Source: Seeking Alpha, http://seekingalpha.com
by Davis Freeberg
Over the past week, I?셶e spent a lot of time thinking about DivX?셲 (DIVX) decision to close down Stage6. When I first heard the news, I wasn?셳 sure how to feel about the decision. On one hand, I believe strongly in the free market system and when DivX chose to go public, they took on an obligation to look after their shareholder interests.
By turning to the public, DivX was able to raise more than $140 million in cash from investors who believed in the future of the company. Having access to this kind of capital opened a lot of doors for DivX, but it also came with strings attached. While it?셲 easy to blame DivX?셲 insiders for pulling the plug, without their initial support, DivX never would have been able to create Stage6 to begin with. I disagree with the final decision to shut the site down, but I can at least understand the economic realities that drove the decision to remove Stage6 from the core business.
On another hand, I was a fan of DivX long before their IPO and a loyal member of the Stage6 community. Without DivX?셲 community, they never would have succeeded in the first place and to abandon their fans over corporate profits speaks volumes about the priorities behind the decision makers at the helm of the company. While the cold hearted capitalist in me has no moral high ground to stand on, the fan in me can?셳 help but be heartbroken by the realization that DivX may have lost their soul in the course of going public.
I?셶e been using Stage6 from the very beginning and while it has always had its fair share of eccentricities, I?셶e found that it?셲 gotten better and better as the site has developed.
Over the last year and a half, I?셶e been able to watch ?쐗eb??videos on my 60??television, I?셶e been able to discover high quality original content that is more relevant to me than anything on cable, and I?셶e even been able to connect directly with the artists whom I?셶e admired. When the history of Stage6 is finally written, it will be easy to be distracted by Stage6?셲 problems with piracy or the politics at the corporate level, but to see those independent artists lose this platform is the real tragedy behind the Stage6 story.
Seeing DivX shut down Stage6 has been tough, but watching the fallout from it has been even more depressing. Initial reports blamed lack of traffic as the reason behind Stage6?셲 failure. Silicon Valley Insider?셲 headline on the story read ??span class=”yshortcuts” id=”lw_1204808193_16″>YouTube Kills Another Rival.??In Gizmodo?셲 coverage of the news, they write, ?쏽ou may only be vaguely aware of DivX?셲 Stage 6 video site (which probably explains why it wasn?셳 successful).??/p>
The problem with this theory is that Stage6?셲 traffic was actually quite impressive. If anything, Stage6 was a victim of its own popularity. From the get go, DivX tried to rein in the growth of the site, but in the end, high quality downloadable video proved too compelling to stop the explosion in their traffic.
DivX first launched Stage6 in August 2006. Initially, it was intended to be a modest experiment where DivX could showcase their technology. After two months and very little marketing, traffic to the site was already in the ?쐆undreds of thousands user range.??On DivX?셲 first conference call with investors, Jordan Greenhall told analysts that ?쐇n 2007 we have specifically modeled Stage6 to spend no more than $5 million, until and unless we specifically decide to do otherwise.??
Had Stage6 remained underground, DivX would likely have treated the site as a minor marketing expense, but as word about the site leaked out, it created momentum that DivX was powerless to stop.
At the time, $5 million in budgeting seemed appropriate, but even Greenhall couldn?셳 have anticipated how popular Stage6 would turn out to be and by the end of 2006, Stage6?셲 traffic was clocking in at 2.4 million unique visitors per month. By February of 07??Stage6 hit 3 million uniques and 2 months later, traffic was at 4.3 million visitors.
By July Stage6 traffic hit 10 million visitors and it was clear that DivX had tapped into something very powerful. In the first six months of 2007, Stage6 had already burned through the $5 million that they had budgeted and expenses were continuing to climb. In order to better capitalize on their Stage6 asset, DivX announced plans to divest the business and Jordan Greenhall agreed to step down as CEO, under the guise that he would take control of the new Stage6 entity.
By the 3rd quarter of 07?? DivX was spending $4 million a quarter with about 2/3rds of the expense going towards bandwidth. To help control these costs, DivX started an aggressive campaign to remove porn and copyrighted content from their servers, but their efforts were of limited success. When they updated their web player to block certain sites from playing Stage6 content, the pirates were quick to point out that users could get around this restriction by installing older versions of the software. When they started to aggressively remove copyrighted content, people built automated uploading tools that where able to overwhelm the Stage6 staff. Their efforts did help to slow down the growth rate at the site, but by October traffic had still risen to 11.4 million visitors.
With traffic continuing to rise, DivX warned investors that they were budgeting another $6.5 – $10 million in Stage6 expenses for the 4th quarter/second half of 2008. When DivX finally pulled the plug on Stage6, they had likely spent $17 – $20 million on the ?쐃xperiment??and had over 19 million unique visitors to show for it.
To help put this growth into perspective, 19 million uniques is roughly two thirds the number of US visitors that YouTube was getting when they were acquired by Google (GOOG) for $1.6 billion in stock.
With DivX facing the prospect of having to fund another $20 million in 08??just to keep Stage6 running, I?셫 not surprised that the traffic eventually proved too bitter a pill for shareholders to swallow. From the outside, it’s easy to blame YouTube for Stage6?셲 demise, but in reality, the site was far more popular than most observers realize.
Given the growth trajectory and the size of the Stage6 community, I had expected that Stage6 would have no difficulty in raising capital to fund the venture, but in December DivX unexpectedly announced Greenhall?셲 resignation from the board of directors and warned that the Stage6 divestiture would not take place in the time frame given to investors.
At the time, I had a lot of trouble making heads or tails of this announcement and it wasn?셳 until Michael Arrington leaked the sordid details behind the breakdown of Stage6, that I realized the significance of Greenhall?셲 departure. According to Arrington, DivX had raised commitments for $27 million in capital at a $90 million valuation. Given that my own internal valuation had pegged the site at $85 million, it would appear to me that this was a fair valuation for both DivX shareholders as well as Stage6 investors. Why this deal broke down isn?셳 exactly clear and the devil really is in the details, but Arrington pins the blame on massive egos getting in the way of shareholder interests.
At a meeting in late November the DivX board was asked to approve the spinoff and venture financing. But at the last minute the board decided to cancel the spinoff and retain control of Stage6. It?셲 not clear why they did this – perhaps they were surprised at the valuation and wanted to keep control of the assets. Or perhaps the revenue from Stage6 was too material for them to let it go over the long run. From what we hear a massive battle of egos ultimately killed the deal. But when the decision was made, the key Stage6 founders resigned.
Arrington speculates as to why DivX?셲 board turned down the offer, but the reasons he cites don?셳 really mesh with what the company was trying to do from a financial perspective. It could be that DivX?셲 board simply didn?셳 like the terms of the deal or that the financing was never really in place to begin with, but my own conspiracy theory is far more insidious.
I think that the board wanted out of DivX and engineered a coup to take over control of the company.
Greenhall always had grand visions for DivX and clearly wasn?셳 afraid to take risks. Starting Stage6 was both a brilliant and stupid move on his part. In a very short period of time, he created a valuable asset for the company, but its cost structure punished shareholders who didn?셳 buy into his long term vision. The very reckless nature that was crucial to his success as an entrepreneur, understandably made Wall St. more than a little nervous.
Knowing that Greenhall would never willingly cede control, the board tempted him by offering him control over the Stage6 spinoff. Stage6 was Greenhall?셲 brainchild to begin with and the bait proved more than he could resist, so in July 2007, he stepped aside as CEO to begin raising funds for the venture. Initially, I don?셳 think that the board planned on shutting down Stage6, but when financing failed to materialize, they ran out of patience and began to dismantle the team behind the community. When Greenhall found out about their plans, his emotions likely got the better of him and after cornering himself into an ultimatum, he was tricked into giving up the little remaining control that he had left.
While there is no way to know the exact details behind what really happened amidst the backdrop of the Stage6 revolt, there were two noteworthy public filings that hinted of the trouble brewing in Shangri La.
The first was the revelation that Insight Venture Partners had unloaded their shares on the open market. The second was an amendment adopted by the board that provides significant financial incentives for management to engineer a sale of the company.
At the time, I had trouble reconciling these two filings because if DivX?셲 board was trying to shop the company, then it wouldn?셳 have made sense for Insight Ventures to bail out of the stock. Given what we now know about the Stage6 implosion, it doesn?셳 surprise me that Insight Ventures took the quick exit on this one.
One of the more interesting clauses buried in the change in control agreement is a provision that limits the rights of shareholders to elect new leadership at the board level. If a majority of the incumbent directors are replaced within an 18-month period, it triggers a provision that would cost DivX shareholders dearly. With 3 of the original board members having now resigned, it doesn?셳 surprise me that the board backdated the agreement prior to Greenhall leaving, so that Hell?셲 appointment to the board would count against this limit.
It?셲 easy to overlook this fine print as business as usual, but I think the board implemented these measures to ensure that they would remain in control, in the event that DivX?셲 long term shareholders objected to their short sighted decisions.
No one enjoys having their dirty laundry aired publicly and it?셲 easy to get distracted by the drama surrounding the closure of Stage6, but I think it?셲 important for investors to look past the soap opera and focus on what these decisions tell you about the priorities of DivX management. It?셲 hard to know the exact details behind Stage6?셲 failure, but there are a few facts that you can verify.
Whether intentionally or by accident, the DivX board removed Greenhall as CEO. In December DivX saw a mass exodus of their founders. Why they left may be open to interpretation, but the fact that they left together underscores how significant of an event this is. Given its traffic and growth, Stage6 had real value to the right investor, yet DivX?셲 board wasn?셳 willing to take the short term earnings hit, in order to maximize the value of the asset. During the time that Stage6 was falling apart, the board adopted an executive compensation plan that encourages management to sell the company even if it means sacrificing DivX?셲 long term future.
Now it?셲 entirely possible that I?셫 reading too much significance into the rift between the board and the Stage6 founders, but the only justification that I can see for the board leaving this kind of money on the table would be if they were trying to dress DivX up for an acquisition. For as much as Stage6 was potentially worth, it was just as much of a liability. Spinning off the site would have allowed DivX to maximize their investment in Stage6, but it would have involved a long legal fight that would have certainly scared off potential suitors.
Figuring out a way to monetize all that traffic would have been the best solution for Divx?셲 long term strategic positioning, but by closing the site, DivX chose to manipulate two important financial levers instead. Not only do Stage6?셲 expenses now translate directly into net income for the company, but DivX has decided to use the $20 million it would have cost to keep Stage6 running to boost the price of their stock through a share buyback program.
Normally I would be a fan of these sorts of shareholder friendly initiatives, but as a growth company, I think that DivX owes more to their investors. The company is in the middle of one of the hottest sectors of the new economy and to see them use their cash to buy back stock is a startling admission of how little conviction they have in the long term potential of their business. If DivX?셲 management really believes the company is undervalued, then why has there only been one insider purchase over the last six months? DivX may cite maximizing shareholder value as the rationale behind these moves, but closing down Stage6 to buy back their stock reeks of desperation. I may be misjudging the board?셲 motivation, but I can?셳 help but be suspicious that the real purpose behind the buyback announcement is to boost their stock price, so that their insiders can try to unload the business.
9 times out of 10, I?셝 argue that having the founders leave a company is a bad sign for investors, but in the case of DivX, I don?셳 think that it’s true. The people who really cared about the future have abandoned ship and Wall St. now controls DivX?셲 destiny. For investors to react to these events by selling off the stock 25% makes very little sense.
It?셲 hard to know what DivX would be worth to the right buyer, but I think that their recent sell off leaves them vulnerable to a low ball offer. If you strip out DivX?셲 cash, they are currently trading at an enterprise value of less than $200 million, their trailing 12 month P/E is at 18.50 and they are now trading at slightly more than 2 times book. For a company bringing in $80 million a year at 90%+ gross margins, this seem ridiculously undervalued in my opinion.
Whether DivX wasted money on Stage6 or not, their current valuation completely ignores the impact that the Stage6 savings will have on their earnings and certainly doesn?셳 reflect the potential that DivX?셲 board may be open to selling to the highest bidder. When you compare DivX?셲 current valuation to potential suitors, it?셲 easy to understand why DivX?셲 trojan horse would be worth a premium to the right strategic investor.
I hope that I?셫 wrong and that DivX?셲 attempts to maximize shareholder value only represents a temporary set back for their community, but when I connect the dots I see a board that is more interested in engineering short term profitability than in making the tough decisions necessary to ensure the long term success of the business. If the board was really in DivX for the long haul, it would have been easy for them to overlook DivX?셲 short term valuation while they tried to find a buyer for Stage6. If their goal was really to sell the company, then it was to their benefit to sacrifice Stage6.
Hopefully, I?셫 wrong about their plans and DivX will refocus on bringing innovative products to the market. Still, I can?셳 help but fear that the breakdown of Stage6 really represents the beginning of the end for a brand that I?셶e come to love. I?셫 in no position to pass judgment on DivX for thinking exclusively of their investors, but as a member of their community, it?셲 painful to lose one of my favorite web destinations over corporate profits.
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