenues in the back half.

That’s really our expectation especially has Paul Coster indicated, Q2 is seasonally down, we do recognize revenue a quarter in arrears so the things that are coming out set-top boxes, DVDs, things that would take a long lead time we feel good about what it looks like for the back half. But then you throw that in with the macro and you kind of stir it all up and it’s choppy. But, to your point the new emerging products is back half loaded.

Justin Cable – Global Hunter Securities

Particularly on Blu-Ray you have 117 Blu-Ray players certified, how much is the overall market of that?

Kevin Hell

Well, if you look at the stats there we have approximately half – if you look at all the OEMs that we currently have Blu-Ray models they represent about half of the market and that’s kind of comparable with the number that I was saying earlier on DTV. In terms of our penetration we don’t have real detailed stats, the one number I do have is for the European market where we have penetration as of Q4 of 26% currently. That’s the attach rate of devices in Europe in Q4 and we’re just starting to emerge in the US market there. In the US we have Philips, Panasonic, [inaudible] currently with certified devices.

Justin Cable – Global Hunter Securities

The last question I have is given that the June quarter is probably the seasonally slowest quarter what’s your confidence in the company’s ability to sustain a free cash flow positive during that quarter?

Dan l. Halvorson

The comfort zone I mean, look Q2 it depends on that top line but we don’t have a lot, we have depreciation and amortization, we have other things. I think Q2 will be a challenge but I think we’re going to continue to manage through it. I’d love to give you more clarity, I’d like to talk about the year but right now I think that the key there is with the $135 million in the bank, $135 million in cash and investments I think some of the comments that Kevin has made in his prepare and I’ve made, I think that DivX can withstand even if we do dip down in a seasonally low quarter even with the H.264 investment, I think say even if it were to dip down we’d be fine.

I think the key is to look at the operational margins and look at what we expect this year. I think that although we’ve given guidance at $17.5 to $18.5 million, sure I’d like to have a toolbar in there but I would tell you and everybody listening I’m not ashamed of this model, I’m not ashamed of the guidance we’ve given. I think it’s solid guidance. I think that when you strip out the non-cash stock-based comp and you back out the kind of GAAP amortization for the intangibles related to the main concept, I think we’ve got a very strong balance sheet and we’ve got a profitable business that is not as profitable for us as it’s been but compared to a lot of other companies out there I think we’re positioned to weather the storm.


At this time there appear to be no further questions. I’d like to turn the call back over to Mr. Kevin Hell for any additional or closing comments.

Kevin Hell

I want to thank everyone for joining us on the call today. We look forward to talking with you next quarter.


That does conclude today’s conference call. Thank you for your participation. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!