DivX IPO: Key Background For Investors

| About: DivX, Inc. (DIVX)

Born amidst the backdrop of the wild west P2P underground movement, DivX (DIVX) was first created when a French hacker named Jerome Rota developed the codec by hacking into a Microsoft MPEG and extracting and rebuilding the code. The codec allows someone to take high quality video and compress it into very small packages for digital distribution. Because the codec allows for faster data transfer rates, it soon became a favorite on the P2P networks and drew the support of a vast open source network of programmers. Over the next two years, the format underwent a series of evolutions and in 2000 Rota started DivX Networks Inc.

For a year and a half DivX Inc. continued to work hand in hand with the open source community, but in mid 2001 an anonymous employee known only as “Sparky” brought this peace to a sudden end by uploading a new version of DivX to an open source website. DivX Inc. quickly moved to remove the file, but Sparky’s action proved to be the first shot in what’s turned out to be a long and difficult war with the hacking community. Armed with a copy of the DivX source code and frustrated with DivX Inc.’s attempts to go private, the open source community rebelled against DivX by creating a free open source alternative named XviD.

Facing a brutal stock market implosion and a less then stellar reputation among mainstream companies, in 2002 DivX Inc. turned to the infamous Gator to help fund their on going cash needs. While the version of Gator that they installed was an opt in version, the open source community still was furious about the relationship and consistently attacked DivX over the issue until the company finally relented in 2004 and promised not to partner with anymore adware providers.

Going legit turned out to be the right move for the company and since abandoning the spyware strategy the company has seen their revenues grow from $16 million in '04 to $33 million in '05 to $27 million in the first half of 2006. While many of these gains have been driven by increases in CE licensing revenues, distribution of the more legitimate Google toolbar has turned out to be a much better solution and now makes up about 20% of the company’s revenue.

While the DivX of today looks like a very different company then the DivX of the past, they didn’t make it through these turbulent events without collecting some battle scars. They face significant competition from better funded rivals, they still have an uphill task in trying to convince Hollywood to trust something that was born from the P2P movement and if you think that the digital underground has forgotten about DivX, all you need to do is visit their own video sharing site and you can see that there is still strong resentment against their brand.

Nonetheless, Hollywood is starting to take downloading seriously and with Microsoft and Apple’s DRM having already been cracked again, frustrated studio execs could warm to the idea of a DivX with DRM solution. All it takes is the right deal and DivX could quickly become a significant competitor in the digital distribution space.

DivX is also currently engaging in alpha testing for a mobile video product and with the cellular companies salivating over the thought of new revenue streams, DivX’s remarkably efficient compression technology could allow them to make significant in roads into the bandwidth strapped cellular industry.

To date, DivX’s biggest success has been with the consumer electronic manufacturers. In exchange for a royalty, DivX allows DVD, PVR and portable device manufacturers to license their software so that consumers can play DivX files on their electronic gear. In total, the company has seen over 46 million DivX Certified devices ship to consumers and has had their software downloaded over 200 million times. While most of their licensing agreements are only 1 - 2 years in nature, DivX has been sucessful in negotiating these agreements with the CE manufacturers in large part because of the sheer number of people who are are actually watching pirated content on their DVD players. As the company moves more mainstream it will be interesting to see how they end up balancing the rights of the content holders with their dependence upon piracy to secure their CE deals.

The company’s stock will also face significant hurdles. Their business model is anything but easy for investors to understand and despite not having a connection with the other DIVX (Digital Video Express), Many investors won’t be able to differentiate between DivX the codec and the DIVX that went bankrupt during 1999 in a failed attempt at creating a DVD format war. The company also faces some litigation risk and has registered only a single patent to their name.

Despite everything that could go wrong with this confusing tech company, I’m actually pretty excited about the potential possibilities for the DivX brand. There are still many question marks, but all it takes is the right deal and all the pieces could come together very quickly. With $100+ million in new cash, it will be very interesting to watch what direction DivX takes with their acquisitions. They could use the money to help beef up the content on their stage 6 website or they could use the funds to try and expand their distribution agreements with new VOD providers.

In the end, the company may end up being a crap shoot, but between the small float, the expanding revenue and the media frenzy surrounding digital video, it will be fascinating to watch whether Wall St. ends up getting caught up in the blitz or if they end up focusing on many of the doubts surrounding their business model.