Consumer electronics have overtaken PCs as the main driver of semiconductor sales. As a result, stocks such as Broadcom ( BRCM) and Marvell ( MRVL) have had great runs.

If you're looking for a good value play on consumer electronics chip growth, check out Zoran ( ZRAN).

While Broadcom and Marvell are trading at 28 times and 27 times their 2007 consensus estimates, respectively, Zoran trades at 18 times 2007 consensus estimates, in part due to its lingering image as a chip provider for the slower-growth DVD market. However, the company has been diversifying into new markets, and in the last quarter the DVD segment represented only 34% of sales, compared with 82% in 2003.

Zoran is a provider of chips for DVD players, digital cameras, mobile phones, digital TVs and printers. Its chips appeared in more than 100 new products in this year's Consumer Electronics Show, and are primarily used to compress and decompress video, audio and images from an analog into a digital format to allow for more efficient storage and delivery.

For example, in the 1990s a two-hour movie recorded using a low-resolution rate required two CDs. Now, movies can be stored in high resolution on a single DVD.

Several international compression standards exist, such as JPEG, MPEG, and DivX. Zoran differentiates itself from competitors by offering additional features to the original standards that improve image and sound quality and allow its chipsets to be programmed easily. Its COACH (camera on a chip) processor includes most of the electronics of a digital camera on a single chip.

One of the most exciting products using Zoran chips is the iSee 360i video recorder, which won Best of Show at Apple's Macworld this year. As of January, it was the only portable media player that allowed users to record video content on to Apple iPods and view the content on a separate, larger LCD screen, according to the company.

Zoran's competitors include ESS Technology ( ESST), Cirrus Logic ( CRUS) and STMicroelectronics ( STM).

Expanding Into New Markets

Zoran is a leader in the DVD chip market, with approximately 30% market share, according to the company. DVD player sales growth has been slowing simply because many people already have one, but DVD recorders remain a strong area of potential growth to replace machines that can only play DVDs, and Zoran's supplying chips for those recorders.

To expand its total addressable market, the company has been expanding into new consumer electronics areas, so the revenue base is now more diversified and less reliant on the DVD market. In 2003, the revenue mix was 82% DVD and 18% in the mobile segment (digital cameras and mobile phones). In 2004, the mix improved to DVD at 61% of revenue; mobile, 10%; digital TV, 7%; and imaging (printers), 22%. In 2005, the mix improved considerably, with DVD representing 38% of revenue; mobile, 28%; digital TV, 13%; and imaging, 21%. The acquisition of Oak Technologies in August 2003 helped Zoran expand into digital television and imaging.

Zoran's digital-camera revenue grew 217% year over year in the latest quarter, which ended Dec. 31, 2005. Its customers include top-tier companies Kodak and Olympus. Zoran announced new design wins with two more, unnamed, tier-one manufacturers on the last earnings call, held Jan. 30 to discuss fourth-quarter results.

Additionally, camera manufacturers are moving from "captive" products, that is, those using their own chips, to "merchant," or outsourced, chips to save on cost. That's an opportunity for Zoran. Over the last year, merchant products have increased to 60% from 40% of the total used by digital camera manufacturers, according to the company. By the end of 2006, Zoran expects merchant products to increase to 70% of the total.

Zoran's revenue from sales of its digital TV chips grew 75% year over year, and there's more where that came from. The market has several catalysts in the U.S. government's mandate concerning conversion of television broadcasts from analog to digital. This month, per FCC rules, all midpriced TVs with screens 25 inches and larger manufactured in or imported to the U.S. must include a digital tuner that uses the ATSC (Advanced Television Systems Committee) standard. By March 2007, all TVs, VCRs and DVD recorders with a TV tuner also must have one. By February 2009, TV stations must broadcast digitally.

Zoran also expects the multimedia mobile-phone market to be a future growth driver for the company. The acquisition of Emblaze in July 2004 helped Zoran expand into this market. While currently small, Zoran expects it to be a major revenue contributor in 2007.

Strong Financials

In the latest quarter, Zoran reported strong numbers. Revenue of $109 million represented 46% year-over-year growth and beat the Street estimate of $104 million. Pro-forma EPS was 23 cents, beating the Street estimate of 15 cents. Gross margin improved to 46%, compared with 44% in the September quarter.

An overhang on the stock was recently removed with the resolution of patent litigation with MediaTek in January and United Microelectronics in February. Zoran will receive from MediaTek an initial cash payment for licensing fees and continuous monthly payments for royalties.

The company has no debt and more than $3 in cash per share. Consistency has been a concern of the company's critics, but management has beaten EPS estimates in the last three quarters. Zoran stumbled hard in October 2004, when global DVD licensing authorities began enforcing penalties on unlicensed manufacturers. About 40 companies went out of business in China quickly as a result, and hence their products were dumped on the market, causing an inventory glut. That's no longer an issue for Zoran.

The Path Ahead: Upward

Zoran shares currently trade around $20, but I believe they could reach $25, which would represent 23 times the 2007 consensus EPS estimate of $1.10. Zoran's expected five-year growth rate is 20% -- strong, but below the expected growth rates for Broadcom of 25% and Marvell of 30%. Therefore, I believe Zoran should trade at a multiple lower than that of those companies', which are 28 and 27, respectively.

One risk to note is that several brokers released notes toward the end of February saying their channel checks indicated weakness in DVD player sales in both Asia and the U.S. However, this may already be priced into the stock.

On that point, Wedbush Morgan issued a note on Feb. 24 that said even though channel checks indicated softer DVD demand in Asia, the selloff was overdone. Shares were trading at $19.09 at the time. Another risk is that actual sales-price declines in the slower-growing DVD player market can be difficult to predict, although the company says the declines are hitting a plateau.


Please note that due to factors including low market capitalization and/or insufficient public float, we consider ESS Technology to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Joseph Wana is founder and president of Naga Capital Management. At the time of publication, Wana had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Wana appreciates your feedback; click here to send him an email.