A look at On2 Technologies and why Google wants it

It's not very often that Google makes an acquisition and the target inspires a collective "who?" But that's what happened when the search giant bought On2 Technologies, a penny stock trading in obscurity on the American Stock Exchange, for 60 cents a share. And unless you've followed the wonderful world of video codecs On2 may still be a bit of a mystery.

Here's a look at On2's business and Google's grander plans.

What does On2 do?

According to On2's annual report, the company owns a series of video compression technologies that help transmit video over bandwidth constrained cellular networks and high-def over the Internet. On2 has a proprietary platform that includes video codecs VP6, VP7 and VP8, Flix Pro, a Web development platform, Flix Publisher, a series of Web browser plug-ins, Flix Engine, a server transcoding platform and Flix DirectShow SDK, a library for video content creation. What will Google do with this? In Google's statement, the company noted that video compression should be part of the Web platform. Simply put, On2's technology will be lumped into the Chrome browser, YouTube and other key areas.

Is On2's technology a threat to Adobe's Flash platform now that Google owns it?

While some folks view the Google purchase of On2 a threat to Adobe's Flash it's unclear what'll happen. For starters, Adobe is a customer of On2's. The company reports in its SEC filings:

In 2004, we licensed our video compression technology to Macromedia, Inc. (now Adobe Systems Incorporated) for use in the Adobe Flash multimedia player. In anticipation of Adobe using our codec in the Flash platform, we launched our business of developing and marketing video encoding software for the Flash platform. Flash encoding has become an increasingly important part of our business. In December 2008, we entered into a license agreement with Sun Microsystems for the use of our video compression technology in the JavaFX platform and anticipate further growth for our encoding and transcoding businesses as a result of this transaction.

In fact, On2 notes that it is the video engine for Flash 8 video. What will Google (not to mention Adobe) do now? Google could open source On2's proprietary technology, which competes with a bevy of standard compression specifications from industry groups. Or it could just continue to license On2's technology to Adobe. The licensing of On2's Flash encoding tools accounted for 27%, 41%, and 64% of its revenue for the fiscal years ended December 31, 2008, 2007, and 2006, respectively.

Another wrinkle: Google and Adobe could become tighter in their battle with Microsoft. Indeed, On2 has been upbeat about its relationship with Adobe.

We continue to believe that VP6 will be an important part of the Flash video ecosystem for three reasons: (1) Adobe has in the past provided backwards compatibility with all generations of Flash video codecs; (2) VP6 has certain performance advantages over H.264 (e.g., HD VP6 content may be played back on a lower-powered processor than HD H.264 content); and (3) there is a vast amount of existing VP6 content that consumers want on portable and mobile devices.

Will Google embed itself into multiple areas with On2?

It's quite possible that Google could use On2 to embed itself into multiple areas. On2 caters to hardware and software developers that create everything from teleconferencing services to video instant messaging to surveillance to mobile television and video transported via wireless networks. On2 also offers custom engineering and consulting services and a cloud-based pay as you encode service built on Amazon EC2. What will Google do with this stuff? On2's technology will be sprinkled into a host of side ventures.

Who highlights On2's customer roster?

Aside from Adobe and Sun, On2 notes that Move Networks and Skype are also customers. It's unclear whether these customers will think differently after Google completes the deal.

What competition does On2 face?

On2 listed H.264, a standard codec that is the successor to MPEG-4, as a primary competitor. The company said:

We believe that our technology is superior to H.264, and that we can offer significantly more flexibility in licensing terms than customers get when licensing H.264. H.264 has nevertheless gained significant adoption by potential customers because, as a standards-based codec, it has the advantage of having numerous developers who are programming to the H.264 standard and developing products based on that standard. In addition, a number of manufacturers of multimedia processors have done the work necessary to have H.264 operate on their chips, which makes H.264 attractive to potential customers who would like to enable video on devices. For example, Apple Inc. uses H.264 in its QuickTime® player and has thus chosen H.264 for the current generation of video iPods. Finally, there is already a significant amount of professional content that has been encoded in H.264. These advantages may make H.264 attractive to potential customers and allow them to implement a solution based on H.264 with less initial development time and expense than a solution using On2’s proprietary video codecs might require.

On2 also competes with a lot of household names.

We believe that the principal competitive factors in our business include technological innovation, versatility of products, pricing, availability of content, ease of integration with and availability of use on low-cost processors, customer service, service offerings and the flexibility to adapt to changing market conditions. Our video compression technology competes with that of companies such as Microsoft and RealNetworks and with standards-based codecs such as MPEG-2, H.264, MPEG-4 and several codecs that position themselves as “MPEG-4-based.” Companies such as Apple, Inc. and DivX, Inc. also have popular players that they have derived from standards-based technology; Apple’s QuickTime player is based on H.264, and DivX uses a variant MPEG-4 and H.264.

What's the Microsoft hook?

Every Google story has some Microsoft angle to it and the On2 purchase is no different. On2 noted that Microsoft is becoming a significant competitor. On2 said:

A continuing trend in our business is the growing presence of Microsoft Corporation as a significant competitor in the market for digital media creation and distribution technology. In 2007, Microsoft released Silverlight, a rich Internet application that allows users to integrate multimedia features, such as vector graphics, audio and video, into web applications. Silverlight may compete directly with Flash. If Silverlight gains market share at the expense of Flash, it could have a negative impact on our Flix business. In addition, Microsoft VC1 format also competes in the marketplace with H.264 and our VPx technologies. We believe that our VPx technologies have the same advantages over VC1 as they do over H.264.

Although we expect that competition from Microsoft, H.264 developers, and others will continue to intensify, we expect that our video compression technology will remain competitive and that our relatively small size will allow us to innovate in the video compression field and respond to emerging trends more quickly than monolithic organizations like Microsoft and the MPEG consortium.

Then in a sentence that probably won't be written again once the Google deal closes, On2 noted that some customers find it appealing to work with a smaller company.

What exactly will Google do with On2's hardware business?

On2 has a hardware business where it develops digital electronic hardware designs (known as register transfer level designs or RTL) of video and audio codecs to manufacturers of computer chips and multimedia devices. A licensee of On2's RTL design might use that product to implement a video decoder on a chip with the decoder built into the circuitry. What would Google do with this business? Sounds like a netbook-Chrome OS play of some sort doesn't it?

Are any of On2's businesses worth keeping?

Probably not if all you do is look at the financial picture. Google could just open source everything On2 has and not blink an eye. Here's the annual financial picture, which isn't even a rounding error in Google's world: