Description

DIVX (DIVX: Nasdaq) is one hell of a misunderstood company...and its market capitalization illustrates this fact. With issued and outstanding shares of 32.7 mm (approximately 33 mm diluted) and a closing yesterday (price relects close on 11/17, closed on 11/27 at $5.02) of $5.40, the company has an equity market capitalization of $176.6 mm. This compares to net assets of $183 mm and net cash and short term investments of $139mm.

DIVX trades below a cash laden book value and is currently unprofitable after adjusting for a $9.5mm pre-tax legal settlement with Yahoo.  The total enterprise value is a paltry $38 mm and, with a depressed LTM EBITDA of $1.7mm, the enterprise value multiple is 22x. Adjusting EBITDA for $9.1mm in stock based compensation, the company trades at an enterprise value multiple of 3.5x. 

I argue that the earnings should recover as licensing revenue from emerging device categories and from the new software distribution relationship with Google ramp up. Additionally there is opportunity to reduce operating expenses. Stock based compensation appears high, depreciation expense will decline as the company fully depreciates PP&E in 2010, and cost of technology sales, which ballooned concurrent with recent new product and version launches, will likely moderate.

I recommend a long position in DIVX and expect a return to positive operating leverage. Consensus earnings for next year are currently earnings of $0.9 per share. I argue that the company should earn closer to $0.16 next year and $0.40 in 2011 and think that the stock is a double.  Downside risk from these levels is to cash, which is currently around $4.21 per share and growing due to the cash generated even despite reported losses.

THE DIVX BUSINESS MODEL

DIVX is in the business of developing compression and decompression software ("codecs") used to facilitate the efficient distribution of recorded visual content. The company currently makes money by:  1) licensing its software to a growing range of consumer hardware device OEMs 2) licensing software to other software vendors and directly to consumers, and 3) distributing third-party software. In all, licensing represented approximately 88% of revenue during the most recent quarter and distribution 12%.

Licensing revenues have historically been driven by retail sales of DVD devices. Licensing agreements typically call for fees to be earned on each unit sold and is recognized by the company one quarter in arrears. As DVD sales have contracted so has licensing revenues. Perceptions of further secular declines in DVD hardware sales appear to be a major reason for the low market valuation. To combat this erosion in DVD related revenues the company stepped up its licensing activities in "emerging" hardware categories.

Emerging product categories represented 16% of (depressed) licensing revenue for Q3 2009 as DIVX boasts having certified in total over 1,100 Digital TV models, 350 Blue-ray devices, 55 mobile phones, and 11 integrated circuit designers and manufacturers. In my estimation, and considering the pace of adoption in the DVD category and the number of DVD OEMs who also manufacture products in these emerging categories, several of these new categories may likewise come to be dominated by DIVX. Management projects that emerging product revenue in Q4 2009 to represent 24% of licensing revenue.

It is useful to highlight the impact of the revenue recognition policy on reported profitability during periods involving the launch of multiple new versions and product platforms. While the expenses associated with getting these product platforms to market are recognized when incurred the revenue is booked a quarter after the OEM ships the product into the market. Several product upgrades, including DIVX 7, have recently been launched into the market. At the same time products have been customized and made suitable for the emerging products categories discussed. Revenue from emerging products is just becoming visible and will ramp during the upcoming quarters. I expect that product costs will moderate going forward, leading to increased technology licensing gross margins .

Complimenting DIVX's OEM strategy are its efforts to package and protect content by signing agreements with a growing list of movie studios. Multi-year format agreements are now in place with four studios: Sony Pictures, Warner Brothers, Paramount and Lionsgate. And the library of movies available in the DIVX format is growing. This accomplishment is intended to be monetized indirectly by the licensing of software to on-line exhibitors and/or distributors.

This success on the content side could not have happened were it not for the company's decision in early 2008 to shut down a wildly popular (and expensive to operate) website called Stage6. Stage6 was devoted to hosting content uploaded by DIVX users and video developers. It became a bazaar where all manner of studio and other content was available for viewing, presumably to the displeasure of the major studios.

A major management schism developed as a result of the decision to and the manner in which Stage6 was shut down. While the details aren't directly pertinent to this recommendation, the results included the resignation of several key executives, the alienation of perhaps several thousands users and video developers, and, on the positive side of things, significant dollar savings associated with the elimination of the bandwidth and administrative costs required to run the site.  

Shutting down Stage6, as mentioned, helped the company patch up relations with content providers and paved the way for the studio deals signed in the last year.  Nonetheless, overhanging the company until recently was an unresolved legal dispute with Universal Music Group (UMG) concerning the operation of Stage6 which alleged copyright infringement among other things. On November 16, 2009 the companies reached a settlement under which DIVX may be obliged to pay UMG either $6mm or $15mm. According to the 8-K filed on that date, "no amounts are due from the Company to UMG under the UMG Settlement and the Company does not believe that the triggers under the UMG Settlement are probable to occur".

On the distribution end of the business the past years have also witnessed severe disruptions from which the company has recovered nicely.  The distribution business is the business of offering those who download DIVX software the option to also download third-party software. For each download and/or activation the third-party pays a fee.

The value of this unique distribution channel is clear. According to the company, there were over 1.2 billion launches of the DIVX player and web player during the first nine months of the year and 450 mm during Q3. With the release of DIVX 7 in January, many of those launches represented a potential upgrade opportunity and a shot at a consumer opting in for a third-party download. In addition there were 12.2 million average monthly unique visitors to DivX.com during Q2 2009, an increase of 22% over last year. The software download button features prominently on the home page.

During 2006-2007 DIVX distributed software for Google (mainly the Firefox Browser). In November 2007, as the term of the Google agreement approached, a two year distribution agreement was signed with Yahoo to distribute the Yahoo toolbar. In November 2008 Yahoo breached its agreement and discontinued making payments to DIVX for software downloads. Prior to the close of Q3 2009 DIVX and Yahoo settled the matter with Yahoo paying DIVX $9.5 mm.

At current a two year agreement with Google covering the distribution and activation of Google Chrome and toolbar for Internet Explorer is in place.  That agreement will term in 2011 and has a renewal option. The first full quarter of revenues was booked in Q3 2009 at $1.9mm. 

FINANCIAL FOOTPRINT

Below is a snapshot of the firm's operating performance.

Profitability collapsed this year as a result of the decline in total revenue and gross margins and an increase in cost of technology licensing.

The decline was most severe in both dollars and percentage terms in distribution services where the loss of the Yahoo toolbar business had its impact. The new Google relationship contributed its first full quarter of revenue in Q3 of $1.9mm. I expect that this business can reach $3mm per quarter with gross margins of around 90% and essentially no incremental operating expense. This business alone can contribute $0.20 per share in after-tax earnings annually. 

The technology licensing business suffered from a 10% decline in revenue and a doubling of cost of sales when comparing LTM 2009 to CY 2008. Revenue declines are attributable to the weakness in the DVD business, which I believe is caused by both cyclical (poor overall global consumer spending) and secular (decline in DVD shipments due to saturation in key markets, like USA) factors.

In the USA the DVD market is saturated. According to data complied by Netflix and presented at its 2008 Investor Day, approximately 100mm of the country's 113mm households have DVD players indicating an 88.5% penetration rate. The UK and EU are also well penetrated, with the UK also around 90%. Household penetration rates in emerging countries tell a different story though:

                Russia                   52%

                Mexico                  48%

                Brazil                    44%

                China                    35%

                South Korea        19%

                Source: Iconoculture, "Global View Super Trend"

Shipments of DVD players are projected to continue their decline in the North America, Europe and Japan and increase in China, India and the rest of the world. Overall shipments of players and recorders are expected to decline at a CAGR of 3.5% from 2007-2010 (Sources: In-Stat and Electronic Design & Strategy News), which sets a baseline for the rate of decline in DIVX revenue attributable to number of certified traditional DVDs sold into the market (the company claims to maintain its share of DVD shipments). Assuming an additional decline of 1.5% in fees per shipment, I think it is reasonable to project a 5% revenue decline attributable to secular factors. The remaining 5% decline experienced during the LTM period is therefore attributed to cyclical factors, which should recover with overall consumer spending.

As mentioned, licensing revenue on a LTM basis declined 10% but the cost of technology licensing doubled. Approximately 50% of the increase in cost of technology licensing stemmed from incremental costs since the beginning of the year associated with licensing of a software component (H.264) from a third party in connection with the launch of DIVX 7. This fee will persist in future periods, reducing gross margins on technology licensing and increasing operating leverage. The remaining portion of the increase is related to other launch related costs and is likely to moderate.

Cash flow tells a different story altogether. Despite the decline in revenue and profits, and even adjusting for the Yahoo settlement, DIVX generated goodly amounts of cash flow. Key adjustments to net income include depreciation, amortization and stock based compensation, which in total represented close to $15 mm during the last twelve months.

Net plant, property and equipment totaled $2.4mm at 9/30/09 while depreciation/amortization for the nine month period to 9/30/09 totaled $4.8mm. Absent any huge new purchases of capital equipment, Net PP&E should be depreciated to near zero in the next quarter or two benefiting operating margins.

Finally, the soaking of insiders with stock options represented a justifiable effort to retain talent against the backdrop of the Stage6 episode and the turnover it caused and can not be maintained indefinitely. It will moderate.

I have no idea as to why the cash flow generative properties of this business get ignored by investors but it apparently does.

EARNINGS ESTIMATES

Current estimates for 2010 appear to be too low. Eight analysts on average project revenue of $74.75 mm and EPS of $0.09. I expect 2010 EPS to come in closer to $0.16, operating cash flow of $13mm, and a year end cash balance of around $4.60 per share (assuming no acquisitions or buybacks). For 2011 I project EPS of $0.40, operating cash flow of $18.5mm, and a year end cash balance of $5.00 per share. My model is below:

Key assumptions are as follows:

Return to Growth in Technology Licensing. Primary factors include a decline in traditional DVD more than offset by the significant ramp in emerging product revenue. My projections assume the following on an average quarter basis:

                                                         Q3 2009                                2010                       2011

        Traditional DVD               12,700                   12,065                   11.460                   assumes a 5% decline

        Emerging Products             1,900                      5,435                      8,665                   

                        Total            14,600                   17,500                   20,125

       Traditional DVD                  87%                         69%                       57%

       Emerging Products              13%                         31%                       43%

Increase in Distribution Revenue. The Google arrangement is projected to yield $3 mm per quarter, or 50% more than actual revenue generated in Q3 2009. This compares to average quarterly revenue of $3.8 mm in the 2006-2007 period, the last time the company performed this service for Google. Since that time the number of downloads of DIVX software has grown dramatically.

Moderate Expectations for Gross Margins. Combined gross margins are consistent with the LTM period but reflect a decline in technology licensing of about 80 bps (due to the licensing costs) and an increase of 460 bps in distribution (due to increased revenue).

Operating Expenses Moderate. I assume that stock based compensation is reigned in from an annual rate of $9mm  to $5mm. The logic is that the company has achieved its goal of retaining key talent and stabilizing the organization and that a more normal pattern will emerge at a lower level. Additionally, PP&E is fully depreciated in 2010.

VALUATION

Applying a multiple of 15x to 2011 earnings estimates and adding the expected $5.00 per share in cash gets me to $11.15 per share. For a comparable, Dolby Labs currently trades at 20x TLM earnings.

RISKS

While there are risks to the company achieving the growth I've modeled, particularly in emerging products category, this growth potential is certainly not imputed in the current share price. On a two year hold I think the downside risk from this level is on the order of 10-20% and the potential is at least a double.

Catalyst

1. Operating performance, including resumption of revenue growth and moderate operating leverage

2. Analyst upward revision to currently low EPS projections