Riding the Rambus Still Too Dear for Some

Last year, a double-digit rise in shares of semiconductor designer Rambus (RMBS Quote) was as common as a dot-com millionaire.

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No longer. After a 583% surge last spring, Rambus stock has dropped by two-thirds over a year as investors have reassessed the prospects for its fundamental business, licensing chip designs to semiconductor manufacturers. Yet by many standards the stock remains expensive even now, investors and analysts say, pointing up the ongoing danger of investing during an era of boundless tech optimism.

Rambus rose to its lofty valuation at a time when cash was plentiful and rumors, innuendo and pure speculation were major market forces. Back then, investors dreamed freely of a day when Rambus would dominate the entire memory market with Rambus DRAM, or RDRAM. Chip giant Intel (INTC Quote) planned to include RDRAM with its new Pentium 4 microprocessor for personal computers, furthering those lofty daydreams.

A year later, it's far less likely that RDRAM will take over the memory market. A consortium of DRAM makers are together behind another next-generation memory chip, called double data rate or DDR. Rambus has filed lawsuits against these chipmakers, contending that DDR and the current standard, synchronous DRAM or SDRAM, are covered by Rambus patents. At the same time, Intel's plan to use RDRAM still isn't ironclad. Intel will launch Pentium 4 compatible technology for SDRAM by the end of the year and possibly for DDR next year.

Cheap?

So Rambus today trades at more earthly levels, right? Hardly. Its stock has a lofty price-to-earnings ratio, with the stock trading at about 92 times fiscal 2001 earnings. To put that in perspective, Qualcomm (QCOM Quote) -- a telecommunications company with a similar licensing business -- trades at 46 times forward earnings, while a growth chip company like Applied Micro Circuits (AMCC Quote) trades at 59 times fiscal 2001 earnings, both of which are still considered expensive by some.

"I think the problem with Rambus was that it was being driven more by news stories than fundamentals," says Dan Niles, an analyst at Lehman Brothers who no longer covers the stock. "Back then it was very much chat rooms, or hearing a rumor on the Internet." (Lehman hasn't done recent underwriting for Rambus.)

But even while some of the froth has gone out of Rambus, the bulls are still able to find fuel for a story of eventual RDRAM domination that they can use to justify its current high price.

For one thing, Rambus could end up litigating its way into more market share. Those patent suits against Micron Technology (MU Quote), Infineon and Hyundai Electronics could result in Rambus receiving royalties from all memory makers on SDRAM and DDR in addition to RDRAM. Rambus has already signed up SDRAM and DDR makers accounting for 40% of the market by volume.

If

"If Rambus wins these court cases, a year from now they will win a royalty on every DRAM, which would result in an earnings number which means the stock is very cheap today," says one New York money manager who's long the stock. "But who knows?"

Riding Rambus Down Like an Internet stock, Rambus' valuation was based more on hope than reality

The bear scenario on this point for Rambus seems equally compelling. If Rambus loses, the money manager says, those DRAM companies will be unlikely to pay, and Rambus loses a potential revenue stream. In addition, the consortium may push DDR rather than RDRAM, which could hurt Rambus' already uncertain source of revenue. And growing revenue in the current market environment, with DRAM prices dropping daily, matters if Rambus wants to keep its comparatively high valuation.

Rambus currently derives revenue from contracts and royalties on its DRAM and logic devices. The company says it collects royalties of 1% to 2% on RDRAM and of 2% to 5% on memory controller chips. But so far, RDRAM has been a small business. RDRAM made up about 1.4% of the total DRAM market in 2000 in terms of volume, with SDRAM at about 90% of the market, according to Gartner Dataquest.

What It Needs

In order to grow its revenue, Rambus needs to build its share of the DRAM market. The total DRAM market was worth $32 billion in 2000 -- an increase of about 40% over the previous year -- but is expected to fall about 35% this year because of high inventory and weak demand, Gartner Dataquest analyst Richard Gordon says. That means if Rambus earns average royalties of 1.5% of the price of the RDRAM produced, and RDRAM accounts for, say, 7% of the total DRAM market, then royalty revenue in 2001 would be roughly $25 million in calendar 2001.

But there's a fair amount of speculation in that projection. Right now RDRAM is about four times the price of SDRAM, which is around $4. But increased supply in 2001 related to Intel ramping up Pentium 4 production may bring RDRAM prices closer to SDRAMs, Gordon says. In addition, how much of the market RDRAM will get this year is unclear. For 2001, Gartner estimates RDRAM will make up from 5% to 11% of the market by volume, up from 1.4% this year.

To buy Rambus now, investors need to believe that the courts, Intel, the industry and the economy will all come together and work to Rambus' favor. Of course, that's a lot to ask for.