I’ve always been a bit of a strange bird when it comes to the things that I look forward to. Most people will get excited when their favorite TV show comes out of summer reruns or when a band they liked in college is coming to town.
Sometimes, people will even line up overnight just to have the opportunity to see an event that they really care about. While I like entertainment as much as the next person, it’s not the movie premieres that make me drool, it’s events like the JP Morgan Global Internet Conference that was held in New York, earlier this week.
I find these “stuffy” business events exciting, in part because I’m naturally interested in business, but more importantly because I get an opportunity to hear some of my favorite companies share information with the investing public. Oftentimes, these types of presentations offer consumers a unique glimpse into the real motivation behind some of your favorite brands. When these companies normally present to consumers, they tend to focus on their low prices or the positive benefits of their services, but if you lock technology executives into a room filled with shareholders, a very different perspective comes out.
The one downside to these investor conferences is that there are so many great presentations, it’s next to impossible to cover all of them and this year’s event was no exception. JP Morgan hosted 70 different public and private companies that compete in the internet space, including many of the companies that I follow closely.
I would have liked to have done a write up on all of the presentations that I’ve listened to over the past couple of days, but the company I have been the most interested in recently has been DivX (DIVX), so I’ve focused my coverage on CFO John Tanner’s presentation to investors. Nonetheless, I’d encourage you to listen to some of the other presentations, if you happen to be interested in any of the companies that attended this year's event.
During his presentation, Tanner gave a great rundown on the different moving pieces that make up DivX’s business model. He told investors that its codec has now been disseminated over 240 million times. On it’s own, this number is impressive, but it’s even more remarkable when you consider that when it first filed its S1 to go public, it referenced 180 million downloads. When it filed its first earnings report, it had hit the 200 million download mark and now approximately 6 months later, it is reporting 240 million downloads.
While DivX doesn’t necessarily earn any revenue from disseminating its codec, it does have an opportunity to pick up some advertising revenue when people install their media player. Seeing this number continue to increase is also a very good indication that DivX has not only maintained its community over the last year, but has been increasing its relevance as well.
How DivX Sees the Digital Video Market
When planning for its future, DivX has had to make some assumptions in how it sees the market for digital video unfolding. In a world where technology seems to change everyday, this can be a difficult task. To help investors better understand how DivX sees the digital video market unfolding, Tanner listed five different assumptions that DivX is making when analyzing the evolution of the digital video market:
1.) Open systems win - This is at the core of everything that DivX does. It doesn’t charge excessive mark ups for its technology, it doesn’t try to isolate partners by granting exclusivity, it wants to be an open standard for the world and if you believe that people will embrace choice, then DivX is well positioned to benefit from this trend.
2.) Consumers get what they want despite artificial economic or market barriers - Given DivX’s history, this assumption makes a lot of sense, but it has also caused some trouble for it as well. Consumers have embraced the DivX standard over the bit torrent networks, in large part because Hollywood has refused to legally sell its movies in a digital format to consumers. If you try and take away this technology from consumers they will take it back whether content owners like it or not. While DivX does not support piracy, the fact that consumers have used their technology to gain access to digital films has created problems when it comes to licensing content from the Hollywood studios.
3.) Digital reshapes media - In the past it has taken serious financial backing to make and distribute a film. Because the distribution channels for film were largely controlled by the studios, it made creating a film a very expensive process. Digitization is democratizing content and has shifted the power equation back to the consumer and the independent producer. As this technology infiltrates its way into our lives, it will create change and DivX hopes to be there as the economics of the film business transform.
4.) Communities will end up driving the market - This is something that I’ve been recently thinking quite a bit about. Of all the mainstream media shows out there, I think that Stephen Colbert understands this better than anyone. Colbert will often drive his fans to places like YouTube or Wikipedia where they can communicate and interact. By doing so, he’s been able to extend his brand beyond his time slot on Comedy central and into other areas of the net. As television and movies increasingly begin to interact with the communities that consume their content, there will be opportunities for film makers to create a whole new dimension of how their customers experience their video.
5.) The entire market for digital video will be transformed - I don’t think that anyone would disagree that the digital revolution is changing how content is being produced and consumed. With so many players having their own unique vision for digital video, this seems to be the most obvious assumption. Even though this assumption doesn’t guarantee that DivX will be the end solution, this shift could be a catalyst for creating demand for DivX’s brand.
One of the things that I found interesting during Tanner’s presentation was that he gave some great commentary on DivX’s growth cycle and the sales process that it's adopted in the past. DivX’s development cycle typically starts by partnering with a single inexpensive chip manufacturer, so that its OEM partners aren’t turned off by a high cost to implementing DivX support into their products. It then tries to expand these relationships with even more chip makers, in order to provide more flexibility to its CE partners.
We design our technology to work on the very cheap silicon, but that takes a little more work to process, than it would by having a very expensive chip available to us, so we get into a first IC reference platform and then we get into multiple reference platforms to allow our OEM partners some choice in the chips that they use, both from a cost perspective and from a design perspective. Then we get into an early adopter OEM, who provides us with a first to market product. Once that product starts to establish its ability to take market share from the other OEMs, the first mass market OEM will adopt the technology and get into the market and then shortly thereafter multiple mass market OEMs will come in.
While this is represents a typical product development cycle for DivX, it is worth noting that Tanner told investors that when it comes to its DivX connected product, it's been able to bypass the early adopter OEMs and that the demand for the product has been coming from its tier 1 CE partners. This is a good indication that DivX is gaining momentum with its most important partners and is something investors should watch.
Tanner also mentioned an interesting footnote while discussing DivX Connected, he told investors that DivX management hasn’t settled on DivX Connected as being the final name for its living room hub. I’m not sure what I would try and brand the product as, but I found it interesting that it is still considering alternatives for what it might name the product.
DivX as Content Broker
Another intriguing part of Tanner’s presentation was when he broke down the different ways that DivX is integrating content into its brand. While these revenues only represent 2 - 3% of what the company is earning right now, its importance in driving demand for its codec, as well as diversifying its future revenue streams, really can’t be understated. Currently, DivX is serving in multiple capacities when it comes to content.
On one level, it serves as a wholesale broker for content. It does this by licensing films from studios and then distributing DVDs with multiple DivX films on them, to people who buy DivX certified machines. Tanner used its relationship with LG electronics as an example of how it is leveraging its OEM partners to help it sell content to the end consumer. It's been distributing content this way for about 6 months now and Tanner indicated that it has been earning 55 - 60% gross margins serving as a middleman.
From the standpoint of consumers, they get a bonus that highlights DivX’s functionality when they buy a certified machine, and from the standpoint of the OEM, this program helps to reinforce the value created by including DivX in its products. While it’s still too early to tell how lucrative of a revenue stream this could end up being, it is worth noting that just yesterday morning, DivX announced an extension of this program and will be licensing content from the CBC to include with DivX certified devices distributed by Samsung.
On another level, DivX is serving as an actual distributor of content using its Stage6 brand. Content owners can sell their content directly from Stage6 and DivX will split whatever profits it makes, 50/50 with the creators. This strategy leverages the relationships that it has within its own community, but in my mind it also has the most question marks when it comes to monetizing this potential revenue stream.
Finally, DivX is getting involved in the content game by licensing its technology to other video sites and letting partners be responsible for licensing and distribution of the content. It is these relationships that intrigue me the most and where I see Stage6 being the most attractive for the company.
Licensing to Cell Phone Makers
While most of Tanner’s comments were pretty broad in nature, there were a few new juicy details leaked out at the conference. One of the more interesting questions that was raised was how DivX was pricing the licensing of its codec to the cell phone manufacturers.
Tanner hinted that because the market for cell phones was bigger then the market for DVD players, PVRs & Personal media players combined, it would be open to pricing its technology even more aggressively, if it could make up the discounts on the volume. While the company hasn’t finalized what it intends to eventually charge the cellular industry, Tanner did say that currently, it is charging the cell phone OEMs its standard DVD player rates, while it sorts this out. This means that for each F500 movie phone that Samsung can sell, DivX should get $1 - $2 in licensing revenue, depending on the total number of units sold.
Lock Up Expiration Concerns
At the very end of the presentation, Tanner addressed concerns over DivX’s lock up expiration period ending. Beginning March 21st, investors who were contractually restricted from selling after its IPO, will now have the option of getting out. The closer this date has gotten, the bigger this issue has become for some investors. While I believe that insider selling would help to increase the liquidity for investors, by allowing more shares to trade in the open market, people have nonetheless been concerned about the potential for insider unloading once the lock up expires.
Tanner addressed these concerns by pointing out that when it first tried to take the company public, it had trouble getting its VC backers to actually sell.
I can only report what their disposition was during the IPO. It was very difficult for me, as you know, to get enough shares from the secondary providers of shares during the offering, to make the offering as big as it was. I finally did get some cooperation on the part of some investors, whether or not their own particular circumstances for each of the VCs has changed since then, is known only to them, so even if they were to offer me up a prognostication of their behavior, I would have to take that with a grain of salt anyway, having dealt with VCs in the past. The best thing that I can say is that nobody has expressed a desire to do any share dumping to me and I’m confident that most of them still have a strong holding from the story.
At $30 a share I could see why the end of the lock up could create some concern that insiders might bolt for the exits, but with the stock now trading under $20 a share, it’s hard for me to take this threat seriously. While no one knows for sure what DivX’s VC backers will do, if DivX had a tough time convincing them to let go of the shares at the IPO, then I’m not sure that I’d expect them to sell after DivX’s stock has sold off.
DivX continues to be one of the more exciting companies that is operating in the digital media space. While its business model is tough to understand, it's positioned themselves in an enviable position to have exposure to the growing digital market, but it's also been able to build a fairly secure competitive moat around its business by focusing on its community to help drive growth. While there is certainly a healthy degree of long term risk and short term volatility associated with investing in its business, if DivX can continue to perform at these levels, it should become the undeniable de facto standard for digital distribution for the 21st century.
DIVX 6-mo chart