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I have no idea whatsoever why DIVX continues to climb higher. It is one of my few losing picks, despite being based on what I believe to be solid analysis. So, recently I decided to read their 10-Q filing from November 13th. After reading the 10-Q I'm more convinced than ever that DIVX is going to disappoint many wishful thinkers out there and that their stock prices is based almost entirely on "irrational exhuberance". Here are the key points I have gleaned from the 10-Q:

 

1. DIVX's net revenues are up roughly 90% from this time last year, due mostly to increased sales of DIVX-certified devices by licensees and payments from Google for distributing their toolbar with the DIVX installer.

 

2. The vast majority of DIVX's profits come from licensing fees from hardware manufacturers and the majority of that comes from only two manufacturers. Their net revenues break down into 4 areas like this: hardware licensing - 70%; software licensing - 9%; Advertising 3rd party products (mostly Google Toolbar) - 20%; Media distribution (Stage 6) - 1%.

 

3. DIVX has not been successful in generating widespread interest in their format for streaming use and has not managed to woo any major web content distribution partners. This is most likely due to the fact that to stream DIVX you need a special web player and existing technologies such as Flash video are already ubiquitous and more functional as streaming web formats. Flash video is far more versatile for content creators and has features that make it ideal for web content creators. Content creators and distributors have zero incentive to adopt a new format that will be more problematic, costly, and less feature-rich than Flash.

 

4. DIVX's attempt to create their own content distribution network is not yet successful in any relevant way. Unless they totally focus their company on becoming a content distribution network, they will not stand a chance of breaking into territory already owned by Google/YouTube, Yahoo, and MySpace, all of whom use Flash and even then, their prospects for actually making money off it are almost zero. The legal bills alone would sink them.

 

Here's a few quotes from their latest 10-Q that I found particularly interesting:

 

"A small number of customers account for a significant percentage of our revenues. In the third quarter of 2006, two customers accounted for 24% and 12%, respectively, of our revenues. For the nine months ended September 30, 2006, the same two customers accounted for 21% and 9%, respectively, of our revenues."

 

In other words, they are extremely vulnerable to cheaper competing technologies. They don't really have many big paying customers and if one or two of them stops paying DIVX, then DIVX's net income will plummet overnight.

 

"If our online video community website, Stage6.com, is successful, our associated Internet connectivity and content licensing costs may increase at a higher rate than the revenues we derive from Stage6.com, which would reduce our gross margins."

 

In other words, even if their video distribution business picks up, it will likely COST them more money than it makes them directly. The only financial benefits they might expect to glean from a successful video portal would be increased demand for hardware devices that license their technology -- and this is one of the more important new revenue streams in their overall business plan.

 

DIVX spokemen have recently made some very nebulous statements about their relationship with Google/YouTube, saying things like "YouTube recommends DIVX" video format and implying that there may be some kind of shift to using DIVX to stream YouTube videos. Strangely, there is no evidence of this on YouTube, which uses Flash video. Perhaps there is something in the works, but I see little reason for YouTube to switch from Flash video to a less widely-used codec. The only way I can see YouTube or other services that currently use Flash video switching to DIVX is if Adobe were to directly incorporate DIVX compression into the Flash plugin. This seem unlikely as it would probably lead to a dramatic increase in the size of the Flash Plugin installer and require licensing fees which Adobe has no need to pay if they simply implement their own version of MPEG4 compression. Also, it would take a couple of years for the installed base of Flash users to update their plugin to be able to take advantage of a new video format. There is always a chance that Adobe will simply acquire DIVX instead of implementing their own MPEG4 codec, which is the only happy ending I can imagine for DIVX investors over the long term. Still, I don't see why Adobe wouldn't be just as likely to use the open-source XVID codec instead.

 

Probably the most telling aspect of the current DIVX hype is the fact that their competitors who are already hugely successful in the streaming media space that DIVX covets, have not enjoyed a similar dramatic rise in stock price, even as they have strengthened their hold on the industry. For instance, while the media hype machine was busy gushing about the YouTube purchase by Google, there was no obvious impact on Adobe's stock price and no mention in the press or anywhere else I could find, of the fact that YouTube and most other major streaming video sites use Flash Video format. This is particularly odd because it represents a dramatic shift in the streaming video industry over the past two years as Flash video format has gone from near obscurity to near ubiquity while established players such as Real Networks and Microsoft have floundered despite having some excellent technology and a large installed user base. The same optimism that is boosting DIVX's stock price should have already rocketed ADBE through the stratosphere, so this is a clear sign that DIVX investors are totally detached from reality or they would be buying Adobe stock instead. Granted Adobe's market cap is huge compared to DIVX and they don't receive licensing fees for the use of Flash video, but that's all the more reason to be suspect of DIVX's prospects in this space. I mean, come on, if you are competing for a market that is already dominated by one of the most successful and prolific software makers in the world (and it only took them 2 years to pull it off), then you're going to have to do something extra special. In particular you're going to have to execute a strategy that includes monetizing an industry that your dominant competition has shown no interest in monetizing. The JAVA folks over at Sun Microsystems could teach a course on this issue, but I digress. Adobe could do nothing but lose money on Flash Video forever and not even notice it in their bottom line because they are so profitable everywhere else. And let's not even talk about Windows Media, Real Video and Apple's video format (Quicktime or whatever they are pushing this week). DIVX will never compete with these companies in the streaming media space, even if MPEG4 was a good choice for streaming web video, which so far, it isn't.

 

So here we have a stock showing excellent growth but trying to justify a P/E of about 568. The stock price is based entirely on revenue growth and wishful thinking, and completely fails to factor in relevant risk and future limitations. Does anyone else here smell history repeating itself? I haven't seen a bubble this overinflated since 2000.

 

I realize that I'm focusing mostly on their weakness in the streaming media space when they are currently more suited to breaking into the Video on Demand market, but everything I see from DIVX right now suggests that they really want to break into streaming video and I can't see that happening. As for VOD, I just don't see the market improving for it until the format wars have settled down. I believe that the industry is moving toward finding a single format that can handle both streaming and VOD distribution methods in a way that doesn't piss off users with DRM. I think this will most likely come in the form of Adobe's Flash plug-in. If Adobe were to buy DIVX and fold the DIVX (or other MPEG4) codec into the Flash player, then Flash would become the undisputed online video distribution format of choice for streaming and VOD. Perhaps everyone out there is banking on Adobe acquiring DIVX, but that's really the only long-term upside I can see on this one. Otherwise, DIVX will just be relegated to playing pirated movies and video game trailers.

 

So that's my take on DIVX. I would love to hear what others have to say about it.

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