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September 02, 2006

DivX IPO: Is it a Good Deal?

posted by MR WAVETHEORY at 9/02/2006 04:44:00 PM
Divx (DIVX) , the producer of the DivX Player, is going public during the week of September 18th. JP Morgan is underwriting the deal. It will be the first company related to online video sharing to go public - ever. Is the DivX IPO a good deal? I walked through the DivX S-1 to answer that question.Market Opportunity
DivX Inc describes itself as being in the business of providing video compression codecs used for delivering high-quality video online.

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. We have since built on the success of our codec with other consumer software, including the DivX Player application. During the second quarter of 2006, we distributed over 15 million copies of the DivX Player application to consumers from our website, DivX.com, which averaged over five million unique visitors per month during that same period.

The DivX codec is the heart of DivX's business. Consumers download the player so they can play videos online. The fact that DivX has been downloaded 180 million times is very impressive. Download.com lists it as the 13th most downloaded software as of the week ending August 27th - the top 3 downloads title are all spyware removers - AdAware, WebRoot, and Spyware Doctor.

The truth is that it is also somewhat troubling, because consumers often use the player to view pirated content. In fact, DivX admits this is a major risk to its business in its prospectus:
We have also been asked by content owners to stop the display or hosting of copyrighted materials on our websites pursuant to the Digital Millennium Copyright Act.
Many consumers download the player specifically to view content encoded in DivX as opposed to the other way around. As big media goes after pirated content, there will be less pirated content and there is a risk that consumers will stop downloading the player.

Business Model
DivX describes itself as being in the business of providing video compression codecs used for delivering high-quality video online. At a very high level, DivX makes money from 1) installing Google ToolBar on computers when consumers download the DivX player and 2) fees paid by consumer electronics manufacturers who license the DivX codec to embed in their DVD players.

1) Consumers download the DivX player for free, and DivX makes money by bundling the Google Toolbar with its application. DivX writes that Google accounted for 20% of its revenues in the first half of 2006 or roughly $5 million.
Assuming 25 million downloads during the first half of 2006, that means DivX earned an average of $.20 per download of DivX Player. DivX writes,

The Google agreement accounted for approximately 20% and 15% of our total revenue in the first half of 2006 and in the full year ended December 31, 2005, respectively.

In the first half of 2006 and in the full years 2005, 2004 and 2003, we derived 20%, 15%, 17% and 28%, respectively, of our revenues from the inclusion of advertisements and third party software applications in our software products.

This part of its business carries certain risks, because the more successful and popular Google becomes, the less money DivX makes. The major risk is market saturation of the Google Toolbar. For instance, like many people, I already have the Google Toolbar installed on my computer. That means, DivX is not paid when I download the DivX player since it would be a duplicate install. As more people have Google Toolbars, revenue from Google Toolbar to decline.

Any decline in the popularity of either our products or Google's products among consumers or market saturation by these products could result in a decrease in revenue under this agreement.In particular, the Mozilla Firefox Browser may not achieve widespread adoption by consumers and may lead to fewer downloads and activations than past versions of Google's software included with our products.

Market saturation of the Google Toolbar is a major risk.If we assume that revenue from Google declined to zero (from $5 million during the first half of 2006), then DivX would go from being a moderately profitable business to a breakeven business. We can see that DivX generated $6.6 million in operating profit in the first half. Stripping out the Google revenue, DivX would only have generated $1.5 million in profits in the first 6 months of 2006.

In fact, I would venture to go as far as to say that DivX as a business would have seen much slower revenue growth without Google. After all, the company generated $14 million in the first half of 2005 and $27 million in the first half of 2006. Strip out Google revenue of $10 million, and you have a flat business that is growing 50% per year as opposed to 100% per year. Furthermore, you cannot assume that DivX will be able to do a repeat performance of that growth in 2007 due to market saturation of the Google Toolbar.

Therefore, the consumer side of the business is very risky.

2) The bulk of DivX revenues come from technology licensing to consumer electronics manufacturers.

Our technology licensing revenues from consumer hardware device manufacturers comprised 70%, 71%, 55% and 22% of our total revenues in the first half of 2006 and in the full years 2005, 2004 and 2003, respectively, and are derived primarily from per-unit royalties received from original equipment manufacturers.

This business has been growing rapidly.

The $14.4 million, or 161%, increase in revenues from technology licensing to consumer hardware device manufacturers from 2004 to 2005 resulted primarily from a $13.5 million increase in net royalty revenues due to an increase in the volume of consumer hardware devices sold by our licensees that incorporate our technologies, principally attributable to the worldwide growth in sales of DVD players that incorporate our technologies.

However, the licensing business is very hard to predict because DivX enters into these agreements for only 1 to 2 years.

Original equipment manufacturers pay us a per unit fee for each DivX Certified device they sell. Our license agreements with original equipment manufacturers typically range from one to two years, and may include the payment of initial fees, volume-based royalties and minimum guaranteed volume levels.

There is also a question of whether its largest customer, Phillips, will renew its agreement with DivX which comes up in June 30, 2007.

One of our original equipment manufacturer customers, Philips, accounted for approximately 13% and 10% of our total revenue in the year ended December 31, 2005 and in the first half of 2006, respectively. Our agreement with Philips, under which Philips is obligated to pay us a minimum of $11 million over the two year term of the agreement, expires on June 30, 2007. Philips is under no obligation to renew this agreement.

Valuation
The valuation of DivX is by no means cheap. Underwriters are seeking to list the shares at between $12-14, implying a fully diluted valuation of $300-$350 million or 6-7x times.

Conclusion
DivX is by no means an easy deal to understand. In its prospectus, DivX tries to position itself as a media and entertainment business by mentioning Stage6.com, its nascent video sharing site no more than 38 times (it generates no revenue as far as I can tell), but the basic metrics of the business seem to suggest that DivX is hardly an exciting media business, but a Toolbar and codec business, that faces significant competitive risks.DivX even cites MySpace and YouTube as competitors, but it is not close to being in the same league. Daily traffic reports seem to say DivX.com gets about 800,000 users per day.

Given the excitement over online video, it could price wildly into the stratosphere, for no simple reason than the fact that online video sharing is taking off. In fact, if DivX takes off as a deal, it could mean a faster than expected IPO for YouTube which recently hired a CFO who hails from Yahoo. If you are lucky to get an allocation, take it, though it may be wise to sell it on the pop. However, for those who are less fortunate, rather than jumping in hole hog on opening day, you may be better off taking a wait and see approach on the DivX IPO.

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4 Comments:

Anonymous Anonymous said...

I found this post through a Google search. Outstanding work here! Many thanks.

12:31 PM  
Anonymous Anonymous said...

You have provided a very reasoned take on the DIVX IPO.

Among several things the numbers don't make rational sense. I suspect we are seeing here a renewal of the tech bubble investment mentality and the thinking on DIVX and the underwiters' parts that the internet video mania starting to take shape will cause less astute investors to turn a blind eye to fundmentals surrounding this company that strongly argue their self perceived value is way overstated.

This is a potentially dangerous offering from the standpoint that DIVX is using the Google card. Everybody wishes they had a piece of Google. Big mistake. DIVX by itself isn't another Google. Not even close. Big problem. Google could also quit being one of their big benefactors any time.

Looks to me like the only sure fire winners in this IPO will be the insiders unloading their 1.6 million shares. Wouldn't mind being one of them. But think I will be watching from the sidelines on this one. As a street investor the Risk/reward ratio doesn't smell all that good to me. But you are correct. If enough get infected with euphoria over this one it could skyrocket out the gate. But then how long after that when it hits the ground with a big thud? For sure if everyone starts flipping then this has the potential become one ugly deal when the rush to the exit picks up speed. Guess we will find out.

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