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Small-Cap Spotlight: DivX Dicey, but Possibly Doable

This tech name's roller coaster has left investors queasy. Is it ready to soothe?

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.

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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


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


(AAPL) - Get Apple Inc. Report



(ADBE) - Get Adobe Inc. 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.

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The Lowdown on DivX

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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,


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announced it would be buying YouTube for $1.65 billion in stock.



(AKAM) - Get Akamai Technologies Inc. Report

, 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.

But after tagging the $30 level about a year ago, shares suffered as the company could not keep up with the Street's optimistic expectations. In addition, confidence in DivX management was shaken by the departure of CFO John Tanner in April for "personal reasons."

It's rarely a good sign when the CFO leaves less than a year after the IPO. To make matters worse, the analyst community was less than pleased when management preannounced positive revenue results for DivX's first quarter, only to report worse-than-expected earnings (due to a higher tax rate) when the quarterly results were announced a few weeks later.

So there's no defending management's performance over the past year, and I won't argue that DivX's technology will crush the competition. But, aggressive small-cap investors could seize the opportunity created by the missteps and lowered expectations.

DivX bottomed around $12 a few weeks ago ahead of its recent earnings report. The market had expected another disappointing set of quarterly results, but DivX reported a surprisingly strong third quarter, beating consensus earnings estimates by 5 cents, topping revenue expectations, and even pushing fourth-quarter earnings guidance above consensus estimates.

Obviously, many investors had already thrown in the towel on DivX, and more tellingly, the short interest position in DivX had ballooned to over 4 million shares from 1.7 million at the beginning of 2007. That created a heck of a short squeeze considering that DivX has a float of just over 20 million shares.

What's particularly noteworthy is that DivX hasn't changed much on a fundamental basis over the past year. The company continues to penetrate the DVD player market, and it appears on track with its push into devices like cell phones and digital cameras.

On Tuesday, the company announced that it signed a licensing agreement with


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for the Playstation 3 gaming console, which is not a huge development by itself but shows the continued momentum in proliferating DivX technology. I find it interesting that Sony entered this agreement considering that it has refused to incorporate DivX into its DVD players.

Another important focus for investors is DivX's international opportunity. In the U.S., only about one-third of DVD players are DivX-certified. However, the company's penetration in Europe is about 90%, and investors should consider the potential in China, India and other international markets where the competition has less of a foothold, and where DivX's ability to be used for transferring copyrighted material is a much smaller concern than in the U.S. This enormous potential, once a key driver for shares following the DivX IPO, has taken a back seat since the company released the weaker-than-expected short-term financial results.

So aggressive investors can pick up a company with enormous long-term upside at a cheap price, thanks to its self-inflicted wounds. The future of digital video remains highly uncertain, but DivX has a strong reputation as being the high-quality option, and a look at the quality of videos on YouTube should give you an idea of how much further there is to go.

Curzio: Safer on the Sidelines

Two weeks ago, DivX reported solid third-quarter results and raised its guidance, sending shares 50% higher on the week to over $19. This was great news for investors and analysts considering that all seven covering the stock had either buy or strong buy ratings despite shares falling sharply since April.

In April, management preannounced that its first-quarter results would exceed estimates sending shares more than 20% higher. A few weeks later, its forecast seemed misleading considering quarterly results were positive but guidance was soft. The news not only sent shares sharply lower, but DivX lost credibility with analysts.

Today, practically every sell-side analyst remains optimistic on the company's prospects. However, I believe the reward does not outweigh the risks following the significant move in the stock.

Looking at the current quarter, DivX has made progress increasing its worldwide penetration into the core DVD market to 37% from 25% over the previous 12 months. This market accounted for 71% of total revenues for the six months ending June 30 but management is quick to point out in its quarterly report that it does not expect sales of DVD players to continue to grow as quickly as they did in the past.

DivX is making strides in the digital camera and mobile phone markets, as Larsen mentioned above, but short-term growth will be heavily dependant on the company's ability to increase its market share in a relatively mature and increasingly commoditized industry.

Also, while Larsen points out heavy competition from Apple and Adobe, I would include


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(MSFT) - Get Microsoft Corporation Report

to this list of tech giants as competitors that have more resources than DivX.

On the valuation front, DivX has a strong balance sheet with $4.75 in cash and no debt. Also, shares are trading 24 times next year's earnings and are expected to grow at a very respectable 30% annually over the next three years according to Capital IQ.

These solid fundamentals and growth potential were highlighted by management at the JP Morgan conference and at the SMH Capital Markets growth conference. But my question is if management is so positive on the company, then why are they selling the stock?

In the past six months, insiders sold over 300,000 shares in 24 separate transactions. Many could argue that this is not a major factor, but most sales occurred from April to November when DivX was hitting new 52-week lows. At least insiders for


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dumped shares when these stocks were trading near all-time highs.

DivX remains a show-me stock and as of now, the future is uncertain. The company may continue to deliver strong results in its core market and expand its technology into new growth markets, but with the stock up 50% in less than two weeks and the numerous risks mentioned above, I would be taking profits here and monitoring its progress from the sidelines.

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Curzio and Kusick.