InterVideo (NASDAQ:IVII) is a software developer that sells the leading DVD player for PCs, called WinDVD, with 50 million copies sold so far. After going public this month, the stock trades at $20, or about 32 times its expanding free cash flow. In my last column, we studied the business strategy and the many positives for InterVideo. Now, it's time to tackle the darker side of the equation: the risks and negatives.

In general, there are extra risks in buying a young company, but with InterVideo (as with many newly public companies), it isn't the firm's age that investors should focus on, but the specific business risks. In this case, those risks are many.

Knowing your companies
First, my friends, if you own or are considering buying any stock, you should take a good few hours to read the recent SEC statements -- the company's 10-Q, 10-K (this annual report tends to have more information), or, with IPOs, the prospectus.

Print those bad boys and head to a cafe with a highlighter or pen, get a cup of something tasty and a snack, and dig in. Read, highlight, make notes. Drink, eat, tip well. You'll learn more about your company in those few hours than if you had dinner with the CEO (and you won't be "wowed" by spin).

On to the show...

InterVideo's unwinding risks
You know this business well now (if you don't, you might go back and read our previous column), so now we'll serve the risks up about as dry as a good martini, but hopefully as enlightening:

  • InterVideo sold its first product in February 1999, so it lacks operating history. Much more importantly, there's been tremendous change in digital video and audio software in the last four years, and that change is only going to accelerate.

  • Just as several companies provide basic online video and audio players, many are likely to address the PC DVD and digital entertainment software market. InterVideo's current largest competitors include Adobe Systems (NASDAQ:ADBE), Cyberlink, Pinnacle Systems, Roxio (NASDAQ:ROXI), Sonic Solutions (NASDAQ:SNIC), and Ulead Systems, but dozens of new entrants are possible. A larger company could also acquire one of InterVideo's competitors and enter the market.

  • In response to competition, InterVideo expects "prices for our products to decline over the next few years." Diminishing margins for PC manufacturers, softness in the PC market, and competition have forced InterVideo to charge less for its WinDVD product, and it expects this downward pricing trend to continue. Therefore, it needs to increase sales volume and add new products to avoid a decline in revenue.

  • Growing sales is increasingly challenging when only a handful of large PC manufacturers exist, and InterVideo already has contracts with a majority (eight of the 10 largest). Aside from new products, new distribution channels direct to consumers will prove vital.

  • Five customers accounted for a majority of revenue, with Dell (NASDAQ:DELL) and Hewlett-Packard (NYSE:HPQ) accounting for more than 30% of sales. This concentrates sales risk and makes quarterly fluctuations more likely.

  • InterVideo's software is primarily based on Microsoft (NASDAQ:MSFT) Windows, putting the company in the one position that all software companies try to avoid but few do: at the mercy of Bill Gates. Microsoft could enter InterVideo's market with its own products (we all know how it took away Internet browsers from Netscape), or it could license and promote a competing product in its Windows operating system. Although at present neither risk appears imminent nor likely, this could change at any time, making InterVideo a higher-risk proposition no matter how you cut the deck.

  • InterVideo licenses technology for its products from various third parties, including Dolby Laboratories, the DVD Copy Control Association, MPEG LA, and Thomson Licensing (for MP3 technology). InterVideo pays royalties to each licensee, and is dependent upon contract renewals. Again, this gives InterVideo less control of its fate.

  • Where there is patented technology, there is often a lawsuit -- or two. InterVideo, unfortunately, is involved in a few, and more may come. DVDs use a technology called MPEG-2, which controls the process of storing video in digital form. A handful of companies -- mainly consumer electronic (CE) manufacturers -- own MPEG-2 rights and formed a consortium called MPEG LA to protect those rights. This consortium has sued InterVideo for patent infringement on its DVD software. MPEG LA has also filed complaints against PC manufacturers for selling InterVideo's WinDVD. In 2002, InterVideo issued 350,000 shares of its stock to Dell Computer to settle claims against its product, but InterVideo's prospectus says, "We expect to make additional cash payments to settle similar claims in the future." So, MPEG-2 battles don't appear over.

  • Another group of companies formed a consortium called DVD 6C (where do they get these great names?), and has informed InterVideo that it may need to pay a license fee for use (it claims) of the consortium's DVD technology. Additionally, Nissim Corporation and other third parties may have patent claims against InterVideo, and InterVideo may eventually be forced to pay fines or royalties.

Those are the primary risks facing InterVideo: a rapidly evolving market; increasing competition; declining product prices with the possibility that its main product will become a commodity; only a handful of large customers and few large sales contract possibilities remaining; Microsoft (enough said); patent lawsuits; and ongoing royalty payments.

Those negatives are quite a contrast to the positives we highlighted two days ago: a varied, scalable business strategy based on software products that are in a sweet spot as digital multimedia blossoms; the leading position in PC DVD software; profitable growth and $6.2 million in free cash flow last year; $52 million in cash and no debt, giving it an enterprise value of $200 million, or 32 times last year's free cash flow. Finally, 60% net income growth last quarter, impressive financials, patents on its technology, and more.

It's yin and yang, isn't it?

Risk vs. reward
With every investment decision, you need to weigh the good against the bad to try to reach a conclusion. Is the risk commensurate with the likely reward? Buying a well-known large cap for the long term, your risk should be lower than average, but so is your potential reward. When investing in young or risk-laden companies, you want a tremendous amount of upside potential to compensate for the above-average risk.

But with InterVideo, there appears to be considerably more risk than with many other young companies at similar valuations. For example, I much preferiPayment's (NASDAQ:IPMT) risk-reward scenario. iPayment does not face severe pricing pressure, rapidly evolving technology, patent lawsuits that might lead to higher royalty payments, or a limited core customer base. And so forth. Sometimes, side-by-side comparisons can illuminate an investment decision.

With InterVideo, if you only read the press releases and newswire coverage, you'll have no idea how many tangible risks the company faces. You'd only know that it's the profitable WinDVD producer, with 50 million copies sold. Realizing what it's up against, I need to see a much lower valuation before I'd reconsider the risk-reward scenario, so I'll keep looking for investments elsewhere.

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The Motley Fool has a full disclosure policy . Jeff Fischer doesn't own shares in any companies mentioned.