DivX 10-Q 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
for the quarterly period ended September 30, 2007
For the transition period from to
Commission File Number 001-33029
(Exact name of Registrant as specified in its Charter)
4780 Eastgate Mall
San Diego, California 92121
(Address of Principal Executive Offices, including Zip Code)
(Registrants Telephone Number, Including Area Code)
(Former name, former address and former fiscal year if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:
Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (check one):
Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer x
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934):
Yes ¨ No x
The number of shares of the Registrants Common Stock outstanding as of October 31, 2007 was 34,604,860.
QUARTERLY REPORT ON FORM 10-Q FOR THE PERIOD ENDED SEPTEMBER 30, 2007
TABLE OF CONTENTS
PART I FINANCIAL INFORMATION
CONSOLIDATED CONDENSED BALANCE SHEETS
(In thousands, except share data)
The accompanying notes are an integral part of these unaudited consolidated condensed financial statements.
CONSOLIDATED CONDENSED STATEMENTS OF INCOME
(In thousands, except per share data)
The accompanying notes are an integral part of these unaudited consolidated condensed financial statements.
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these unaudited consolidated condensed financial statements.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
Note 1Background and Basis of Presentation
Basis of Presentation
The accompanying consolidated condensed balance sheets as of December 31, 2006 and September 30, 2007, the consolidated condensed statements of income for the three and nine months ended September 30, 2006 and 2007 and the consolidated condensed statements of cash flows for the nine months ended September 30, 2006 and 2007 are unaudited. These statements should be read in conjunction with the audited consolidated financial statements and related notes, together with managements discussion and analysis of financial condition and results of operations, contained in the Annual Report on Form 10-K filed by the Company with the Securities and Exchange Commission, or SEC, on March 29, 2007.
The accompanying unaudited consolidated condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. In the opinion of the Companys management, the unaudited consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements in the Annual Report, and include all adjustments (consisting of normal recurring accruals) necessary for the fair presentation of the Companys financial information for the periods presented. The results for the three and nine months ended September 30, 2007 are not necessarily indicative of the results to be expected for the year ending December 31, 2007.
The Companys technology licensing revenues are derived primarily from per-unit royalties received from original equipment manufacturers. The Company licenses its technologies to manufacturers of integrated circuits designed for consumer hardware products, as well as consumer hardware device manufacturers who have licensed its technologies for incorporation in products such as DVD players, personal media players, portable media players, digital still cameras, smart TVs and mobile handsets. The Companys licensing arrangements typically entitle it to receive a royalty for each product unit incorporating its technologies that are shipped by licensed original equipment manufacturer. Because royalties are generated by the shipment volumes of consumer hardware device customers, and because sales by consumer hardware device manufacturers are highly seasonal, historically revenues relating to consumer hardware devices have been highly seasonal, with second quarter revenues in any calendar year being generally lower than any other quarter in a calendar year.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from these estimates.
Note 2Recently Issued Accounting Standards
In June 2006, the Financial Accounting Standards Board, or FASB, issued Interpretation No. 48, or FIN 48, Accounting for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109. FIN 48 clarifies the recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 was effective for fiscal years beginning after December 15, 2006. The Company adopted FIN 48 effective January 1, 2007. The cumulative effect of the adoption resulted in an increase in the Companys income tax liability for unrecognized tax benefits of $2.4 million, with a corresponding increase to accumulated deficit. See Note 6 for additional discussion regarding the impact of the Companys adoption of FIN 48.
Also in September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, or SFAS 157. SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact, if any, of the provisions of SFAS 157.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, or SFAS 159, which permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. The provisions of SFAS 159 are effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact, if any, of the provisions of SFAS 159.
Note 3Earnings Per Share
For periods where the Company had two classes of equity securities, it followed Emerging Issues Task Force, or EITF, Issue No. 03-6, Participating Securities and the Two-Class Method under FASB Statement 128, which established standards regarding the computation of earnings per share, or EPS, by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the Company. EITF Issue No. 03-6 requires earnings available to common stockholders for the period, after deduction of preferred stock dividends, to be allocated between the common and preferred stockholders based on their respective rights to receive dividends. Basic EPS is then calculated by dividing income allocable to common stockholders (including the reduction for any undeclared, preferred stock dividends assuming current income for the period had been distributed) by the weighted average number of shares outstanding, net of shares subject to repurchase. EITF Issue No. 03-6 does not require the presentation of basic and diluted EPS for securities other than common stock; therefore, the following EPS amounts only pertain to the Companys common stock.
Upon the closing of the Companys initial public offering, in September 2006, all outstanding shares of preferred stock were converted to shares of common stock. Since the Company became a public company, the Company has followed SFAS No. 128, Earnings Per Share, which requires that basic EPS be calculated by dividing earnings available to common stockholders for the period by the weighted average number of shares of common stock outstanding. Income for the periods presented was allocated between the preferred and common stockholders on a straight-line basis over the number of days of the respective periods presented.
The Company calculates diluted EPS under the if-converted method unless the conversion of the preferred stock is anti-dilutive to basic EPS. To the extent preferred stock is anti-dilutive, the Company calculates diluted EPS under the two-class method.
The following table sets forth the computation of basic and diluted net income per share (in thousands, except per share amounts):
Potentially dilutive securities, which are not included in the calculation of diluted net income per share because to do so would be anti-dilutive, are as follows (in thousands):
Note 4Short-term investments
Cash and cash equivalents consist of cash, money market funds and other highly liquid investments with original maturities of three months or less from the date of purchase.
Investments with original maturities at the date of purchase greater than three months are classified as short-term investments. The Company manages its cash equivalents and short-term investments as a single portfolio of highly marketable securities, all of which are intended to be available for the Companys current operations. As such, all of the Companys short-term investments are classified as available-for-sale and are reported at fair value, as determined by quoted market prices, with any unrealized gains and losses, net of tax, recorded as a separate component of accumulated other comprehensive (loss) income in stockholders equity. The cost of securities sold is based on the specific-identification method. Investments in auction rate securities are recorded in short-term investments, at cost, which approximates fair value due to their variable interest rates, which typically reset every 7 to 28 days, and, despite the long-term nature of their stated contractual maturities, the Company has the ability to quickly liquidate these securities.
The following table summarizes short-term investments by security type as of September 30, 2007 (in thousands):
The following table summarizes short-term investments by security type as of December 31, 2006 (in thousands):
The following table summarizes the contractual maturities of the Companys short-term investments (in thousands):
Values for asset-backed securities have been assigned to maturity categories within the contractual maturities table based upon the set maturity date of the security. Realized gains and losses on short-term investments are included in interest expense and other in the accompanying Consolidated Condensed Statements of Income. The Company recorded no realized gains or losses on its short-term investments in the three or nine months ended September 30, 2006 or 2007.
As of September 30, 2007, the Company had no investments that have been in a continuous unrealized loss position for a period of 12 months.
Note 5Stock-Based Compensation Expense
Total stock-based compensation expense was as follows (in thousands):
The Company recorded $923,000 and $3.4 million in stock-based compensation expense during the nine months ended September 30, 2006 and 2007, respectively, related to stock-based awards granted during those periods. The remaining stock-based compensation expense primarily related to stock option awards granted in earlier periods. In addition, for the nine months ended September 30, 2006 and 2007, $60,000 and $1.5 million, respectively, was presented as financing activities in the consolidated condensed statement of cash flows to reflect the incremental tax benefits from stock options exercised in those periods. At September 30, 2007, total unrecognized estimated compensation costs related to non-vested stock options granted prior to that date was $26.0 million, which is expected to be recognized over a weighted-average period of 1.5 years.
In May 2007 and August 2007, the Company granted 324,000 and 72,000 stock options, respectively, all of which are performance-based awards. These awards vest upon the achievement of certain performance targets prior to December 31, 2007. Accounting guidance dictates that, for purposes of recognizing compensation expense for these types of awards, that compensation expense related to the performance-based awards be recognized ratably over the period from the date of the award through the estimated achievement date of satisfying the performance criteria, based on managements assessment of the probability that the performance targets will be met. If the performance targets are not reached by December 31, 2007, the corresponding stock options will be forfeited. At September 30, 2007, managements assessment was that it was not yet probable that the performance targets would be met, therefore as of September 30, 2007 no compensation expense has been recorded.
In October 2007, R. Jordan Greenhall resigned as an employee of the Company. Mr. Greenhall has indicated that he will continue to serve as the Chairman of the Companys board of directors. In connection with Mr. Greenhalls resignation from the Company as an employee, he agreed to cancel 495,000 unvested shares subject to stock options, which under the terms of the Companys 2006 Equity Incentive Plan would have continued to vest with his continued service as a non-employee member of the Companys board of directors. As prescribed by SFAS No. 123(R), Share-Based Payment, the Company will record a pretax charge of approximately $3.2 million in the fourth quarter of 2007 as a result of the settlement of these unvested shares subject to stock options.
Note 6Income Taxes
In June 2006, the FASB issued FIN 48 which creates a single model to address accounting for uncertainty in income tax positions. FIN 48 prescribes a minimum threshold that an income tax position is required to meet before being recognized in the financial statements. The interpretation also provides guidance on derecognition and measurement criteria in addition to
classification, interest and penalties and interim period accounting, and it significantly expands disclosure provisions for uncertain tax positions that have been or are expected to be taken in a companys tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006 and the Company, accordingly, has adopted this statement as of January 1, 2007. The cumulative effect of adopting FIN 48 has been recorded in accumulated deficit and other accounts as applicable.
As a result of the adoption of FIN 48, the Company has recorded an increase to accumulated deficit at January 1, 2007 of $2.4 million. Including the cumulative effect adjustment, at the beginning of 2007 the Company had $3.1 million of total unrecognized tax benefits that, if recognized, would favorably affect the Companys effective income tax rate in future periods. Additionally, management has determined, in accordance with FIN 48, that the total amount of unrecognized tax benefits at January 1, 2007 should be classified as a current liability on the Companys balance sheet. There have been no significant changes to these amounts during the three or nine months ended September 30, 2007. The Companys continuing practice is to recognize interest and/or penalties related to income tax matters as income tax expense. The Company had no accrued interest or penalties at January 1, 2007 and $103,000 of accrued interest and $0 accrued for penalties at September 30, 2007.
The $2.4 million cumulative effect adjustment for the implementation of FIN 48 relates to research tax credits. In managements judgment, these credits do not satisfy the more-likely-than-not standard required for recognition in the financial statements due to inadequate documentation. During 2007 the Company intends to undertake a detailed study of the research expenditures and accumulate supporting documentation to the extent reasonably possible. Upon completion of such study, management may conclude that it is more-likely-than-not that some portion of these research tax credits could be sustained upon audit. At that time, the Company would recognize that portion of the unrecognized tax benefit for these research tax credits as a reduction to tax expense as a discrete item in that periods tax provision.
The Company is subject to income taxation in the United States and various state jurisdictions. The Companys tax years for 2002 and later are subject to examination by the United States and state tax authorities.
Note 7Strategic Investments
In May 2007, the Company made an equity investment in a private corporation that aggregates and distributes art via its web community and facilitates an open forum where artists can exhibit their artwork and build community around that art in an effort to drive commerce. The Companys investment consisted of $3.5 million cash for which it received certain shares of the private corporations Series A Preferred Stock and entered into an advertising and marketing agreement. The Company has allocated approximately $650,000 of the investment to the advertising and marketing agreement, based on its estimated fair value, and the remaining $2.9 million will be carried as an investment. The value allocated to the advertising and marketing agreement will be amortized ratably over the period in which the services are expected to be rendered: October 2007 through March 2009. As the Companys ownership is less than 20%, the investment has been accounted for using the cost basis, and will periodically be reviewed for impairment. The investment and the long-term portion of the advertising and marketing agreement are included in other assets on the condensed consolidated balance sheet. The current portion of the advertising and marketing agreement is included in prepaid expenses.
In July 2007, the Company acquired all of the assets of a limited liability company engaged in real-time digital video processing for the purposes of producing enhanced video search and discovery services. At the time of acquisition, the operations of the limited liability company had been wound down and no development projects were in-process. The acquisition was accounted for as an acquisition of assets in accordance with Emerging Issues Task Force Issue No. 98-3, Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business. The total purchase price for the acquisition is up to $4.3 million comprised of an initial upfront cash payment of $2.0 million, which the Company made in July 2007, and subsequent cash payments up to $2.3 million upon the achievement of certain technology related milestones. The Company did not acquire any tangible assets or assume any liabilities as a result of the acquisition.
The Company allocated the initial cash payment of $2.0 million, along with the first milestone of $250,000, and $31,000 of acquisition related costs, for total purchase consideration of $2.3 million to the one identifiable intangible asset, a patented technology license. The asset will be amortized over the remaining life of the patented technology license, approximately 8 years.
In July 2007, subsequent to the asset purchase, the Companys board of directors approved a plan to separate the Companys Stage6 operations into a separate private entity. As a significant portion of the benefit from the acquired patented technology license was originally subscribed to Stage6 future activities, the Company evaluated the intangible asset for impairment as of September 30, 2007 in accordance with Statement of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets based on the projected benefits solely attributable to the Companys core consumer electronics business. Based on the Companys revised forecasts excluding the Stage6 future activities and discounting the cash flows attributable to the Companys core consumer electronics business, the Company concluded that the carrying amount of the asset was not fully recoverable and an impairment charge should be recognized. An impairment charge equal to $2.2 million was recorded in the third quarter of 2007, as the acquired patented technology license was considered to have a recoverable value of approximately $60,000.
Note 8Subsequent Event
On November 7, 2007, the Company and DivX Holdings, Inc., a wholly owned subsidiary of the Company (DivX Holdings), entered into a Share Purchase Agreement (the Purchase Agreement) with each of the shareholders of MainConcept AG, a corporation organized under the laws of Germany (MainConcept). Under the Purchase Agreement, DivX Holdings agreed to purchase all of the outstanding shares of MainConcept for approximately $16.2 million in cash and 88,940 shares of the Companys Common Stock. The Purchase Agreement also provides that DivX Holdings will purchase outstanding loans originally extended to MainConcept by one of its shareholders in an aggregate amount of approximately $4.4 million. In addition, the Purchase Agreement provides for additional payments of up to approximately $5.8 million upon the achievement by MainConcept of certain product development goals and certain financial milestones during 2008.
You should read the following discussion and analysis of our financial condition and results of our operations in conjunction with our consolidated condensed financial statements and the notes to those statements included elsewhere in this Quarterly Report on Form 10-Q, as well as our audited consolidated financial statements and notes to those statements as of and for the year ended December 31, 2006 included in our Annual Report on Form 10-K filed with the SEC on March 29, 2007. This discussion contains forward-looking statements reflecting our current expectations that involve risks and uncertainties. Our actual results and the timing of events may differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed in the section entitled Risk Factors, and elsewhere in this Quarterly Report on Form 10-Q.
We create products and services designed to improve the consumers experience of media. Our first product offering was a video compression-decompression software library, or codec, which has been actively sought out and downloaded by consumers over 250 million times since January 2003, including over 80 million times during the last twelve months. These downloads include those for which we receive revenue as well as free downloads, such as limited-time trial versions, and downloads provided as upgrades or support to existing end users of our products. We have since built on the success of our codec with other consumer software products, including the DivX Player application, which we distribute to consumers from our website, DivX.com. We also license our technologies to consumer hardware device manufacturers and certify their products to ensure the interoperable support of DivX-encoded content. Over 100 million DivX Certified hardware devices have been shipped worldwide through September 30, 2007. Our customers include major consumer video hardware original equipment manufacturers, or OEMs. We are entitled to receive a royalty for each DivX Certified device that our customers ship. In addition to technology licensing to consumer hardware device manufacturers, we currently generate revenue from software licensing, advertising and content distribution.
Sources of revenues
We have four revenue streams. Three of these are derived from our technologies, including technology licensing to manufacturers of consumer hardware devices, software licensing to independent software vendors and consumers, and services relating to digital media distribution over the Internet that is made possible via the deployment of our technologies. Additionally, we derive revenues from advertising and distributing third-party products on our website.
Our technology licensing revenues are derived primarily from per-unit royalties received from OEMs. We license our technologies to manufacturers of integrated circuits designed for consumer hardware products, as well as consumer hardware device manufacturers who have licensed our technologies for incorporation in products such as DVD players, personal media players, portable media players, digital still cameras, smart TVs and mobile handsets. Our licensing arrangements typically entitle us to receive a royalty for each product unit incorporating our technologies that is shipped by our OEM partners. Though significantly smaller in magnitude than royalties from unit-based shipments, we also receive technology fees from integrated circuit manufacturers, original design manufacturers and OEMs for rights to include our technologies in their products and for DivX product certifications. Because royalties are generated by the shipment volumes of our consumer hardware device customers, and because sales by consumer hardware device manufacturers are highly seasonal, we expect revenues relating to consumer hardware devices to be highly seasonal, with our second quarter revenues in any calendar year being generally lower than any other quarter in a calendar year.
Our software licensing revenues are derived primarily through per-unit royalties from independent software vendors, and to a lesser extent from direct software sales to consumers via our website. We work with independent software vendors to help them incorporate our technologies into their video creation, editing and playback software products. Our licensing arrangements typically entitle us to receive a royalty for each DivX-enabled software unit shipped by our independent software vendor partners. We offer software to consumers via our website both for a fee and on a free or trial basis. We believe that downloads of this software benefit our business both directly and indirectly. Our business benefits directly from increased revenues when the user downloads a for-pay version. Our business benefits indirectly when free or trial versions are downloaded, as we believe such downloads increase our installed base and therefore the demand for consumer hardware devices that contain our technologies.
Advertising and product distribution revenues have generally been earned when we include third-party software products with DivX software that is available for download to consumers from our websites. Presently, our only arrangements of this type are with Google and Yahoo!, although we have had arrangements with other parties in the past. Pursuant to our agreement with Google, with each download of included software, consumers are offered the opportunity to install Google software. Google pays us fees for meeting certain monthly distribution commitments related to our offering of included Google software to consumers, and activations of the software by consumers. In October 2007, we entered into an amendment to our arrangement with Google, which, among other things, modifies the expiration date to November 30, 2007, modifies the cap on the maximum amounts payable by Google to us under the agreement, and limits Googles payments to us during the month of November 2007 to certain installations occurring in such month instead of fees based on the number of downloads or activations of the included software by consumers as provided for under the original agreement.
In September 2007, we entered into a two-year agreement with Yahoo! to distribute the co-branded Yahoo! toolbar and Internet Explorer browser with our software. Yahoo! will pay us fees under the agreement based on the number of certain distributions or installations of the Yahoo! software. Distribution pursuant to the Yahoo! agreement commenced in early November 2007 and the agreement expires on December 31, 2009.
We earn digital media distribution revenues by providing a hosted service through our Open Video System to content providers that allows them to download their digital media content to users via the Internet. In such cases, digital media distribution revenues are derived as a revenue-share percentage of total content sales prices. We also derive revenues by encoding third-party content into the DivX format to allow such content to be delivered more efficiently via the Internet. Revenues for digital media distribution and other services have declined slightly for each period presented. In the third quarter of 2006, we reported our first instance of revenue related to content distribution arrangements with consumer hardware OEMs who pay us a fee for each copy of DivX-encoded content that is encoded on physical media and bundled with their consumer hardware products.
A small number of customers account for a significant percentage of our revenues. In the third quarter of 2007, two customers accounted for 23% and 14% of our revenues, respectively. For the nine months ended September 30, 2007, those same customers accounted for 23% and 11% of our revenues, respectively.
We are a global company with a broad, geographically diverse market presence. We have offices in six countries, and our hardware and software products are distributed in over 150 countries and territories. We have historically generated a substantial amount of our revenues from international sales, which have grown to represent a large percentage of our overall revenues. For the nine months ended September 30, 2007 and the fiscal year 2006, our revenues outside North America comprised 73% and 76%, respectively, of our total revenues. A large portion of our total revenues come from licensing our technologies to consumer hardware device manufacturers, most of whom are located outside of North America.
Cost of revenues
Our cost of revenues consists primarily of license fees payable to providers of intellectual property that is included in our technologies. Generally, royalties are due to our third-party intellectual property providers based on when certain of our products are sold, subject to contractually agreed-upon limits. To a much lesser extent, cost of revenues also includes depreciation on certain computing equipment and related software, the compensation of related employees, Internet connectivity costs, third-party payment processing fees and allocable overhead. Although this may not be the case in the future, and although we have experienced some variability to our cost of revenue structure in the past, in general our costs of revenues have not been highly variable with revenue volumes. As a result, we generally expect our overall gross margins to fluctuate with revenues. However, to the extent that digital media distribution revenues increase, we expect that gross margins associated with such revenue will be lower than we have historically experienced on our technology licensing or advertising revenues.
Selling, general and administrative
The majority of selling, general and administrative expenses consists of employee compensation costs. Selling, general and administrative expense also includes internet connectivity expenses, marketing expenses, business travel costs, trade show costs, outside consulting fees, allocable overhead and costs associated with being a publicly traded company, including expenses associated with comprehensively analyzing, documenting and testing our system of internal controls and maintaining our disclosure controls and procedures as a result of the regulatory requirements of the Sarbanes-Oxley Act. Our headcount for selling, general, and
administrative related personnel, including employees and outside contractors increased by 39 from 135 as of September 30, 2006 to 174 as of September 30, 2007. We intend to hire additional employees and outside contractors for our sales and marketing staff and to increase our selling and marketing budget in the future as we attempt to continue to raise awareness of our products and services, however we expect this to be at a slower pace than in past. We also expect that selling, general and administrative expense will fluctuate on a quarterly basis both in absolute dollars and as a percentage of revenues.
Internet connectivity costs for Stage6.com, our online video community service, are currently included in marketing costs as Stage6.com is currently producing insignificant revenues. As Stage6.com continues to build traffic prior to producing material revenues, we expect that associated internet connectivity costs will increase and will be reflected in marketing costs. The total costs directly associated with Stage6.com, which were approximately $4.0 million and $7.4 million in the three months and nine months ended September 30, 2007, respectively, and are expected to increase to approximately $6.0 million for the three months ending December 31, 2007. In July 2007, we announced the potential separation of Stage6.com and we have retained an investment banker in order to evaluate the various alternatives available to us related to Stage6.com.
The majority of product development expense consists of employee compensation for personnel responsible for the development of new technologies and products. Our headcount for product development related personnel, including employees and outside contractors increased by 7 from 117 as of September 30, 2006 to 124 as of September 30, 2007. Product development expense also includes depreciation of computer and related equipment, software license fees and allocable overhead. We expect to increase our product development expenses in absolute dollars as we continue to invest in the development of our products and services, though as a percentage of revenues such expenses may fluctuate on a quarterly basis. While we expect to continue to hire additional employees to meet our business needs, if permanent employees are not available for hire, we intend to use outside contractors to fulfill our labor needs when and as required to accomplish our operating goals.
Impairment of acquired intangibles
In the third quarter of fiscal 2007, we recorded an impairment charge of $2.2 million related to the patented technology license intangible asset acquired in connection with our acquisition of a limited liability company in July 2007. As more fully discussed in Note 7 in the accompanying unaudited consolidated condensed financial statements, management performed an impairment analysis of the assets in accordance with SFAS No. 144, and concluded that the asset was not fully recoverable and an impairment loss should be recognized as of September 30, 2007. The remaining $2.0 million contingent milestone payments under the asset purchase agreement entered into in connection with the acquisition may be expensed as each milestone is achieved, which is currently expected to occur during 2008.
Critical accounting policies
This discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements in accordance with GAAP requires us to use accounting policies and make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingencies as of the date of the financial statements and the reported amounts of revenue and expenses during a fiscal period. We consider an accounting policy to be critical if it is important to our financial condition and results of operations, and if it requires significant judgment and estimates on the part of management in its application. We have discussed the selection and development of the critical accounting policies with the audit committee of our board of directors, and the audit committee has reviewed our related disclosures. Although we believe that our judgments and estimates are appropriate and correct, actual results may differ from those estimates.
Our critical accounting policies are described in the notes to the consolidated financial statements included in our Annual Report on Form 10-K filed with the SEC on March 29, 2007. In addition, we have adopted the following critical accounting policy as a result of our strategic investments during the nine months ended September 30, 2007:
Strategic investments include equity investments accounted for under the cost method of accounting. For investments that represent less than a 20% ownership interest, the investments are carried at cost. Under the equity method of accounting, which generally applies to investments that represent 20% to 50% ownership, our proportionate ownership share of the earnings or losses of the affiliate would be recorded as equity income (loss) in earnings of affiliates in our consolidated statement of operations. We are required to exercise judgment in determining whether an investment is more accurately reflected using the cost or equity method.
We will periodically review indicators of the fair value of our strategic investments in order to assess whether available facts or circumstances, both internally and externally, may suggest an other than temporary decline in the value of the investment. The carrying value of an investment may be affected by the ability of the investee to obtain adequate funding and execute its business plans, general market conditions, industry considerations specific to the investees business, and other factors. The inability of an investee to obtain future funding or successfully execute its business plan could adversely affect our equity earnings of the investment in the periods affected by those events. Future adverse changes in market conditions or poor operating results of the investee could result in equity losses or an inability to recover the carrying value of the investment that may not be reflected in an investments current carrying value, thereby possibly requiring an impairment charge in the future. We will record an impairment charge when we believe an investment has experienced a decline in value that is other-than-temporary.
We have updated the following existing critical accounting policy as a result of the granting of performance based awards during the quarters ended June 30, 2007 and September 30, 2007:
Effective January 1, 2006 we adopted SFAS 123(R), which requires that all share-based payments to employees, including grants of employee stock options and restricted stock, be recognized in our financial statements based on their respective grant date fair values. Under this standard, the fair value of each share-based payment award is estimated on the date of grant using an option pricing model that meets certain requirements. We currently use the Black-Scholes option pricing model to estimate the fair value of our share-based payment awards. The determination of the fair value of share-based payment awards utilizing the Black-Scholes model is affected by our stock price and a number of assumptions, including expected volatility, expected life, risk-free interest rate and expected dividends. We have only a limited history of market prices of our common stock as we were not a public company prior to September 2006, and as such we estimate volatility in accordance with Staff Accounting Bulletin No. 107 using historical volatilities of similar public entities. The expected life of the awards is based on a simplified method which defines the life as the average of the contractual term of the options and the weighted average vesting period for all open tranches. The risk-free interest rate assumption is based on observed interest rates appropriate for the terms of our awards. The dividend yield assumption is based on our history and expectation of paying no dividends. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Stock-based compensation expense recognized in our financial statements in 2006 and thereafter is based on awards that are ultimately expected to vest. We evaluate the assumptions used to value our awards on a quarterly basis. If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. Future stock-based compensation expense and unearned stock-based compensation will increase to the extent that we grant additional equity awards to employees or we assume unvested equity awards in connection with acquisitions.
Non-market vesting conditions attached to performance-based awards are included in assumptions about the number of shares that the employee will ultimately receive relating to management assessment of the probability the performance targets will be met and the shares will vest. On a regular basis we review the assumptions made and revise the estimates of the number of shares subject to performance-based awards that are ultimately expected to vest, where necessary. Any subsequent revisions to the estimates of the number of shares subject to performance-based awards ultimately expected to vest may increase or decrease total compensation expense. Such increase or decrease adjusts the prior period compensation expense in the period of the review on a cumulative basis for unvested shares subject to performance-based awards for which compensation expense has already been recognized in the profit and loss account, and in subsequent periods for shares subject to performance-based awards for which the expense has not yet been recognized in the profit and loss account.
Results of Operations
The following table presents our results of operations as a percentage of total net revenue for the periods indicated:
The following table summarizes and analyzes the revenues we earned for the three and nine months ended September 30, 2006 and 2007:
Technology licensingconsumer hardware: The $4.7 million, or 43%, increase in net revenues from technology licensing to consumer hardware device manufacturers from the third quarter of 2006 to the third quarter of 2007, and the $12.8 million, or 43% increase in revenues from technology licensing to consumer hardware device manufacturers from the nine months ended September 30, 2006 to the nine months ended September 30, 2007, resulted primarily from an increase in net royalty revenues associated with increased shipped-unit volumes of devices that incorporate our technologies reported to us by our licensee partners. In addition, $1.8 million in technology licensing revenues were recognized during the nine months ended September 30, 2007, that had been deferred under minimum volume commitment arrangements. These arrangements included certain average pricing levels based on the customer achieving certain minimum volumes. Upon the lapse of each minimum volume commitment period, any remaining deferred revenue was recognized. From time to time, we will recognize revenue under similar circumstances.
Technology licensingsoftware: The $45,000, or 3%, decrease in software licensing revenues from the third quarter of 2006 to the third quarter of 2007 was due primarily to a $300,000 decrease in license revenue from Google for use of certain of our technology. Such revenue is associated with a two-year contract that expired during August of 2007. The $1.3 million, or 34% increase in revenues in software licensing revenues from the nine months ended September 30, 2006 to the nine months ended September 30, 2007, resulted primarily from a $1.2 million increase in license revenue from Google for use of this same technology.
Advertising and third-party product distribution: The $1.9 million, or 67%, increase in advertising and third-party product distribution revenue from the third quarter of 2006 to the third quarter of 2007, and the $3.8 million, or 46% increase in advertising and third-party product distribution revenue from the nine months ended September 30, 2006 to the nine months ended September 30, 2007, resulted from an increase in revenues associated with our distribution of Googles software under our software distribution and promotion agreement with Google.
In September 2007, we entered into a two-year agreement with Yahoo! to distribute the co-branded Yahoo! toolbar and Internet Explorer browser with our software. This agreement will replace our existing agreement with Google. Yahoo! will pay us fees under the agreement based on the number of certain distributions or installations of the Yahoo! software. Distribution pursuant to the Yahoo! agreement commenced in early November 2007 and the agreement expires on December 31, 2009.
Digital media distribution and related services: The $6,000, or 4%, decrease in digital media distribution and services revenue from the third quarter of 2006 to the third quarter of 2007, and the $178,000, or 29%, decrease in advertising and third-party product distribution revenue from the nine months ended September 30, 2006 to the nine months ended September 30, 2007, reflect decreases in sales by our Open Video System customers and in encoding revenues.
The following table shows the gross profit earned on each of our revenue streams for the three and nine months ended September 30, 2006 and 2007 in absolute dollars and as a percentage of related revenues:
Technology licensing: The increase in gross margin from the third quarter of 2006 to the third quarter of 2007 and the increase in gross margin from the nine months ended September 30, 2006 to the nine months ended September 30, 2007, was due primarily to increased royalties from technology licensing to consumer hardware device manufacturers without a corresponding increase in royalty expenses due to our licensors, as such costs are to a large extent fixed in nature.
Advertising and third-party product distribution: Our cost of advertising and product distribution revenue has remained relatively fixed as a percentage of such revenue because the cost of bandwidth associated with product downloads is directly proportional to the volume of downloads.
Digital media distribution and related services: Our digital media distribution and related services gross margin has continued to decrease due to diminished revenues over a relatively fixed cost base. If our content licensing arrangements with consumer hardware OEMs are successful, our associated content licensing costs may increase at a higher rate than the revenues we derive from such arrangements, which would further reduce our gross margins. Additionally, if we do not complete the proposed separation of our online video community service, Stage6.com, and we begin to derive material revenues from Stage6.com, our associated internet connectivity costs may increase at a higher rate than such revenues, resulting in a further reduction in our gross margins.
The following table summarizes and analyzes our operating expenses for the three and nine months ended September 30, 2006 and 2007:
Selling, general and administrative: The $8.5 million, or 127%, increase in selling, general and administrative expenses from the third quarter of 2006 to the third quarter of 2007 was principally due to a $3.4 million increase in costs resulting from increased average headcount, which grew from an average of 121 for the third quarter of 2006 to an average of 173 for the third quarter of 2007, predominantly in the sales and marketing functions. Costs associated with these headcount increases were comprised of salaries and benefits, performance based compensation, stock-based compensation, travel costs, recruiting fees and facilities costs. In addition, we experienced a $2.8 million increase in internet connectivity related costs primarily associated with marketing aspects of our online video community service, Stage6.com, a $1.1 million increase in professional services, particularly legal and accounting services associated with being a publicly traded company and compliance with the Sarbanes-Oxley Act, and a $445,000 increase in marketing costs, particularly tradeshow, advertising and content and branding expenses.
The $20.6 million, or 112%, increase in selling, general and administrative expenses from the nine months ended September 30, 2006 to the nine months ended September 30, 2007 was principally due to a $10.0 million increase in costs resulting from increased average headcount, which grew from an average of 113 for the nine months ended September 30, 2006 to an average of 150 for the nine months ended September 30, 2007, predominantly in the sales and marketing functions. Costs associated with these headcount increases were comprised of salaries and benefits, performance based compensation, stock-based compensation, travel costs, recruiting fees and facilities costs. In addition, we experienced a $5.1 million increase in internet connectivity related costs primarily associated with marketing aspects of our online video community service, Stage6.com., a $2.3 million increase in professional services, particularly legal and accounting services associated with being a publicly traded company and compliance with the Sarbanes-Oxley Act, and a $1.1 million increase in marketing costs, particularly tradeshow, retail marketing, advertising and market research expenses.
Product development: The $193,000, or 5%, increase in product development expense from the third quarter of 2006 to the third quarter of 2007 was principally due to an increase average product development headcount from 107 for the third quarter of 2006 to 117 for the third quarter of 2007. Costs associated with such increase in headcount were comprised primarily of salary, benefits and stock-based compensation partially offset by a decrease in recruiting costs.
The $2.1 million, or 19%, increase in product development expense from the nine months ended September 30, 2006 to the nine months ended September 30, 2007 was principally due to an increase average product development headcount from 95 for the nine months ended September 30, 2006 to 119 for the nine months ended September 30, 2007. Costs associated with such increase in headcount were comprised primarily of salary, benefits and stock-based compensation partially offset by a decrease in recruiting costs.
Impairment of acquired intangibles: In the third quarter of fiscal 2007, we recorded an impairment charge of $2.2 million related to the patented technology license intangible asset acquired in connection with our acquisition of a limited liability company in July 2007. As more fully discussed in Note 7 in the accompanying unaudited consolidated condensed financial statements, management performed an impairment analysis of the assets in accordance with SFAS No. 144, and concluded that the asset was not fully recoverable and an impairment loss should be recognized as of September 30, 2007.
Interest and other income, net: We reported net interest income of $2.0 million for the third quarter of 2007 compared to $489,000 for the third quarter of 2006 and $6.0 million for the nine months ended September 30, 2007 compared to $1.1 million for the nine months ended September 30, 2006. The increase is reflective of higher average cash balances, which principally resulted from proceeds from the sale of shares of our common stock in our initial public offering in addition to increased cash balances from positive cash flows from operations.
Income tax provision: We recorded a provision for income taxes of $433,000 for the third quarter of 2007, based upon a 34.7% effective tax rate, compared to $1.0 million for the third quarter of 2006, based on a 24.8% tax rate and a provision for income taxes of $3.5 million for the nine months ended September 30, 2007, based upon a 39.1% tax rate, compared to $2.4 million for the nine months ended September 30, 2006, based upon a 20.9% tax rate.
The effective tax rate is based upon our estimated fiscal 2007 income before the provision for income taxes. To the extent the estimate of fiscal 2007 income before the provision for income taxes changes, our provision for income taxes will change as well. The effective tax rate for the entire year 2007 is expected to be approximately 40.6%, excluding any discrete items.
The increase in the effective tax rate from the prior year period is due primarily to the release of valuation allowance during fiscal 2006 as a result of our recent sustained history of operating profitability and the determination by management that the future realization of the net deferred tax assets was determined to be morelikely-than-not.
Liquidity and capital resources
The following table presents data regarding our liquidity and capital resources as of (in thousands):
Cash Flows (in thousands)
Cash provided by operating activities: The $17.9 million of cash provided by operating activities for the nine months ended September 30, 2007 was primarily due to net income of $5.5 million, depreciation and amortization of $1.6 million, stock-based compensation of $5.4 million, impairment of acquired intangibles charge of $2.2 million and changes in other working capital accounts, primarily increases in accrued liabilities and deferred revenue and an decrease in accounts receivable all partially offset by an increase in income taxes receivable.
The $12.4 million of cash provided by operating activities for the nine months ended September 30, 2006 was principally driven by net income of $9.0 million, depreciation and amortization of $1.1 million, stock-based compensation of $1.5 million and increases in other working capital accounts, primarily accrued compensation.
Cash used in investing activities: The $67.5 million of cash used in investing activities for the nine months ended September 30, 2007 was primarily for net short-term investments of $59.9 million, an investment in a private corporation and payments related to the purchase of the assets of a limited liability company of $5.5 million and $2.4 million for the purchase of property and equipment, primarily computer hardware and software, to support the growth of our company.
The $1.7 million of cash used in investing activities for the nine months ended September 30, 2006 was principally for the acquisition of property and equipment to support our growth, including $351,000 for the acquisition of Corporate Green.
Cash provided by financing activities: The $2.3 million of net cash provided by financing activities for the nine months ended September 30, 2007 was primarily due to the net proceeds from the sale of $1.7 million of our common stock and an excess tax benefit of $1.5 million, both principally due to the exercise of stock options and employee stock purchase plan participation, partially offset by the payment of $467,000 of costs related to our initial public offering and $352,000 of payments on our debt obligations.
The $110.6 million of net cash provided by financing activities for the nine months ended September 30, 2006 was primarily due to the net proceeds from the issuance of $111.8 million of our common stock, principally in our initial public offering, partially offset by $667,000 costs related to our initial public offering, and $578,000 of payments on our debt obligations.
Market risk represents the risk of loss that may impact our financial position, results of operations or cash flows due to adverse changes in financial and commodity market prices and rates. We are exposed to market risk primarily in the area of changes in the United States interest rates. These exposures are directly related to our normal operating and funding activities. We do not have any material foreign currency or other derivative financial instruments.
Interest Rate Risk. All of our fixed income investments are classified as available-for-sale and therefore reported on the balance sheet at market value. Changes in the overall level of interest rates affect our interest income that is generated from our investments. If a 100 basis point decline in overall interest rates were to occur in 2007, our interest income would decline approximately $1.6 million, on an annual basis, assuming investment levels consistent with those at September 30, 2007.
Our long-term capital lease obligations bear interest at fixed rates and therefore we do not have significant market risk exposure with respect to these obligations.
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commissions rules and forms and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by Securities and Exchange Commission Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.
There has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II OTHER INFORMATION
On September 6, 2007, we filed a lawsuit seeking a declaratory relief judgment against Universal Music Group, Inc. and related entities (UMG) in the United States District Court for the Southern District of California. In the lawsuit we allege that UMG has asserted claims of copyright infringement against us arising from the operation of Stage6, our online video community service. We further allege that UMG claimed that the Digital Millennium Copyright Act, including without limitation its notice-and-takedown procedures, was inapplicable to the activities of Stage6. We ask that the court declare that we are not liable to UMG for copyright infringement based upon the operation of Stage6 or in the alternative that any potential liability is barred by provisions of the Digital Millennium Copyright Act. UMG has responded by filing a lawsuit against us in the Central District of California on October 22, 2007, and has announced it will seek to dismiss or transfer the lawsuit that we initially filed in the United States District Court for the Southern District of California. Litigation is inherently uncertain and an unfavorable resolution of this proceeding could materially affect our future operating results or financial conditions in particular periods.
We are also involved in various legal proceedings from time to time arising from the normal course of business activities, including commercial, employment and other matters. In our opinion, resolution of these proceedings is not expected to have a material adverse effect on our operating results or financial condition. However, it is possible that an unfavorable resolution of one or more such proceedings could materially affect our future operating results or financial condition in a particular period.
Before you decide to invest or maintain an interest in our common stock, you should consider carefully the risks described below, together with the other information contained in this Quarterly Report on Form 10-Q. We believe the risks described below are the risks that are material to us as of the date of this Quarterly Report on Form 10-Q. If any of the following risks comes to fruition, our business, financial condition, results of operations and future growth prospects would likely be materially and adversely affected. In these circumstances, the market price of our common stock could decline, and you may lose all or part of your investment.
The risk factors set forth below with an asterisk (*) next to the title are new risk factors or risk factors containing changes, including any material changes, from the risk factors previously disclosed in our annual report on Form 10-K for the year ended December 31, 2006, as filed with the Securities and Exchange Commission.
Risks related to our business
* Our business and prospects depend on the strength of our brand, and if we do not maintain and strengthen our brand, we may be unable to maintain or expand our business.
Maintaining and strengthening the DivX brand is critical to maintaining and expanding our business, as well as to our ability to enter into new markets for our technologies and products. If we fail to promote and maintain the DivX brand successfully, our ability to sustain and expand our business and enter into new markets will suffer. Maintaining and strengthening our brand will depend heavily on our ability to continue to develop and provide innovative and high-quality technologies and products for consumers, content owners, consumer hardware device manufacturers and software vendors as well as to appropriately manage our relationship with Stage6.com during its planned sale or transition to a private company. Moreover, because we engage in relatively little direct brand advertising, the promotion of our brand depends, among other things, upon hardware device manufacturing partners displaying our trademarks on their products. If these partners choose for any reason not to display our trademarks on their products, or if our partners use our trademarks incorrectly or in an unauthorized manner, the strength of our brand may be diluted or our ability to maintain or increase our brand awareness may be harmed. In addition, if we fail to maintain high-quality standards for products that incorporate our technologies through the quality-control certification process that we require of our licensees, or if we take other steps to commercialize our products and services that our customers or potential customers reject, the strength of our brand could be adversely affected. Further, unauthorized third parties may use our brand in ways that may dilute or undermine its strength.
* If we are unable to penetrate existing markets or adapt or develop technologies and products for new markets, our business prospects could be limited.
We expect that our future success will depend, in part, upon our ability to successfully penetrate existing markets for digital media technologies, including:
To date, we have penetrated only some of these markets, including the markets for DVD players, network connected DVD players, portable media players, digital still cameras, smart TVs and mobile handsets. Our success depends upon our ability to further penetrate these markets, some of which we have only penetrated to a limited extent, and to successfully penetrate those markets in which we currently have no presence. Demand for our technologies in any of these developing markets may not grow or develop, and a sufficiently broad base of consumers and professionals may not adopt or continue to use our technologies. In addition, our ability to generate revenue from these markets may be limited to the extent that service providers in these markets choose to provide competitive technologies and entertainment at little or no cost. Because of our limited experience in certain of these markets, we may not be able to adequately adapt our business and our technologies to the needs of consumers and licensees in these markets.
* We face significant competition in various markets, and if we are unable to compete successfully, our ability to generate revenues from our business will suffer.
We face significant competition in the digital media markets in which we operate. We believe that our most significant competitive threat comes from companies that have the collective financial, technical and other resources to develop the technologies, services, products and partnerships necessary to create a digital media ecosystem that can compete with the DivX ecosystem. Those potential competitors currently include Adobe Systems, Apple Computer, Google, Microsoft, News Corporation, Sony and Yahoo!.
We also compete with companies that offer products or services that compete with specific aspects of our digital media ecosystem. For example, our digital rights management technology competes with technologies from companies such as Apple Computer, ContentGuard, Intertrust Technologies, Microsoft, Nagra Audio, NDS Group and 4C Entity, as well as the internal development efforts of certain of our licensees. Similarly, content distribution providers, such as Amazon.com, Apple Computer, CinemaNow, Google, Joost, MovieLink, Netflix and subscription entertainment services and cable and satellite providers compete against our content distribution services. In addition, Google, Microsoft, Yahoo!, MySpace.com, a subsidiary of News Corporation, and YouTube, a subsidiary of Google, offer online communities that compete with Stage6.com.
Our proprietary technologies also compete with other video compression technologies, including other implementations of MPEG-4 or implementations of H.264/AVC. A number of companies such as Google, Microsoft, On2 Technologies and RealNetworks offer other competing video formats.
We also face competition from subscription entertainment services, cable and satellite providers, DVDs and other emerging technologies and products related to content distribution. Stage6.com faces significant competition from services, such as peer-to-peer and content aggregator services that allow consumers to directly access an expansive array of content without securing licenses from content providers.
Some of our current or future competitors may have significantly greater financial, technical, marketing and other resources than we do, may enjoy greater name recognition than we do, or may have more experience or advantages than we have in the markets in which they compete. For example, companies such as Apple Computer, Amazon.com, Google, Microsoft, Sony and Yahoo! may have competitive advantages over us because of their greater size and resources and the strength of their respective brand names. In addition, some of our current or potential competitors, such as Apple Computer, Dolby Laboratories, Microsoft and Sony, may be able to offer integrated system solutions in certain markets for entertainment technologies, including audio, video and rights management technologies related to personal computers or the Internet, which could make competing products and technologies that we develop unnecessary. By offering an integrated system solution, these potential competitors also may be able to offer competing products and technologies at lower prices than our products and technologies. Further, many of the consumer hardware and software products that include our technologies also include technologies developed by our competitors. As a result, we must continue to invest significant resources in product development in order to enhance our technologies and our existing products and introduce new high-quality technologies and products to meet the wide variety of such competitive pressures. Our ability to generate revenues from our business will suffer if we fail to do so successfully.
* We are dependent on the sale by our licensees of consumer hardware and software products that incorporate our technologies. Our top 10 licensees by revenue accounted for approximately 50% of our total net revenues during the nine months ended September 30, 2007, and a reduction in revenues from those licensees or a loss of one or more of our key licensees would adversely affect our licensing revenue.
We derive most of our revenue from the licensing of our technologies to consumer hardware device manufacturers, software vendors and consumers. We derived 79%, 80% and 82% of our total net revenues from licensing our technology in the nine months ended September 30, 2007 and in the full years 2006 and 2005, respectively. One or a small number of our licensees generally represents a significant percentage of our technology licensing revenues. For example, in the nine months ended September 30, 2007, LG accounted for approximately 11% of our total net revenues, and our top 10 licensees by revenue accounted for approximately 50% of our total net revenues. Our technology licensing revenues are particularly dependent upon our relationships with consumer hardware device manufacturers such as LG and Sony. We cannot control consumer hardware device manufacturers and software developers product development or commercialization efforts or predict their success. Our license agreements typically require manufacturers of consumer hardware devices and software vendors to pay us a specified royalty for every shipped consumer hardware or software product that incorporates our technologies, but many of these agreements do not require these manufacturers to guarantee us a minimum royalty in any given period. Accordingly, if our licensees sell fewer products incorporating our technologies, or otherwise face significant economic difficulties, our licensing revenues will be adversely affected. Our license agreements are generally for two years or less in duration, and a significant number of these agreements expire in any given quarter. Upon expiration of their license agreements, manufacturers and software developers may not renew their agreements or may elect not to enter into new agreements with us on terms as favorable as our current agreements.
* Our software distribution and promotion agreement with Google, which represented approximately 20% of our total net revenues in the nine months ended September 30, 2007, is scheduled to expire on November 30, 2007, and if we do not effectively transition our software distribution and promotion relationship from Google to Yahoo! our revenues may significantly decrease.
In the past we have relied on a software distribution and promotion agreement with Google for a significant portion of our revenue. Pursuant to our agreement with Google we include and distribute the Mozilla Firefox Browser and Certain related Google software products with our software products. Revenues under our agreement with Google represented approximately 20% of our total revenues in the nine months ended September 30, 2007. Our agreement with Google is scheduled to expire on November 30,
2007. In September 2007, we entered into a software distribution and promotion agreement with Yahoo! which is expected to replace our existing agreement with Google. Although we commenced distribution pursuant to the Yahoo! agreement in early November 2007, if we fail to effectively transition our software distribution and promotion business from Google to Yahoo!, our revenues would significantly decrease.
* Our September 2007 software distribution and promotion agreement with Yahoo! is our first distribution agreement with Yahoo!, and if products from Yahoo! are not as popular as Google products, or if they are more difficult to install or distribute than Google products, or if products from Yahoo! have greater market saturation than Google products, then our revenues may significantly decrease.
Pursuant to our September 2007 agreement with Yahoo!, we agreed to distribute a version of Internet Explorer browser optimized for Yahoo! and a co-branded version of the Yahoo! Toolbar with our software products and Yahoo! will pay us fees based on the number of certain distributions or installations of the Yahoo! software. Our agreement with Yahoo! also affects our ability to offer our software products with third party web browsers, toolbars and search services other than those provided by Yahoo!. As a result, if the Yahoo! products we plan to distribute are not as popular as, or if they have greater market saturation than, the Google products we have distributed in the past, or if they are more difficult to install or distribute, our revenues may significantly decrease. Any decline in the popularity of our products or Yahoo!s products among consumers or market saturation of those products could result in a decrease in revenue under our agreement with Yahoo!. In addition, if we fail to achieve certain minimum distribution volumes or certain minimum installations of the Yahoo! software for specific periods described in the agreement, Yahoo! may elect to terminate the agreement.
* The success of our business depends on the interoperability of our technologies with consumer hardware devices.
To be successful we must design our digital media platform to interoperate effectively with a variety of consumer hardware devices, including personal computers, DVD players, DVD recorders, digital cameras, portable media players, smart TVs and mobile handsets. We depend on significant cooperation with manufacturers of these devices and the components integrated into these devices, as well as software providers that create the operating systems for such devices, to incorporate our technologies into their product offerings and ensure consistent playback of DivX-encoded files. Currently, a limited number of devices are designed to support our technologies. If we are unsuccessful in causing component manufacturers, device manufacturers and software providers to integrate our technologies into their product offerings, our technologies may become less accessible to consumers, which would adversely affect our revenue potential.
If we fail to develop and deliver innovative technologies and products in response to changes in our industry, including changes in consumer tastes or trends, our revenues could decline.
The markets for our technologies and products are characterized by rapid change and technological evolution. We will need to expend considerable resources on product development in the future to continue to design and deliver enduring and innovative technologies and products. For example, significant portions of Stage6.com remain under development and we are continuing to upgrade the technologies we license for use in consumer hardware and software products. Despite our efforts, we may not be able to develop and effectively market new technologies and products that adequately or competitively address the needs of the changing marketplace. In addition, we may not correctly identify new or changing market trends at an early enough stage to capitalize on market opportunities. At times such changes can be dramatic. Our future success depends to a great extent on our ability to develop and deliver innovative technologies that are widely adopted in response to changes in our industry and that are compatible with the technologies or products introduced by other participants in our industry. If we fail to deliver innovative technologies, we may be unable to meet changes in consumer tastes or trends, which could decrease our revenues.
Our licensing revenue depends in large part upon integrated circuit manufacturers incorporating our technologies into their products for sale to our consumer hardware device manufacturer licensees and if our technologies are not incorporated in these integrated circuits or fewer integrated circuits are sold that incorporate our technologies, our revenues will be adversely affected.
Our licensing revenue from consumer hardware device manufacturers depends in large part upon the availability of integrated circuits that incorporate our technologies. Integrated circuit manufacturers incorporate our technologies into their products, which are then incorporated into consumer hardware devices. We do not manufacture integrated circuits, but rather depend on integrated circuit manufacturers to develop, produce and sell these products to licensed consumer hardware device manufacturers. We do not control the integrated circuit manufacturers decision whether or not to incorporate our technologies into their products, and we do not control their product development or commercialization efforts. If we fail to develop new technologies that adequately or competitively address the needs of the changing marketplace, integrated circuit manufacturers may not be willing to implement our technologies into their products. The process utilized by integrated circuit manufacturers to design, develop, produce and sell their products is generally 12 to 18 months in duration. As a result, if an integrated circuit manufacturer is unwilling or unable to implement our technologies into an integrated circuit that it is producing, we may experience significant delays in generating revenue while we wait for that manufacturer to begin development of a new integrated circuit that may incorporate our technologies. In addition, while the design cycles utilized by integrated circuit manufacturers are typically long, the life cycles of our technologies tend to be short as a result of the rapidly changing technology environment in which we operate. If integrated circuit manufacturers are unable or unwilling to implement technologies we develop into their products, or if they sell fewer products incorporating our technologies, our revenues will be adversely affected.
Our business is dependent in part on technologies we license from third parties, and these license rights may be inadequate for our business.
Certain of our technologies and products are dependent in part on the licensing and incorporation of technologies from third parties. For example, we have entered into a license agreement with MPEG LA pursuant to which we have acquired rights to use in our technologies and products certain MPEG-4 intellectual property licensed to MPEG LA. Our licensing agreement with MPEG LA grants us a sublicense only to the rights in MPEG-4 intellectual property licensed to MPEG LA. There are other parties who have competing rights to MPEG-4 intellectual property, and to the extent that the rights of such other parties conflict with or are superior to the rights licensed to MPEG LA, our rights to utilize MPEG-4 technology in our technologies and products could be challenged. If the technology we license fails to perform as expected, if key licensors do not continue to support their technology or intellectual property because the licensor has gone out of business or otherwise or if it is determined that any of our licensors are not entitled to license to us any of the technologies or intellectual property that are subject to our current license agreements, then we may incur substantial costs in replacing the licensed technologies or intellectual property or fall behind in our development schedule while we search for a replacement. In addition, replacement technology may not be available for license on commercially reasonable terms, or at all.
In addition, our agreements with licensors generally require us to give them the right to audit our calculations of royalties payable to them. If a licensor challenges the basis of our calculations, the amount of royalties we have to pay them could increase. Any royalties paid as a result of a successful challenge would increase our expenses and could impair our ability to continue to use and re-license technologies or intellectual property from that licensor.
We rely on our licensees to accurately prepare royalty reports for our determination of licensing revenues, and if these reports are inaccurate, our revenues may be under- or over-stated and our forecasts and budgets may be incorrect.
Our licensing revenues are generated primarily from consumer hardware device manufacturers and software vendors who license our technologies and incorporate them into their products. Under these arrangements, these licensees typically pay us a specified royalty for every consumer hardware or software product they ship that incorporates our technologies. We rely on our licensees to accurately report the number of units shipped. We calculate our license fees, prepare our financial reports, projections and budgets, and direct our sales and technology development efforts based in part on these reports. However, it is often difficult for us to independently determine whether or not our licensees are reporting shipments accurately. This is especially true with respect to software incorporating our technologies because software can be copied relatively easily and we often do not have ways to readily determine how many copies have been made. Licensees in specific countries, including China, have a history of underreporting or
failing to report shipments of their products that incorporate our technologies. Most of our license agreements permit us to audit our licensees records, but audits are generally expensive and time consuming. We have initiated, and intend to initiate, audits with certain of our licensees to determine whether their shipment reports for past periods were accurate. Such audits could harm our relationships with our licensees or may result in the cancellation or termination of our agreements with such licensees. In addition, the license agreements that we have entered into with most of our licensees impose restrictions on our audit rights, such as limitations on the number of audits we may conduct. To the extent that our licensees understate or fail to report the number of products incorporating our technologies that they ship, we will not collect and recognize revenue to which we are entitled. Alternatively, we have experienced limited instances in which a customer has notified us that it previously reported and paid royalties on units in excess of what the customer actually shipped. In such cases, the customer requested, and we granted, a credit for the excess royalties paid. If a similar event occurs in the future, we may be required to record the credit as a reduction in revenue in the period in which it is granted, and such a reduction could be material.
Any development delays or cost overruns may affect our ability to respond to technological changes, competitive developments or customer requirements and expose us to other adverse consequences.
We have experienced development delays and cost overruns in our development efforts in the past and we may encounter such problems in the future. Delays and cost overruns could affect our ability to respond to technological changes, competitive developments or customer requirements. Also, our technologies and products may contain undetected errors that could cause increased development costs, loss of revenue, adverse publicity, reduced market acceptance of our technologies and products or lawsuits by participants in the consumer hardware or software industries or consumers.
* We conduct a substantial portion of our business outside North America and, as a result, we face diverse risks related to engaging in international business.
We have offices in five foreign countries as well as sales staff in six other foreign countries, and we are dedicating a significant portion of our sales efforts in countries outside North America. We are dependent on international sales for a substantial amount of our total revenues. For the nine months ended September 30, 2007 and for the full years 2006 and 2005, our sales outside North America comprised 73%, 76% and 78%, respectively, of our total revenues. We expect that international sales will continue to represent a substantial portion of our revenues for the foreseeable future. These future international revenues will depend to a large extent on the continued use and expansion of our technologies in entertainment industries worldwide. Increased worldwide use of our technologies is also an important factor in our future growth.
We are subject to the risks of conducting business internationally, including:
We face risks with respect to conducting business in China due to Chinas historically limited recognition and enforcement of intellectual property and contractual rights.
We currently have direct license relationships with over 50 consumer hardware device manufacturers located in China. In addition, a number of the OEMs that license our technologies utilize captive or third-party manufacturing facilities located in China. We expect this to continue in the future as consumer hardware device manufacturing in China continues to increase due to its lower manufacturing cost structure as compared to other industrialized countries. As a result, we face many risks in China, in large part due to Chinas historically limited recognition and enforcement of contractual and intellectual property rights. In particular, we have experienced, and expect to continue to experience, problems with China-based consumer hardware device manufacturers underreporting or failing to report shipments of their products that incorporate our technologies, or incorporating our technologies or trademarks into their products without our authorization or without paying us licensing fees. We may also experience difficulty enforcing our intellectual property rights in China, where intellectual property rights are not as respected as they are in the United States, Japan and Europe. Unauthorized use of our technologies and intellectual property rights may dilute or undermine the strength of our brand. Further, if we are not able to adequately monitor the use of our technologies by China-based consumer hardware device manufacturers, or enforce our intellectual property rights in China, our revenue potential could be adversely affected.
Pricing pressures on the consumer hardware device manufacturers and software vendors who incorporate our technologies into their products could limit the licensing fees we charge for our technologies and adversely affect our revenues.
The markets for the consumer hardware and software products in which our technologies are incorporated are intensely competitive and price sensitive. For example, retail prices for consumer hardware devices that include our digital media platform, such as DVD players, have decreased significantly in recent years, and we expect prices to continue to decrease for the foreseeable future. In response, consumer hardware device manufacturers and software vendors have sought to reduce their product costs, which can result in downward pressure on the licensing fees we charge our licensees who incorporate our technologies into the consumer hardware and software products that they sell. In addition, we have experienced erosion in the average royalty we can charge for specific versions of our technologies to our OEM partners since the release of these technologies. To maintain higher overall per unit royalties, we must continue to introduce new, more highly functional versions of our products for which we can charge a higher royalty. Any inability to introduce such products in the future or other declines in the royalties we charge would adversely affect our revenues.
* We do not expect sales of DVD players to continue to grow as quickly as they have in the past. To the extent that sales of DVD players level off or decline, or alternative technologies in which we do not participate replace DVDs as a dominant medium for consumer video entertainment, our licensing revenue will be adversely affected.
Growth in our revenue over the past several years has been the result, in large part, of the rapid growth in sales of DVD players incorporating our technologies. For the nine months ended September 30, 2007, and in the full years 2006 and 2005, we derived approximately 70%, 72% and 71%, respectively, of our total revenues from technology licensing to consumer hardware device manufacturers, a majority of which are derived from sales of DVD players incorporating our technologies. However, as the markets for DVD players mature, we do not expect sales of DVD players to continue to grow as quickly as they have in the past. To the extent that sales of DVD players level off or decline, our licensing revenue will be adversely affected. In addition, if new technologies are developed for use with DVDs or new technologies are developed that substantially compete with or replace DVDs as a dominant medium for consumer video entertainment such as high definition DVD or Blu-ray Disc, and if we are unable to develop and successfully market technologies that are incorporated into or compatible with such new technologies, our ability to generate revenues will be adversely affected.
Digital video technologies could be treated as a commodity in the future, which could expose us to significant pricing pressure.
We believe that the success we have had licensing our digital video technologies to consumer hardware device manufacturers and software vendors is due, in part, to the strength of our brand and the perception that our technologies provide a high-quality video solution. However, as applications that incorporate digital video technologies become increasingly prevalent, we expect more competitors to enter this field with other solutions. Furthermore, to the extent that competitors solutions are perceived, accurately or not, to provide the same or greater advantages as our technologies, at a lower or comparable price, there is a risk that video encoding and decoding technologies such as ours will be treated as commodities, exposing us to significant pricing pressure.
Current and future government standards or standards-setting organizations may limit our business opportunities.
Various national governments have adopted or are in the process of adopting standards for digital television broadcasts, including cable and satellite broadcasts. In the event national governments adopt similar standards for video codecs used in consumer hardware devices, software products or Internet applications, our technology may be excluded from such standards. We have not made any efforts to have our technologies adopted as standards by any national governments, nor do we currently expect that our technologies will be adopted as standards by any national government in the future. If national governments adopt standards that exclude our technologies, we will be required to redesign our technologies to comply with such government standards to allow our products to be utilized in those countries. Costs or potential delays in the development of our technologies and products to comply with such government standards could significantly increase our expenses. In addition, standards-setting organizations are adopting or establishing formal technology standards for use in a wide range of consumer hardware devices, software products and Internet applications. We currently do not participate in standards-setting organizations, nor do we seek or expect to have our technologies adopted as industry standards. As such, participants in the consumer hardware or software industries or consumers may elect not to purchase our technologies because they have not been adopted by standards-setting organizations or if a competing technology is adopted as an industry standard.
Our business may depend in part upon our ability to provide effective digital rights management technology.
Our business may depend in part upon our ability to provide effective digital rights management technology that controls access to digital content that addresses, among other things, content providers concerns over piracy. We cannot be certain that we can continue to develop, license or acquire such technology, or that content licensors, consumer hardware device manufacturers or consumers will accept such technology. In addition, consumers may be unwilling to accept the use of digital rights management technology that limits their use of content, especially with large amounts of free content readily available. We may need to license digital rights management technology from third parties to support our technologies and products. Such technology may not be available to us on reasonable terms, or at all. If digital rights management technology is not effective, is perceived as not effective or is compromised by third parties, or if laws are enacted that require digital rights management technology to allow consumers to convert content stored in a protected format into an unprotected format, content providers may not be willing to encode their content using our products and consumer hardware device manufacturers may not be willing to include our technologies in their products.
We have offered and we expect to continue to offer some of our products and technologies for reduced prices or free of charge, and we may not realize the benefits of this marketing strategy.
We have offered and expect to continue to offer some of our products and technologies to consumers for reduced prices or free of charge as part of our overall strategy of developing a digital media ecosystem and promoting additional penetration of our products and technologies into the markets in which we compete. If we offer such products and technologies at reduced prices or free of charge, we will forego all or a portion of the revenue from licensing these products, and we may not realize the intended benefits of this marketing strategy.
* Stage6.com, our online video community service, is rapidly evolving and may not prove to be a viable business model.
Online video distribution is a relatively new business model for delivering digital media over the Internet and we have only recently launched our efforts to develop a business centered around online content delivery. We must continue to scale our online video community service, Stage6.com, to accommodate its rapid growth in users. If we fail to effectively scale Stage6.com, user experience may suffer, which may in turn adversely impact user growth, our brand in general and our ability to monetize the service. We may also fail to develop a viable business model that properly monetizes our online video community.
In addition, distributing video to users of Stage6.com involves substantial cost, including bandwidth costs, and currently all of the content on Stage6.com is available for free. We expect that the costs of Stage6.com will continue to increase significantly before any meaningful revenue is generated by the service. If we are unable to successfully monetize the use of Stage6.com, either through advertising or fees for use, our operating results will continue to be adversely affected.
The success of Stage6.com will depend on our ability to license compelling content on commercially reasonable terms or enter into successful partnering relationships with content providers.
The success of Stage6.com will depend on our obtaining compelling digital media content to attract users. In some cases, we expect to pay substantial fees to obtain premium content even though we have limited experience determining what video content will be successful with consumers. Alternatively, we may be unable to obtain premium content on commercially reasonable terms, or at all.
* We may be unable to attract advertisers to Stage6.com.
We expect that advertising revenue will comprise a significant portion of the revenue to be generated by Stage6.com. Most large advertisers have fixed advertising budgets, only a small portion of which is allocated to Internet advertising. We expect that advertisers will continue to focus most of their efforts on traditional media or may decrease their advertising spending. If we fail to convince advertisers to spend a portion of their advertising budgets with us, we will be unable to generate revenues from advertising.
Also, even if we initially attract advertisers to Stage6.com, they may decide not to advertise to our community if their investment does not generate sales leads, and ultimately customers, or if we do not deliver their advertisements in an appropriate and effective manner. If we are unable to provide value to our advertisers, advertisers may not place ads with us.
* Whether or not the proposed sale or separation of Stage6.com is completed, we will incur substantial costs.
The proposed sale or separation of Stage6.com into a private company will be complex, time consuming and expensive, and may disrupt our business and result in the loss of key personnel. The diversion of managements attention and any delays or difficulties encountered in connection with the transaction also could have an adverse effect on our business and results of operations. We will incur substantial costs related to the proposed sale or separation of Stage6.com, including fees for financial advisors, attorneys and accountants, whether or not the transaction is completed. In addition, we expect to continue to incur significant expenses related to the operation of Stage6.com prior to the proposed sale or separation.
* We will need to increase the size of our organization, and we may experience difficulties in managing growth.
As of September 30, 2007 we had 300 full-time employees, including full-time equivalents. We will need to continue to expand our managerial, operational, financial and other resources to manage our business, including our relationships with key customers and licensees. Our current facilities and systems will not be adequate to support this future growth. We will require additional office space to accommodate our growth. Additional office space may not be available on commercially reasonable terms and may result in a disruption of our corporate culture. Our need to effectively manage our operations, growth and various projects requires that we continue to improve our operational, financial and management controls, reporting systems and procedures and to attract and retain sufficient numbers of talented employees. We may be unable to successfully implement these tasks on a larger scale, which could prevent us from executing our business strategy.
* We have experienced recent changes in our senior management, which may disrupt our operations.
We have recently experienced several changes in our senior management, including the departure of our former Chief Financial Officer, the appointment of Kevin Hell as our Chief Executive Officer and the addition of Dan L. Halvorson as our Executive Vice President and Chief Financial Officer. In addition, we recently announced that R. Jordan Greenhall, our former Chief Executive Officer, has resigned as an employee of DivX, Inc. We may experience disruptions in our operations as a result of these changes and as the new members of our management team become acclimated to their roles and to our company in general. If we experience any of these disruptions or a loss of management attention to our core business, our operating results could be adversely affected.
* Our business, in particular Stage6.com and our content distribution offerings, will suffer if our systems or networks fail, become unavailable or perform poorly so that current or potential users do not have adequate access to our online products and websites.
Our ability to provide our online offerings will depend on the continued operation of our information systems and networks. As our user traffic increases and our products become more complex, we will need more computing power. We expect to spend substantial amounts to purchase or lease data centers and equipment and to upgrade our technology and network infrastructure to handle increased traffic on our website and to introduce new technologies and products. This expansion will be expensive and complex and could result in inefficiencies or operational failures. If we do not implement this expansion successfully, or if we experience inefficiencies and operational failures during the implementation, the quality of our technologies and products and our users experience could decline. This could damage our reputation and lead us to lose current and potential users, advertisers and content providers.
In addition, significant or repeated reductions in the performance, reliability or availability of our information systems and network infrastructure could harm our ability to provide Stage6.com, content distribution offerings and advertising. We could experience failures in our systems and networks from our failure to adequately maintain and enhance these systems and networks, natural disasters and similar events, power failures, intentional actions to disrupt our systems and networks and many other causes. The vulnerability of our computer and communications infrastructure is increased because it is located at facilities in San Diego, California, an area that is at heightened risk of earthquake, wildfires and flood. We are vulnerable to terrorist attacks, fires, power loss, telecommunications failures, computer viruses, computer denial of service attacks or other attempts to harm our systems. Moreover, our facilities are located near the landing path of a military base and are subject to risks related to falling debris and aircraft crashes. We do not currently have fully redundant systems or a formal disaster recovery plan, and we may not have adequate business interruption insurance to compensate us for losses that may occur from a system outage.
Any failure or interruption of the services provided by bandwidth providers, data centers or other key third parties could subject our business to disruption and additional costs and damage our reputation.
We rely on third-party vendors, including data center and bandwidth providers for network access or co-location services that are essential to our business. Any interruption in these services, including any failure to handle current or higher volumes of use, could subject our business to disruption and additional costs and significantly harm our reputation. Our systems are also heavily reliant on the availability of electricity, which also comes from third-party providers. The cost of electricity has risen in recent years with the rising costs of fuel. If the cost of electricity continues to increase, such increased costs could significantly increase our expenses. In addition, if we were to experience a major power outage, it could result in a significant disruption of our business.
Our network is subject to security risks that could harm our reputation and expose us to litigation or liability.
Online commerce and communications depend on the ability to transmit confidential or proprietary information securely over private and public networks. Any compromise of our ability to transmit and store such information and data securely, and any costs associated with preventing or eliminating such problems, could impair our ability to distribute technologies and products or collect revenue, threaten the proprietary or confidential nature of our technology, harm our reputation and expose us to litigation or liability. We also may be required to expend significant capital or other resources to protect against the threat of security breaches or hacker attacks or to alleviate problems caused by such breaches or attacks. Any successful attack or breach of our security could hurt consumer demand for our technologies and products and expose us to consumer class action lawsuits and other liabilities. In addition, our vulnerability to security risks may affect our ability to maintain effective internal controls over financial reporting as contemplated by Section 404 of the Sarbanes-Oxley Act of 2002.
It is not yet clear how laws designed to protect children that use the Internet may be interpreted and enforced, and whether new similar laws will be enacted in the future which may apply to our business in ways that may subject us to potential liability.
The Child Online Protection Act and the Childrens Online Privacy Protection Act impose civil and criminal penalties on persons distributing material harmful to minors (e.g., obscene material) over the Internet to persons under the age of 17, or collecting personal information from children under the age of 13. We do not knowingly distribute harmful materials to minors, direct our websites, including Stage6.com, to children under the age of 13, or collect personal information from children under the age of 13. However, we are not able to control the ways in which consumers use our technology, and our technology may be used for purposes that violate these laws. The manner in which these Acts may be interpreted and enforced cannot be fully determined, and future legislation similar to these Acts could subject us to potential liability if we were deemed to be non-compliant with such rules and regulations.
* We may be subject to market risk and legal liability in connection with the data collection capabilities of Stage6.com.
Improper conduct by users of our websites could subject us to claims and compliance costs.
* We may be subject to legal liability for the provision of third-party products, services, content or advertising.
We may be subject to assessment of sales taxes and other taxes for our licensing of technology or sale of products.
We do not currently directly collect sales taxes or other taxes on the licensing of our technology, the sale of our products over the Internet, or our distribution of content. Although we have evaluated the tax requirements of certain major tax jurisdictions with respect to the licensing of our technology or the sale of our products over the Internet, in the past we have licensed or sold, and in the future we may license or sell, our technologies or products to consumers located in jurisdictions where we have not evaluated the tax consequences of such license or sale. We would incur substantial costs if one or more taxing jurisdictions required us to collect sales or other taxes from past licenses of technology or sales or distributions of our products or content over the Internet, particularly because we would be unable to go back to customers to collect sales, value added or other taxes for past licenses, sales or distributions and would likely have to pay such taxes out of our own funds. Certain of our licensing agreements require our partners to pay taxes to applicable taxing jurisdictions as a result of the sale of products that incorporate our technologies. If our licensees fail to pay such taxes, we may become liable for the payment of such taxes.
We also intend to sell content over the Internet to consumers throughout the world in conjunction with Stage6.com. We intend to comply with applicable tax requirements of certain major tax jurisdictions with respect to such sales. However, we may sell content to consumers located in jurisdictions where we have not evaluated the tax consequences of such sale. If we fail to comply with tax requirements of tax jurisdictions in which we sell content online, we may become liable for substantial costs or penalties.
Inflation and other unfavorable economic conditions may adversely affect our revenues, margins and profitability.
Our consumer software products, as well as the consumer hardware device and software products that contain our technologies, are discretionary purchases for consumers. Consumers are generally more willing to make discretionary purchases during favorable economic conditions. As a result of inflation or other unfavorable economic conditions, including higher interest rates, increased taxation, higher consumer debt levels and lower availability of consumer credit, consumers purchases of discretionary items may decline, which could adversely affect our revenues. In addition, while inflation historically has not had a material effect on our operating results, we may experience inflationary conditions in our cost base due to changes in foreign currency exchange rates that reduce the purchasing power of the United States dollar, increases in selling, general and administrative expenses and other factors. These inflationary conditions may harm our margins and profitability if we are unable to increase our license, advertising and content distribution fees or reduce our costs sufficiently to offset the effects of inflation in our cost base. Our attempts to offset the effects of inflation and cost increases through controlling our expenses, passing cost increases on to our licensees, advertisers and partners or any other method may not succeed.
Failure to comply with applicable current and future government regulations could limit our ability to license our technologies, sell our products or distribute content, and expose us to additional costs and liabilities.
Our operations and business practices are subject to federal, state and local government laws and regulations, as well as international laws and regulations, including those relating to import or export of technology and software, distribution or censorship of content, use of encryption or other digital rights management software and consumer and other safety-related compliance for electronic equipment. Any failure by us to comply with the laws and regulations applicable to us or our technologies, products or our distribution of content could result in our inability to license those technologies, sell those products, or distribute content, additional costs to redesign technologies, products or our methods for distribution of content to meet such laws and regulations, fines or other administrative, civil or criminal liability or actions by the agencies charged with enforcing compliance and, possibly, damages awarded to persons claiming injury as the result of our non-compliance. Changes in or enactment of new statutes, rules or regulations applicable to us could have a material adverse effect on our business.
* If we lose the services of key members of our senior management team, we may not be able to execute our business strategy.
Our future success depends in large part upon the continued services of key members of our senior management team. All of our executive officers and key employees are at will employees, and we do not maintain any key person life insurance policies. The loss of our management or key personnel could seriously harm our ability to execute our business strategy. We also may have to incur significant costs in identifying, hiring, training and retaining replacements for key employees.
We rely on highly skilled personnel, and if we are unable to retain or motivate key personnel or hire qualified personnel, we may not be able to maintain our operations or grow effectively.
Our performance is largely dependent on the talents and efforts of highly skilled individuals. These individuals have acquired specialized knowledge and skills with respect to us and our operations. Our employment relationship with each of these individuals is on an at will basis and can be terminated at any time. If any of these individuals or a group of individuals were to terminate their employment unexpectedly, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while any such successor obtains the necessary training and experience.
Our future success depends on our continuing ability to identify, hire, develop, motivate and retain highly skilled personnel for all areas of our organization. In this regard, if we are unable to hire and train a sufficient number of qualified employees for any reason, we may not be able to implement our current initiatives or grow effectively. We have in the past maintained a rigorous, highly selective and time-consuming hiring process. We believe that our approach to hiring has significantly contributed to our success to date. However, our highly selective hiring process has made it more difficult for us to hire a sufficient number of qualified employees, and, as we grow, our hiring process may prevent us from hiring the personnel we need in a timely manner. Moreover, the cost of living in the San Diego area, where our corporate headquarters are located, has been an impediment to attracting new employees in the past, and we expect that this will continue to impair our ability to attract and retain employees in the future. If we do not succeed in attracting qualified personnel and retaining and motivating existing personnel, our ability to execute our business strategy may suffer.
* Our recent acquisitions, as well as any companies or technologies we may acquire in the future, could prove difficult to integrate and may result in unexpected costs and disruptions to our business.
We recently acquired all of the outstanding shares of MainConcept AG, a leading provider of audio and video codecs and software development kits to the broadcast, film and consumer markets. Earlier this year we acquired all of the assets of a limited liability corporation engaged in developing real-time digital video processing technology for the purposes of producing enhanced video search and discovery services. We expect to continue to evaluate possible additional acquisitions of technologies and businesses on an ongoing basis. Our recent acquisitions, as well as acquisitions in which we may engage in the future, entail numerous operational and financial risks including certain of the following risks:
We have limited experience in identifying new acquisition targets, successfully completing acquisitions and integrating any acquired products, businesses or technologies into our current infrastructure. Moreover, in the future we may devote resources to potential acquisitions that are never completed or that fail to realize any of their anticipated benefits.
* We may not realize the benefits we expect from the acquisition of MainConcept.
The integration of MainConcepts technology may be time consuming and expensive, and may disrupt our business. We will need to overcome significant challenges to realize any benefits or synergies from this transaction. These challenges include the timely, efficient and successful execution of a number of post-transaction integration activities, including:
In particular, we may encounter difficulties successfully integrating our operations, technologies, services and personnel with those of MainConcept, and our financial and management resources may be diverted from our existing operations. For example, following our acquisition of MainConcept we will have additional offices in Germany, Russia and Japan. Maintaining offices in multiple countries could create a strain on our ability to effectively manage our operations and personnel. In addition, the process of integrating operations and technology could cause an interruption of, or loss of momentum in, the activities of one or more of our businesses and the loss of key personnel. The delays or difficulties encountered in connection with the integration of MainConcepts technologies could have an adverse effect on our business, results of operations or financial condition. We may not succeed in addressing these risks or any other problems encountered in connection with this transaction. Our inability to successfully integrate the technology and personnel of MainConcept, or any significant delay in achieving integration, including regulatory approval delays, could have a material adverse effect on us and, as a result, on the market price of our common stock.
Our corporate culture has contributed to our success, and if we cannot maintain this culture as we grow, we could lose the innovation, creativity and teamwork fostered by our culture.
We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, creativity and teamwork. As our organization grows and we are required to implement more complex organizational management structures, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. This could negatively impact our future success.
Risks related to our finances
* Our quarterly operating results and stock price may fluctuate significantly.
We expect our operating results to be subject to quarterly fluctuations. The revenues we generate and our operating results and the market price of our common stock will be affected by numerous factors, including:
As a result of the variances in quarterly volumes reported by our consumer hardware device manufacturing customers, we expect our revenues to be subject to seasonality, with our second quarter revenues expected to be lower than the revenues we derive in our other quarters. In addition, a substantial majority of our quarterly revenues are based on actual shipment of products incorporating our technologies in that quarter, and not on contractually agreed upon minimum revenue commitments. Because the shipping of products by our consumer hardware and independent software vendor partners are outside our control and difficult to predict, our ability to accurately forecast quarterly revenue is substantially limited. Quarterly fluctuations in our operating results may, in turn, cause the price of our stock to fluctuate substantially. We believe that quarterly comparisons of our financial results are not necessarily meaningful and should not be relied upon as an indication of our future performance.
* We have a history of net losses and only recently achieved profitability on a quarterly basis, and we may not be able to sustain our profitability.
We incurred net losses from our inception through June 30, 2005. We may not generate sufficient revenue to be profitable on a quarterly or annual basis in the future. In addition, we devote significant resources to developing and enhancing our technology and to selling, marketing and obtaining content for our technologies and products. We expect our operating expenses to increase, as we, among other things:
In addition, starting January 1, 2006, we adopted SFAS No. 123(R), Share-Based Payment, which required that we record stock-based compensation charges in connection with our equity compensation for employees. As a result, we expect to record significant additional expenses in future periods and we will need to generate significant revenue to be profitable in the future.
We may require additional capital, and raising additional funds by issuing securities, debt financing or through strategic alliances or licensing arrangements may cause dilution to existing stockholders, restrict our operations or require us to relinquish proprietary rights.
We may raise additional funds through public or private equity offerings, debt financings, strategic alliances or licensing arrangements. To the extent that we raise additional capital by issuing equity securities, our existing stockholders ownership will be diluted. Any debt financing we enter into may involve covenants that restrict our operations. These restrictive covenants may include limitations on additional borrowing, specific restrictions on the use of our assets as well as prohibitions on our ability to create liens, pay dividends, redeem our stock or make investments. In addition, if we raise additional funds through strategic alliances or licensing arrangements, it may be necessary to relinquish potentially valuable rights to our potential products or proprietary technologies, or grant licenses on terms that are not favorable to us.
Risks related to our intellectual property
* We are, and may in the future be, subject to intellectual property rights claims, which are costly to defend, could require us to pay damages and could limit our ability to use certain technologies or content in the future.
of disputes can be asserted by our licensees or prospective licensees or by other third parties as part of negotiations with us or in private actions seeking monetary damages or injunctive relief. Any disputes with our licensees or potential licensees or other third parties could harm our reputation and expose us to additional costs and other liabilities.
* We may be unable to adequately protect the proprietary rights in our technologies and products.
We have only two issued patents in the United States and no issued patents elsewhere, and we generally do not rely upon patents to protect our proprietary rights. In addition, our ability to obtain patent protection for our technologies and products will be limited as a result of the incorporation of aspects of MPEG-4 and MP3 technologies into our technologies and products. We license such technologies from third party licensors and do not own any patents relating to such technologies. As a result, we do not have the right to defend perceived infringements of patents relating to such technologies. Moreover, the licensors from which we have acquired the right to incorporate MPEG-4 and MP3 technologies into our products are not the exclusive owners of the patents relating to such technologies. As a result, our licensors must coordinate enforcement efforts with the owners of such patents to protect or defend against infringements of patents relating to such technology, which can be expensive, time consuming and difficult. Any significant impairment of the intellectual property rights relating to the MPEG-4 or MP3 technologies we license for use in our technologies and products could reduce the value of such technologies, which could impair our ability to compete.
Our ability to compete partly depends on the superiority, uniqueness and value of our technologies, including both internally developed technology and technology licensed from third parties. To protect our proprietary rights, we rely on a combination of trademark, patent, copyright and trade secret laws, confidentiality agreements with our employees and third parties, and protective contractual provisions. Despite our efforts to protect our intellectual property, any of the following occurrences may reduce the value of our intellectual property:
Legislation may be passed that would require companies to share information about their digital rights management technology to permit interoperability with other systems. If this legislation is enacted, we may be required to reveal our proprietary digital rights management code to competitors. Furthermore, if content must be formatted such that it can be played on a media player other than a DivX Certified player, then the demand for DivX Certified players could decrease.
We may be forced to litigate to defend our intellectual property rights or to defend against claims by third parties against us relating to intellectual property rights.
Disputes regarding the ownership of technologies and rights associated with digital media technologies and online businesses are common and likely to arise in the future. We may be forced to litigate to enforce or defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of other parties proprietary rights. Any such litigation could be very costly and could distract our management from focusing on operating our business.
Our ability to maintain and enforce our trademark rights has a large impact on our ability to prevent third party infringement of our brand and technologies.
We generally rely on enforcing our trademark rights to prevent unauthorized use of our brand and technologies. Our ability to prevent unauthorized uses of our brand and technologies would be negatively impacted if our trademark registrations were overturned in the jurisdictions where we do business. Our brand and logo are widely used by consumers and entities, both licensed and unlicensed, in association with digital video compression technology, and if we are not vigilant in preventing unauthorized or improper use of our trademarks, then our trademarks could become generic and we would lose our ability to assert such trademarks against others. We also have trademark applications pending in a number of jurisdictions that may not ultimately be granted, or if granted, may be challenged or invalidated, in which case we would be unable to prevent unauthorized use of our brand and logo in such jurisdiction. We have not filed trademark registrations in all jurisdictions where our brand and logo are used.
Some software we provide may be subject to open source licenses, which may restrict how we use or distribute our software or require that we release the source code of certain products subject to those licenses.
Some of the products we support and some of our proprietary technologies incorporate open source software such as open source MP3 codecs that may be subject to the Lesser Gnu Public License or other open source licenses. The Lesser Gnu Public License and other open source licenses typically require that source code subject to the license be released or made available to the public. Such open source licenses typically mandate that software developed based on source code that is subject to the open source license, or combined in specific ways with such open source software, become subject to the open source license. We take steps to ensure that proprietary software we do not wish to disclose is not combined with, or does not incorporate, open source software in ways that would require such proprietary software to be subject to an open source license. However, few courts have interpreted the Lesser Gnu Public License or other open source licenses, and the manner in which these licenses may be interpreted and enforced is therefore subject to some uncertainty. In addition, we rely on multiple software programmers to design our proprietary products and technologies. Although we take steps to ensure that our programmers do not include open source software in products and technologies we intend to keep proprietary, we do not exercise complete control over the development efforts of our programmers and we cannot be certain that our programmers have not incorporated open source software into products and technologies we intend to keep proprietary. In the event that portions of our proprietary technology are determined to be subject to an open source license, or are intentionally released under an open source license, we could be required to publicly release the relevant portions of our source code, which could reduce or eliminate our ability to commercialize our products and technologies.
Risks related to the securities markets and investment in our common stock
* The market price of our common stock may decline as a result of the proposed sale of Stage6.com or separation of Stage6.com into a private company.
The market price of our common stock may decline as a result of our proposed separation of Stage6.com for a number of reasons, including:
Market volatility may affect our stock price and the value of your investment.
The market price for our common stock has been and is likely to continue to be volatile, in part because our shares have only recently been traded publicly. In addition, the market price of our common stock may fluctuate significantly in response to a number of factors, most of which we cannot control, including:
* Shares of our common stock are relatively illiquid.
As of October 31, 2007, we had 34,446,973 shares of common stock outstanding, excluding 157,887 shares subject to repurchase. As a result of our relatively small public float, our common stock may be less liquid than the stock of companies with broader public ownership. Among other things, trading of a relatively small volume of our common stock may have a greater impact on the trading price for our shares than would be the case if our public float were larger.
Anti-takeover provisions in our charter documents and under Delaware law could make an acquisition of us, which may be beneficial to our stockholders, more difficult and may prevent attempts by our stockholders to replace or remove our current management.
Provisions in our certificate of incorporation and bylaws may delay or prevent an acquisition of us or a change in our management. These provisions include a classified board of directors, a prohibition on actions by written consent of our stockholders and the ability of our board of directors to issue preferred stock without stockholder approval. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which limits the ability of stockholders owning in excess of 15% of our outstanding voting stock to merge or combine with us. Although we believe these provisions collectively provide for an opportunity to obtain higher bids by requiring potential acquirors to negotiate with our board of directors, they would apply even if an offer were considered beneficial by some stockholders. In addition, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management.
We do not intend to pay dividends on our common stock.
We have never declared or paid any cash dividend on our capital stock. We currently intend to retain any future earnings and do not expect to pay any dividends in the foreseeable future.
We will incur increased costs as a result of changes in laws and regulations relating to corporate governance matters.
Changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act and rules adopted by the SEC and by The Nasdaq Stock Market, will result in increased costs to us as we continue to evaluate the implications of these laws and respond to their requirements. The impact of these laws and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers. We are presently evaluating and monitoring developments with respect to these laws and regulations and cannot predict or estimate the amount or timing of additional costs we may incur to respond to their requirements.
If we fail to maintain proper and effective internal controls, our ability to produce accurate financial statements could be impaired, which could adversely affect our ability to operate our business and our stock price.
Ensuring that we have adequate internal financial and accounting controls and procedures in place to help ensure that we can produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. We are in the process of documenting, reviewing and, where appropriate, improving our internal controls and procedures in preparation for compliance with Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent auditors addressing these assessments. Both we and our independent auditors will be testing our internal controls in connection with the Section 404 requirements and could, as part of that documentation and testing, identify material weaknesses, significant deficiencies or other areas for further attention or improvement. Our networks are vulnerable to security risks and hacker attacks, which may affect our ability to maintain effective internal controls as contemplated by Section 404. Implementing any appropriate changes to our internal controls may require specific compliance training for our directors, officers and employees, entail substantial costs to modify our existing accounting systems, and take a significant period of time to complete. Such changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain that adequacy, or consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and could materially impair our ability to operate our business. In addition, disclosure regarding our internal controls or investors perceptions that our internal controls are inadequate or that we are unable to produce accurate financial statements may adversely affect our stock price.
* If our executive officers, directors and their affiliates choose to act together, they may be able to control our operations and act in a manner that advances their best interests and not necessarily those of other stockholders.
Our executive officers, directors and their affiliates beneficially own approximately 27.6% of our common stock as of October 31, 2007. As a result, these stockholders, acting together, are able to effectively control all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. The interests of this group of stockholders may not always coincide with our interests or the interests of other stockholders, and they may act in a manner that advances their best interests and not necessarily those of other stockholders.
* Future sales of our common stock may cause our stock price to decline.
As of October 31, 2007, there were 34,446,973 shares of our common stock outstanding. Excluding 157,887 shares subject to repurchase, substantially all of these shares became eligible for sale in the public market upon expiration of lock-up agreements on March 20, 2007, although as of October 31, 2007, 10,287,411 of these shares were held by directors, executive officers and other affiliates and will be subject to volume limitations under Rule 144. In addition, as of October 31, 2007 we had outstanding warrants to purchase up to 77,407 shares of common stock that, if exercised, will result in these additional shares becoming available for sale. A large portion of these shares and warrants are held by a small number of persons and investment funds. Sales by these stockholders or warrantholders of a substantial number of shares could significantly reduce the market price of our common stock. Moreover, the holders of 9,912,726 shares of common stock at October 31, 2007 have rights, subject to some conditions, to require us to file registration statements covering the shares they currently hold or to include these shares in registration statements that we may file for ourselves or other stockholders.
As of October 31, 2007, an aggregate of approximately 5,724,187 shares of our common stock were reserved for future issuance under our 2000 Stock Option Plan, or 2000 Plan, our 2006 Equity Incentive Plan, or 2006 Plan, and our 2006 Employee Stock Purchase Plan, or 2006 Purchase Plan, and the share reserve under our 2006 Plan and our 2006 Purchase Plan are subject to automatic annual increases in accordance with the terms of the plans. These shares can be freely sold in the public market upon issuance. If a large number of these shares are sold in the public market, the sales could reduce the trading price of our common stock and impede our ability to raise future capital.
Purchases of Equity Securities by the Company
Pursuant to the terms of our 2000 Plan, options may typically be exercised prior to vesting. We have the right to repurchase unvested shares from our employees and consultants upon their termination, and it is generally our policy to do so. The following table provides information with respect to purchases made by us of our common stock during the three month period ended September 30, 2007:
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.