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When readers first suggested that I take a look at ON2 Technologies (ONT), I was skeptical. I heavily shorted smallcaps and microcaps from 2000-2002, and leaning on video codec companies was money in the bank. Every six to twelve months another company would come out with a new video compression algorithm that was going to revolutionize content distribution. The companies were always more hype than substance, and after a few disappointing quarters, their investors fled, leaving shorts like me with easy gains.

Admittedly, we are in a different era today. Video has come of age both on the world-wide web and, to a lesser extent, on 3G mobile networks. Still, video compression is a treacherous business with few winners and a lot of disappointments [as Neomagic (OTCPK:NMGC) shareholders know all too well].

After initial research, I think that my readers may have correctly pegged ON2 as one of the rare winners in the codec business. Its TrueMotion VP6 codec is included in Adobe Flash Player 8 and 9, and some consider its TrueMotion VP7 to be the premier video compression scheme today. The company also provides the Flix Engine to transcode video into mobile formats. ON2 is almost in the black, eking out an operating profit but still posting GAAP losses last quarter.

However, it is unclear whether the prospects for ON2 stock are as bright as its technology. The company already has a market cap exceeding $318 million, indicating that investors have already priced a great deal of promise into the stock. Against this backdrop, sales remain relatively meager — only $2.815M last quarter. Annualized, that is only $11.26M, giving ON2 a price/sales ratio of over 28. In contrast, after backing out the cash on its balance sheet, video codec company DivX (DIVX) trades at a price/sales ratio of under 6. That doesn’t ensure a pullback, but it does lower the odds of repeating the rally ON2 shareholders have enjoyed over the last 9 months.

If you have any thoughts on ON2, please leave a comment or drop me an email.

ONT 1-yr. chart:

Disclosure: No position.

UPDATE: For solid technical analysis of ON2, check out Tim Knight’s work on The Slope of Hope blog.

Source: ON2 Technologies: Investors May Be ON2 Something