Bill Simpson prepared an analysis for Tradingipos subscribers of DivX's (DIVX) IPO on September 16th. The company priced at $16 a share on September 21st, above the $12-14 range, raising $145.6 million. The text of the original write up follows:
DivX plans on offering 9.1 million shares at a range of $12-$14. 1.6 million shares of the offering will be sold by insiders. JP Morgan is lead managing the deal, Banc of America and Cowen co-managing. Post-offering DIVX will have 33.5 million shares outstanding for a market cap of $435 million on a $13 pricing. IPO proceeds will be utilized for working capital and general corporate purposes and potentially to acquire or license products, technologies or businesses.
Post-offering Zone Venture Fund will own 23% of DIVX while founder and CEO R. Jordan Greenhall will own nearly 9%.
From the prospectus:
We create products and services designed to improve the experience of media. Our first product offering was a video compression-decompression software library, or codec, which has been actively sought out and downloaded by consumers over 180 million times in the last four years, including over 50 million times during the last twelve months.
DIVX's video compression technology uses a mixture of video compression tools, including some from the MPEG-4 standard, and is capable of producing high-quality video using only a fraction of the amount of data required by a standard-length DVD. DIVX has also developed a digital rights management technology that encrypts and manages the playback of protected content on PCs and consumer hardware devices. It said this ensures that digital video is delivered in a secure manner and used in accordance with rules defined by its publisher.
DIVX's video coding/ compression software was the 13th most downloaded software in August 2006 according to download.com.
Note that DIVX makes little money from the consumer downloads. They are mostly given away free as trial versions by DIVX with more advanced fee versions also available. DIVX derives the bulk of revenues through a licensing model of their technology to consumer hardware device manufacturers as well as via software licensing, advertising and content distribution.
Below we'll look at DIVX technology, relationships and revenues however one thing should be noted up front: Since inception in 2000 DIVX's products, due to transfer speed and storage size, have become one of the standards/ leaders in video coding/ compression/ decompression technology. DIVX main products compress digital video files to allow for easier transfer and storage. The compression (and then decompression) comes with minimum sacrifice in quality of video. With the swift rise in the video storage/ transfer sector, a technology leadership position in this space is a very sweet spot to be. This has allowed DIVX to operate a high margin licensing model of their compression/ decompression technology as demand for DIVX technology among hardware manufacturers has been strong. This strong demand for the DIVX codec/ player applications has also led to a high margin revenue stream from a software licensing deal with Google (NASDAQ:GOOG). Yes, Google pays DIVX for the Google toolbar and Firefox operating system to be bundled with DIVX products.
Video content has boomed this decade. According to DIVX the increase in digitization, connectedness and openness has created a historic transformation of video content. Video content is being created in ever expanding methods and can not be played on more and more devices. DIVX has placed themselves in the middle of the video boom. According to the prospectus, “We have built the technological platform and galvanized the community necessary to enable a digital media ecosystem of consumers, content creators, software vendors, hardware device manufacturers and advertisers, allowing all to benefit from the participation of each other.” How?
1. The DIVX solutions are supported by dozens of software products and operate on over 1,800 models of consumer hardware devices. DIVX features interoperability with many different platforms and products.
2. DIVX provides the ability to cost-effectively and securely create and distribute high-quality content to a large market of consumers and to deliver that content when, where and how consumers want it..
3. To consumer hardware device manufacturers, the DIVX ecosystem provides the ability to offer capture and playback devices that are interoperable with millions of other DIVX Certified devices in a high-quality, secure digital media format that consumers want and use.
DIVX was an early successful mover in the digital video space by gaining a market leadership position for their coding/ compression/ decompression products. DIVX has also created a video 'community' however thus far it is their video coding/ compression/ decompression products that have been the revenue drivers. I suspect this will continue to be the case, as DIVX really looks outclassed when it comes to creating a leading video community. There is money to be made in swift growing sectors and Apple right now is the leading video community with their iPod products. Other competition will surely increase with MySpace, Yahoo, Microsoft, YouTube and Google having their own digital community versions. Looking at the video community competitive landscape I would tend to view DIVX future to continue as more of a 'nuts/ bolts' company rather than a destination video community. I applaud the attempt, but I foresee the revenue drivers here to continue to be DIVX licensing their compression/ decompression tools much more than their 'Stage 6' video community.
I feel DIVX will continue to be more of a technology licensing company than a full content provider and/or video community destination.
There is of course competition also in their technology licensing space. However thus far DIVX has been able to grab early mover status and hold onto that status. They'll need to continue to innovate and improve, but they've done just that in their short history. Adobe Systems, Google, Microsoft and RealNetworks offer competing video formats, although it is quite telling that Google pays DIVX a significant sum to have their toolbar bundled with the DIVX coding/ compression/ decompression downloads.
Licensing their technology has accounted for 80% of all revenues the previous 18 months. Licenses royalties from Philips have accounted for 10% of revenues the past 18 months.
Google has been DIVX largest revenue driver the previous 18 months accounting for approximately 18% of revenues. DIVX has a marketing agreement with Google, not a licensing agreement. Under an agreement between DIVX/ Google, DIVX bundles the Google toolbar and Firefox operating system into the DIVX compression/decompression products. Google pays DIVX a fee for each Google/ Firefox download originated from the bundled DIVX software.
Interesting in that DIVX derives 80% of their revenues from licensing their technology to hardware manufacturers, yet their largest revenue source is from a marketing agreement with Google. NOTE***: The licensing agreement with Philips and the marketing agreement with Google are both set to expire in late 2006/ early 2007. These companies combined accounted for 28% of DIVX revenues the past 18 months. I would expect new agreements between DIVX/Philips, however there is no guarantee at this point of that happening.
75%+ of DIVX revenues since 1/1/05 have been outside North America. With most hardware manufacturers being based in Asia, this is no surprise.
Other than the technology risk inherent in all these type tech infrastructure IPOs the largest risk for DIVX going forward is the potential for the DVD player market slowing. Most of DIVX's licensing revenue is derived from DVD player manufacturers, whether in computer hardware or stand alone. It is anticipated that DVD player sales will continue to grow, that pace will slow.
$4 a share in cash post-offering, no debt. 3.7 X book value on a $13 pricing. DIVX revenues were in start-up stage in 2001. Since then they've ramped impressively, doubling in both 2004 and then again in 2005 to $33 million. It has been licensing of the DIVX technology that has driven revenue growth. DIVX appears on track to double revenues yet again in 2006 to $65 million or so. Three years in a row of doubling revenues is always impressive. Licensing models can be quite powerful. Once the technology is developed, gross margins in a licensing model tend to be robust. Also, because extensive sales/ marketing personnel are not usually needed for this type of model, operating margins tend to be rather strong as well. DIVX does derive the bulk of their revenue from technology licensing, however they're also attempting to branch out into a content community which has impacted their operating margins a bit. Gross margins for 2005 were 89%, for first 6 months of 2006 93%. Again these strong gross margins are indicative of a licensing revenue model. Operating expenses have declined sharply as a % of revenue the past few years. From 100% operating expense ratio in 2004, DIVX posted an 80% operating expense margin in 2005 and appear on track for a 55-60% operating expense margin in 2006. 2005 was DIVX's first year of posting an operating/net profit. DIVX booked a 7% net margin in 2005 and earned $0.07 a share. On a $13 pricing, DIVX would be trading 186 X trailing earnings. Margins and profits are growing strongly in 2006. At a $65 million revenue run rate, net margins should explode to approximately 20-25%. This strong net revenue growth is a testament to the power of a licensing business model. This model allows operating/ net margins to really ramp if/ when revenues take off. 3 straight years of doubling revenues does constitute 'taking off'. I would expect DIVX after full taxes to earn approximately $0.40 a share in 2006. At a $13 pricing, DIVX would be trading at 33 X's 2006 earnings.
I'm not a tech-head, so I certainly cannot make any claims on DIVX technology in comparison to, say, Quicktime/ Realnetworks' products. However I do know numbers. For a company that has doubled revenues for 3 years and expects net margins at a whopping 20-25% annually in '06, 33 X's earnings is too cheap.
Let's try and forecast 2007. First I'll be conservative and assume some revenue growth slowdown. In other words let’s assume DIVX will NOT be able to double revenues again in 2007. First of all I'd expect the pace of revenue from Google to slow, which should slow DIVX revenue growth rate a bit. Let us assume just 50% revenue growth to $100 million, which based on trends the past few years and recent quarters should definitely be achievable. Let us go a step further and assume DIVX picks up the pace on operational expenses as they work on new technology and continue to expand their 'stage6.com' community. When interest on the $100+ million cash on hand is factored in, DIVX should post net margins of 30%. This again assumes a 50% revenue growth rate (not 100% as in previous 3 years) and an increase in the rate of operating expense growth. I would expect DIVX then to earn at least $0.90 a share in 2007 or 15 X forward earnings on a pricing of $13. Again this is simply way too cheap for this sort of growth and net margins.
There are risks here. There is always the technology risk that DIVX will lose their edge. If that occurs then it is conceivable that licensing revenues will dry up. Of note, it does not appear that Apple (arguably the video content leader) utilizes DIVX technology at this point. Still, $13 looks much too cheap here for the growth, margins and business model. If my estimates for 2007 are anywhere in the ballpark, DIVX could easily command a price tag of $25-$30.
Note- Personally I would rather see DIVX continue to license their coding/ compression/ decompression video technology rather than spend in an attempt to gain a foothold in the video community space. I like this IPO a great deal, I would like it even more if DIVX did not have the expense draining Stage6.com effort. I've always been a fan of 'do what you do well' and focus. Stage6.com seems a diversion to me, one that takes away operating profits from the real company driver, the video technology.
Disclosure - tradingipos.com purchased shares of DIVX on the open market on Sept. 22nd at roughly $18 1/2