Last week, DivX (DIVX) dropped a bomb on investors after it announced that it was planning on divesting its Stage6 website and that CEO Jordan Greenhall would be leaving, in order to run the new entity.
The company promised to provide more information on its upcoming earnings call, but this unexpected bizarre move was too much for skittish investors to handle and Wall St.’s initial reaction was to sell.
DivX investors weren’t the only ones who have been scratching their heads over the announcement. Coverage on the net raised more questions than answers. NewTeeVee interpreted the move as a sign that the video sharing industry was in trouble and was struggling to find a business model.
“This is bad news for video-sharing sites, showing they’re having trouble holding their weight without the subsidy of venture capital or Google (NASDAQ:GOOG)-level resources. Stage6 appears to have been too much to handle for its moderately successful public company parent.”
Zatz Not Funny appropriately enough titled his post, DivX Dumps Stage6, but described the spin off more as a divorce, than a child weaning itself from a parent. 24/7 WallSt offered an even more bearish assessment of the move and called the spinoff “more than strange.”
While I can’t argue that DivX’s decision isn’t unusual, I do think that the market may have misread the implications on this one. In thinking through how the spin off would play out, I’m of the opinion that the move makes financial sense in the short run, but have to question whether future growth is being sacrificed for short term gratification?
Wall St.’s Fuzzy Math
Whether you are talking about business, baseball or technological synergies, it is often the case that the whole is greater than the sum of its parts. This philosophy has driven mergers, it has forged partnerships, it has even saved industries from collapse. By working together, businesses are able to earn profits that would elude them otherwise.
What happens though, when things get turned upside down? When an investment in one part of the business actually causes another part of the business to lose a greater value? This is the exact situation that DivX finds itself in. The sum of its parts is actually greater than the whole.
This creates an interesting dilemma for management, because the more it invests in growing its Stage6 business, the more it impacts its current shareholders. On one hand, it wants to see this growth asset continue to be successful, but on the other hand, each dollar it's spending is eating into precious net income.
Because DivX earns such a high profit margin on its licensing business, investors have been willing to pay 25 times their profit even though their revenue is minuscule compared to companies with a similar market cap. While this works in DivX's favor on the money it brings in, it also works against it on the money that it spends to develop new businesses.
DivX has already said that it plans on spending $5 million on Stage6 this year and with no signs of its growth slowing, I expect that this number will only go higher. While DivX does have plenty of cash that it can invest in the venture, even at a $5 million price tag, it's still sacrificing $90 - $125 million in market cap, by subsidizing the site.
Meanwhile, there is real value that is locked into the Stage6 brand, but it can’t be released because DivX’s licensing business is so much more valuable. So far, the analysts have been more concerned about Stage6’s costs than the 10 million visitors who are using the site each month. Trying to get a premium valuation on Stage6 won’t be easy, but there are certainly things that DivX can do in order to make the property more valuable.
One move that it has already taken has been to replace its DivX ads with paid banner ads on the Stage6 website. If DivX also includes its stake in DeviantArt in the spin off, it would also help to boost Stage6’s valuation.
Stage6 and Break.com both receive similar amounts of traffic, but with DivX’s global brand, the superior codec, and a solution for getting into the living room, I think that Stage6 would command a premium to these prices.
If DivX was able to spin off Stage6 for $80 million, then shareholders would not only be able to realize that value, but because they would no longer have to pay the bandwidth, the increased earnings could add $90 - $120 million to their market cap. Add in the $150 million in cash and the current $300 million valuation on the core licensing business and you’ve gone from a market cap of $450 million as a whole entity to $650 million in market cap with the company smashed up into pieces. From a valuation standpoint, the two businesses work against each other, but separated, it should value DivX at $18 - $19 a share, using the current multiples.
Tortoise vs. The Hare
I can’t really argue with what DivX is doing. It has a responsibility to protect shareholders and if it can realize more value by splitting up the company, then it owes it to its investors to consider this carefully. From the short term perspective, I can understand why it would want to dice the company up, but if you take a longer term view of DivX, I can’t help but think of all of the things that it's giving up.
There is a part of me that wants to believe that the two entities will be able to complement each other after the divestiture, but after seeing John Tanner leave, Jerome Rota shift focus to “media experience” and now Greenhall leaving to run Stage6, I can’t help but wonder if the company is really just pruning itself for the sale of its core technology licensing business.
There have already been rumors that Dolby was interested in buying the company and I could probably think of a few other companies that would at least be interested in kicking the tires. A takeover this early always seemed improbable to me, but now that Greenhall has agreed to step down, I’m not sure what to think. With the stock down over 50% from its highs, I could understand if DivX’s VC shareholders wanted to find an alternative exit strategy over unloading more shares than the market can handle.
While DivX could always just sell the company outright, Stage6 could certainly complicate an acquisition. For years, DivX has remained beyond Hollywood’s legal grasp. While the studios have always expressed reservations over DivX’s technology, because consumers are the ones sharing the pirated films, it has limited DivX’s liability.
Once it started its video sharing site, it didn’t take long for the lawsuits to start rolling in. In January, DivX reported that Universal Music Group had sued the company over pirated content that was uploaded to the website. While DivX is certain to argue that it was just hosting the video and would have been happy to comply with takedown notices, after years of legal frustration, I don’t see Universal dropping this. By spinning off Stage6, DivX would be able to help minimize the legal liability for an acquiring company.
If DivX isn’t positioning itself to sell the licensing business then I’ve got to question whether or not this transaction will really help DivX in the long run. In the short run, it could boost its valuation, but DivX doesn’t need to raise money, it already has plenty of cash. If DivX really believes that Stage6 can become a profitable entity, then why not try to maximize the revenue potential of Stage6, without giving up control of the site? This may require some short term pain, but I believe that DivX’s entertainment ecosystem is still much too fragile to risk giving up the leverage that Stage6 brings it.
When I look at DivX’s potential, I see a lot of opportunity, but I also see one very big risk. Just like it only took a child for the Emperor to realize that he wasn’t wearing clothes, DivX's manufacturing partners could just as easily begin questioning whether DivX really adds value to their gadgets.
Early adopters are vocal about demanding support for DivX and as long as there are DivX files and devices to play them on, the ecosystem holds together. If more and more manufacturers start abandoning DivX though, then all of a sudden, their codec has very little relevance. While I believe that DivX is too entrenched at this point to be fully cut out of the market, there are too many deep pockets trying to keep them out of North America for the company to not consider this critical risk.
An independent Stage6 will most certainly continue to support DivX’s codec, but because of its responsibilities to its own shareholders, DivX wouldn’t be able to run the site at a loss, in order to shore up support for its licensing business.
Beyond Video Sharing - Stage6 As An Advertising Platform
Since Stage6’s launch, I’ve followed the development of the site with keen interest and during the times it has been in Alpha/Beta stage, I’ve kept my criticisms limited. With the site considering a public offering though, user bugs and missed opportunities will become even less tolerable.
While the analysts have been more concerned about the potential for DivX to sell advertising on the Stage6 website, I think that DivX needs to be thinking more multi-dimensional when it comes to its monetization strategy. Right now the video advertising marketing is still very much in its infancy and if the company was able to run Stage6’s ad business at a loss or at breakeven, then I believe that it would make the company a threat/target to sites like Google.
Last January, Greenhall said that he wanted DivX to become the Adsense for video. Since then we haven’t seen any plans launched, but DivX was rumored to be in negotiations to buy Revver at one point.
Even though I’m a fan of Revver, I can’t say that I really like the business model. While I think content creators should be rewarded for making good content, I think that there is easier money to be made by selling video ads with the help of the larger DivX community.
Google Adsense may be easy, but any blogger with a lick of traffic will tell you that the rates they pay are chicken scratch. While a public Stage6 wouldn’t be allowed to pay out 90% of its ad revenue, a DivX-supported Stage6 could afford to run a business at break-even if it contributed to the licensing sales.
Back in the 56k days of the web, I remember there being a lot of debate over whether web publishers should support graphic rich applications like flash. With so few people using broadband, webmasters needed to be sensitive to creating a smooth experience for everyone. At that moment in time, it would have been very easy for Adobe (NASDAQ:ADBE) to fail, but instead of hitching its wagon to the content, it instead courted the advertisers. By doing this it was strategically able to position itself in such a way that businesses were actually paying money in order to distribute Adobe’s flash product.
If DivX was serious about wanting to solidify its grip on its eco-system, it would take the same approach with Stage6. Instead of courting the content creators, it should be approaching the advertisers. Given the high quality of its video stream, I think that it would have a natural selling advantage over the current flash video ads. If you were in charge of the marketing budget at Take Two (NASDAQ:TTWO), would you rather have video gamers see a full screen high quality DivX ad or a small low res YouTube copy? To me, this is a no brainer and something that DivX hasn’t taken advantage of.
While there would be nothing to stop an independent Stage6 from trying to create its own ad network, if the company has to be sensitive to profitability, it would limit its ability to attract affiliates to distribute its DivX video ads. By paying out top rates to bloggers and independent publishers, Stage6 could become an advertising powerhouse. If Stage6 is only able to pay Google Adsense rates, then I think publishers will be reluctant to include the ads, when many readers would still need to download software in order to view them.
At this point, it’s probably too early to tell if Greenhall will take Stage6 in this direction, but I believe that placing so much emphasis on content has been a mistake for the company. While it certainly helps to promote Stage6 and DivX’s brand, the margins offer limited upside compared to the longer term benefits of an ad network or a premium service.
There is a lot of potential for the future of DivX and while breaking up the company makes sense on Wall St., I’m not sure that the long term price is worth the short term benefit. While it’s nice to see DivX management focused on enhancing shareholder value, unless it's planning on selling the company, I don’t see how splitting up the company helps its long term competitive position.