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Small-Cap Spotlight: DivX Dicey, but Possibly Doable

This week, Small-cap Spotlight focuses on DivX (DIVX), the video technology licensing company whose shares have taken a rollercoaster ride since going public in September 2006.

The stock rallied off its 52-week low last week when the company posted third-quarter earnings and revenue that beat Wall Street expectations. But is now the time to jump in? Frank and Larsen examine the complicated story of DivX and what the future holds for investors.

Have a small-cap you'd like to see covered? Email Curzio and Kusick .

Kusick: Know the History

"The future is never clear, and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values." -- Warren Buffet

When I started to work on DivX, this quote leapt to mind. Fortunately, we're at the time now when uncertainty is perhaps at its highest for the company, and so investors have the opportunity to pick up shares of a company that could end up as the standard in digital video used on PCs, TVs, cell phones, and anything else with a screen.

Of course, the problem lies with the pair of 800-pound gorillas standing in DivX's way, namely Apple (AAPL - Get Report) and Adobe (ADBE - Get Report). But this is Small-Cap Spotlight, and DivX, with it's $600 million market cap, stands in a unique and definitely uncertain position to carve out its own niche in the realm of high-quality, transferrable digital video.

The Lowdown on DivX

This stock spiked up more than 60% in the two months after going public, and then spent the next 11 months dropping 35% below the IPO price. So let's start by understanding the factors that drove these large swings in share price.

The bulk of DivX revenue comes from licensing its technology to the manufacturers of DVD players and other devices, which enables the equipment to play video content that has been stored using DivX's extremely popular (and free) software. For example, someone who buys a DVD player that is DivX-enabled can play a DVD that they made on their PC using DivX software. The company is also moving into categories like mobile phones, game consoles, set-top boxes and digital cameras, which will generate additional licensing revenue while maximizing the reach of DivX-formatted video.

Video was definitely the hot topic in the investment community when DivX came public on Sept 25, 2006. In October 2006, Google (GOOG - Get Report) announced it would be buying YouTube for $1.65 billion in stock.

Meanwhile, Akamai (AKAM), the leader in online video delivery, had seen its share price more than double since the beginning of the year. So it was no surprise that investors scrambled to pick up shares of DivX, which boasted a large community of users of its software, as well as a fast-growing licensing business with lots of room for continued penetration. Also piquing investor interest was the company's Web property, which is DivX's version of YouTube.

Then on Nov. 1, 2006, analysts at JP Morgan, Cowen and Canaccord Adams all published research reports initiating coverage of DivX with a buy or similarly positive rating. The company's growth story and gross margins above 90% were just too good for analysts to pass up at the time. Essentially, DivX came public at the exact moment that the market was most interested in digital video.
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