You should read the following discussion and analysis of our financial condition and results of our operations in conjunction with our consolidated 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, 2007 included in our Annual Report on Form 10-K filed with the SEC. 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.

Overview

We create products and services designed to improve the experience of media. Our long-term goal is to allow creators to have the ability to capture their content in the DivX format using any device or software of their choosing and to allow consumers of such content to playback and interact with it on any device or platform.

In 2000, the first step towards our goal was to build and release a high-quality video compression-decompression software library, or codec, to enable distribution of media across the Internet and through recordable media. As a result, we created the DivX codec, which has been actively sought out and downloaded by consumers over 250 million times, 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 to existing end users of our products. After the significant grass-roots adoption of our codec, the next step towards our goal was to license similar technology to consumer hardware device manufacturers and certify their products to ensure the interoperable support of DivX-encoded content. Our customers include major consumer video hardware original equipment manufacturers, or OEMs. We are entitled to receive a royalty and/or license fee for DivX Certified devices that our customers ship. In addition to technology licensing to consumer hardware device manufacturers, we currently generate revenue from software licensing and related support, advertising and content distribution.

Complementing our organic growth, in November 2007, we acquired MainConcept GmbH, formerly MainConcept AG (MainConcept), a leading provider of H.264 and other high-quality video codecs and technologies for the broadcast, film, consumer electronics and computer software markets. Through integration, we expect to realize additional opportunities both in our core markets and in related emerging markets that will help advance our long-term goals of supporting high-quality video on any device.

Our next steps, which we have begun working toward, are to bring together the millions of DivX consumers with content creators both large and small to build communities around media, including through the development and licensing of media distribution platforms and services for the Internet and consumer electronics devices. We are optimistic about the future and believe the opportunities for DivX are only beginning to be realized.

Sources of revenues

We have four revenue streams. Three of these revenue streams are derived from our technologies, including technology licensing to producers of consumer hardware devices, licensing to independent software vendors and consumers, and providing services related to content distribution over the Internet. Additionally, we derive revenues from advertising and distributing third-party products on our website.

Our technology licensing revenues from consumer hardware device manufacturers comprise the majority of our total revenues and are derived primarily from royalties and/or license fees received from OEMs, although related revenues are derived from other members of the consumer hardware device supply chain. We license our technologies to OEMs, allowing them to build support of DivX technologies into their consumer hardware devices. In the majority of cases, OEMs pay us a per-unit fee for each DivX Certified device they sell. Our license agreements with OEMs typically range from one to two years, and may include the payment of initial fees, volume-based royalties and minimum guaranteed volume levels. To ensure high-quality support of the DivX media format in finished consumer products, we also license our technologies to companies who create the major components in consumer hardware devices. These companies include integrated circuit manufacturers who supply integrated circuits, and original design manufacturers who create reference designs, for DVD players, digital still cameras and the other consumer hardware devices distributed by our licensee original equipment manufacturers. 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 given calendar year being generally lower than any other quarter in that calendar year.

We license our technologies to independent software vendors that incorporate our technologies into software applications for computers and other consumer hardware devices. An independent software vendor typically pays us an initial license fee, in addition to per-unit royalties based on the number of products sold that include our technology. We also license our technologies directly to consumers through several software bundles. We make certain software bundles available free of charge from our website. These bundles incorporate a version of our codec technology, and allow consumers to play and create content in the DivX format. We also make available from our website an enhanced version of our free software bundles, including additional features that increase the quality and control of DivX media playback and creation. These enhanced versions are available free of charge for a limited trial period, which is generally 15 days. At the end of the trial period, our users are invited to purchase a license to one or more components of the enhanced bundle by making a one time payment to us. If they choose not to do so, they still enjoy playback and creation functionality equivalent to our free software bundle. 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.

We derive revenue from advertisements or third party software applications that we embed in or include with the software packages we offer to consumers. For example, we include and distribute a co-branded Yahoo! toolbar and Internet Explorer browser with our software products. Yahoo! pays us fees based on the number of certain distributions or installations of the Yahoo! software by consumers. Yahoo! may terminate the agreement, or the revenue we derive for such periods will be reduced, if we fail to achieve certain minimum distribution volumes or certain minimum installations of the Yahoo! software for specific periods described in the agreement. This agreement expires on December 31, 2009, and Yahoo! is under no obligation to renew this agreement.

We derive revenue by acting as an application service provider for third party owners of digital video content. We provide encoding, content storage and distribution services to these third parties in exchange for a percentage of the revenue they receive from sales of digital content to consumers. 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. We report revenue related to content distribution arrangements with consumer hardware OEMs who pay a fee for each copy of DivX-encoded content that is encoded on physical media and bundled with their consumer hardware products. If our content licensing arrangements with consumer hardware OEMs or our online video community services are successful, our content distribution revenues may increase in future periods.

Our wholly owned subsidiary, MainConcept, licenses its codec software applications for professional consumers and sells software development kits for software developers. MainConcept's licenses typically range in term from one year to perpetual licenses. MainConcept's customers typically pay upfront fees, periodic maintenance and support fees, volume-based royalties and provide minimum guaranteed volume levels. Revenue from these software licensing agreements is recognized upon delivery of the software, which is generally when the software is made available for download, there is persuasive evidence of an arrangement, collection is reasonably assured, the fee is fixed or determinable and vendor-specific objective evidence exists to allocate the total fees to all elements of the arrangement. MainConcept's licenses generally include maintenance provisions that bundle the license with the related maintenance. Contracts that bundle the software license with software maintenance and technical support are recognized ratably over the contract term.

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 related 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.

Selling, general and administrative

The majority of selling, general and administrative expenses consists of employee compensation costs. Selling, general and administrative expense also includes marketing expenses, business travel costs, trade show costs, outside consulting fees and related overhead. Our headcount for selling, general, and administrative related personnel, including employees and outside contractors increased by 9 from 174 as of September 30, 2007 to 183 as of September 30, 2008, primarily as a result of our acquisition of MainConcept, offset by our shut-down of Stage6. We may hire additional employees and outside contractors for our sales and marketing staff and increase our selling and marketing budget in the future as we attempt to continue to raise awareness of our products and services.

Product development

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 30 from 124 as of September 30, 2007 to 154 as of September 30, 2008, primarily as a result of our acquisition of MainConcept, offset by our shut-down of Stage6. Product development expense also includes depreciation of computer and related equipment, software license fees and related overhead. We may 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 may use outside contractors to fulfill our labor needs when and as required to accomplish our operating goals.

Impairment of acquired intangibles

In the first half of 2008, we recorded an impairment charge of $1.3 million related to the patented technology license intangible asset acquired in connection with our acquisition of Veatros, L.L.C., a limited liability company, in July 2007. As more fully discussed in Note 9 in the accompanying notes to the unaudited consolidated financial statements, management performed an impairment analysis of the asset in accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, and recorded an impairment charge of $1.3 million as management concluded that the asset was not fully recoverable.

Asset Impairment and Restructuring

On February 29, 2008, we shut down Stage6, our online video community service. We evaluated the long-lived assets associated with Stage6 for impairment and concluded that the carrying amount of certain computers and computer equipment, prepaid assets and an intangible asset were not recoverable and an impairment loss equal to the assets' remaining carrying values of approximately $350,000 was recorded. In addition, we identified several contractual obligations associated with Stage6 that were determined to have no future economic value. As a result, we recorded a loss of $477,000 on those contractual obligations during the three months ended March 31, 2008. No costs associated with the closure of Stage6 were incurred in the three months ended September 30, 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.

Except as noted below, our critical accounting policies are described in the notes to the audited consolidated financial statements as of and for the year ended December 31, 2007 included in our Annual Report on Form 10-K filed with the SEC.

Valuation of financial assets and liabilities. Effective January 1, 2008, we adopted Statement of Financial Standards (SFAS), No. 157, Fair Value Measurements (SFAS No. 157). In February 2008, the Financial Accounting Standards Board (FASB), issued a staff position that delays the effective date of SFAS No. 157 for all nonfinancial assets and liabilities except for those recognized or disclosed at least annually. Therefore, we adopted the provisions of SFAS No. 157 with respect to our financial assets and liabilities only. SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Fair value is defined under SFAS No. 157 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measure date. Valuation techniques used to measure fair value under SFAS No. 157 must maximize the use of observable inputs and minimize the use of unobservable inputs.

We value our financial assets and liabilities in accordance with SFAS No. 157, utilizing the fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value which are the following:

Level 1 - Quoted prices in active markets for identical assets or liabilities.

Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Future Accounting Requirements

In December 2007, the FASB issued SFAS No. 141 (Revised 2007) (SFAS No. 141R), Business Combinations, or SFAS No. 141R. SFAS No. 141R will change the accounting for business combinations. Under SFAS No.141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS No.141R will change the accounting treatment and disclosure for certain specific items in a business combination. SFAS No. 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The adoption of SFAS No. 141R will change our accounting treatment for business combinations on a prospective basis beginning the first quarter of fiscal year 2009.

In December 2007, the FASB issued SFAS No. 160, Interests in Consolidated Financial Statements-An Amendment of ARB No. 51 (SFAS No. 160). SFAS No. 160 establishes new accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. We are currently evaluating the impact of SFAS No. 160 on our consolidated results of operations and financial condition.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133 (SFAS No. 161), which requires additional disclosures about the objectives of using derivative instruments, the method by which the derivative instruments and related hedged items are accounted for under FASB Statement No.133 and its related interpretations, and the effect of derivative instruments and related hedged items on financial position, financial performance and cash flows. SFAS No. 161 also requires disclosure of the fair values of derivative instruments and their gains and losses in a tabular format. The statement is applicable for all fiscal years beginning on or after November 15, 2008 and will be effective for our fiscal year 2009. We do not believe that the adoption of this statement will have a material impact on our financial statements.

Results of Operations

The following table presents our results of operations as a percentage of total
net revenue for the periods indicated:



                                                   Three months ended                 Nine months ended
                                                      September 30,                     September 30,
                                                 2008               2007           2008              2007
                                                       (unaudited)                       (unaudited)
Net revenues:
Technology licensing                                 78 %               78 %           77 %              79 %
Media and other distribution and services            22                 22             23                21

Total net revenues                                  100                100            100               100
Cost of revenues:
Cost of technology licensing                          4                  4              4                 4
Cost of media and other distribution and
services (1)                                          1                  1              1                 1

Total cost of revenues                                5                  5              5                 5

Gross margin                                         95                 95             95                95
Operating expenses:
Selling, general and administrative (1)              54                 69             59                64
Product development (1)                              19                 20             22                22
Impairment of acquired intangibles                   -                  10              2                 4

Total operating expenses                             73                 99             83                90

Income (loss) from operations                        22                 (4 )           12                 5
Interest income (expense), net                        4                  9              5                10
Other income (expenses), net                         (3 )               -               1                -

Income before income taxes                           23                  5             18                15
Income tax provision                                  9                  2              7                 6

Net income                                           14 %                3 %           11 %               9 %

(1) The following table presents details of total stock-based compensation expense included in each functional line item in the unaudited consolidated statements of income above:

Cost of revenues                                     -  %               -  %           -  %              -  %
Selling, general and administrative                   8                  9              7                 7
Product development                                   2                  2              2                 2

Net Revenues

The following table summarizes and analyzes the revenues we earned for the three
and nine months ended September 30, 2008 and 2007 (in thousands):



                                      Three Months Ended                            Nine Months Ended
                                         September 30,             Change             September 30,             Change
                                       2008          2007          $       %        2008          2007          $       %
Net revenues:
Technology licensing
Consumer hardware devices           $   15,537     $ 15,452     $    85     1 %   $  45,738     $ 42,708     $  3,030    7 %
% of total net revenues                     64 %         71 %                            65 %         70 %
Software                                 3,571        1,618       1,953   121 %       8,858        5,293        3,565   67 %
% of total net revenues                     14 %          7 %                            12 %          9 %

Total technology licensing              19,108       17,070       2,038    12 %      54,596       48,001        6,595   14 %
% of total net revenues                     78 %         78 %                            77 %         79 %
Advertising and third-party
product distribution                     5,165        4,683         482    10 %      15,698       11,956        3,742   31 %
% of total net revenues                     21 %         21 %                            22 %         20 %
Content distribution and related
services                                   136          142          -6    -4 %         456          435           21    5 %
% of total net revenues                      1 %          1 %                             1 %          1 %

Total net revenues                  $   24,409     $ 21,895     $ 2,514    11 %   $  70,750     $ 60,392     $ 10,358   17 %

Technology licensing-consumer hardware devices: The $85,000, or 1% increase in net revenues from technology licensing to consumer hardware device manufacturers from the three months ended September 30, 2007 to the three months ended September 30, 2008, and the $3.0 million, or 7%, increase in net revenues from technology licensing to consumer hardware device manufacturers from the nine months ended September 30, 2007 to the nine months ended September 30, 2008 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.

Technology licensing-software: The $2.0 million, or 121%, increase in software licensing revenues from the three months ended September 30, 2007 to the three months ended September 30, 2008 was primarily due to approximately $1.7 million of additional revenue from MainConcept acquired in November 2007 for the three-month period ended September 30, 2008, and $900,000 additional revenue from web software sales and new software license agreements, offset by a $600,000 decrease in revenue as a result of the expiration of a codec licensing agreement with Google in 2007. The $3.6 million, or 67%, increase in software licensing revenues from the nine months ended September 30, 2007 to the nine months ended September 30, 2008 was primarily due to approximately $4.3 million of additional revenue from MainConcept, and $1.4 million additional revenue from web software sales and new software license agreements, offset by a $2.1 million decrease in revenue as a result of the expiration of the codec licensing agreement with Google.

Advertising and third-party product distribution: The $482,000, or 10%, increase in advertising and third-party product distribution revenue from the three months ended September 30, 2007 to the three months ended September 30, 2008, and the $3.7 million, or 31%, increase in advertising and third-party product distribution revenue from the nine months ended September 30, 2007 to the nine months ended September 30, 2008, resulted primarily from an increase in revenues under our agreement with Yahoo! in 2008 compared to our agreement with Google in 2007. In November 2007, we switched from the distribution of Google software, to including and distributing a co-branded Yahoo! toolbar and Internet Explorer browser with our software products under agreement with Yahoo!. Pursuant to the agreement, Yahoo! pays us fees based on the number of certain distributions or installations of the Yahoo! software by consumers.

Content distribution and related services: The $6,000, or 4%, decrease in content distribution and related services revenue from the three months ended September 30, 2007 to the three months ended September 30, 2008, and the $21,000, or 5%, increase in content distribution and related services revenue from the nine months ended September 30, 2007 to the nine months ended September 30, 2008 reflects fluctuations in sales by our Open Video System (OVS) customers and in encoding revenues. Our OVS is a complete hosted service that allows content creators to deliver high-quality DivX video content over the Internet. We use our OVS to provide content and service providers with encoding . . .