How Comtech Group Can Benefit From the Digital Video Tsunami

In digital music, Apple (AAPL) CEO Steve Jobs found a rare opportunity to crack open a latent mass market that has become a phenomenon of our times. It is possible to visualize a similar opportunity in digital video.

Similar inefficiencies are palpable in the movie industry as well. Those who are already owners of home theaters crave for an opportunity to simply download a movie. DVD versions of movies from online or local stores are no substitutes—not when many of them are damaged, as is often the case. It is also harder to switch to a better movie when you are using a DVD and are unable to download another one. Above all, the cost of distribution of movies through the Internet is less than 25 cents while the traditional methods incur more than a dollar according to estimates of Level 3.

The opportunity in digital videos is probably much larger than in music. For one, much more user-generated video content is available and it’s not just the one you see on Google's (GOOG) Youtube. Videos of live events, such as sports events available from Major League Baseball (MLB.com), could well be watched in cars, trains or while walking in a park. MLB.com today has 1 million paying subscribers and 6 million unique visitors per day according to statistics quoted by a supplement issued with Level 3’s latest annual report. Portable broadband afforded by WiMAX, with 12 Mbps of bandwidth, will improve the transmission efficiencies to wireless devices.

There are potentially other applications of digital video. Location technologies will allow personalization of content; tourists, for example, could be served footage of sites they are visiting or even advertisements. Multi-player games, with participants from a variety of locations, are already popular; Blizzard Entertainment's World of Warcraft has 8 million subscribers worldwide.

The idea of digital video, served on devices other than television, is not far fetched. According to a survey by E-Poll, 24% of males in the age-group of 13-34 frequently watch video on devices other than TV. Of these, 46% watch digital video content on laptops and another 13% on cell phones and iPods. About 13% transfer video content from their computer to a TV, 50% of them did not know that this is possible and one-third would like to have the ability even if it involved a complicated installation process.

The macro case for investment in digital video is compelling but this can hardly be said of individual companies. Level 3 was until recently presumed to be at the center of the Internet Video tsunami, to use a term from the infamous Internet bubble days. In reality, Level 3 is grappling with the complex job of paying off its high cost debt and integrating the several companies it has acquired. Companies like Clearwire want to offer digital content on broadband wireless and have to acquire enough radio spectrum and pay for a nationwide network. Other companies like JumpTV, which offers content from the around the world, have to invest large amounts of money on marketing and sales. All of this is much too risky for individual investors.

The best bet at this point of time is to invest in companies supplying devices such as set-top boxes or even mobile devices. One such company is the Chinese company Comtech Group (COGO) which develops encoding solutions for set-top boxes in collaboration with Microsoft (MSFT). It has been experienced profit growth of 40% over the last two years and will be able to sustain or exceed this growth rate because digital media is expected to realize margins of 20% compared to 18.7% in its existing product line according to estimates of W R Hambrecht and Company.

COGO 1-yr chart