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Playing the Small Side of Consumer Electronics

It's not only the big-cap tech names that are getting a good ride from tech gadgets.

U.S. companies may be sitting on their wallets, but gadget-hungry consumers are picking up some of the slack.

Last week's news that

Dell

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will push into the consumer electronics market, following similar moves by

Gateway

(GTW)

and

Hewlett-Packard

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, underscores the lucrative profits in gadgets such as fancy TVs and digital cameras. Already a passel of big-name chipmakers -- from

Intel

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to

Texas Instruments

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to

Philips Electronics

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-- have nudged up their third-quarter earnings forecasts amid strong consumer buying.

But plenty of smaller outfits also stand to gain. Fund managers looking for lesser-known names have uncovered the likes of

Zoran

(ZRAN)

,

OmniVision

(OVTI)

and

Silicon Laboratories

(SLAB) - Get Silicon Laboratories Inc. Report

, all consumer electronics-oriented chipmakers that have seen their sales and earnings rocket in line with surging buying.

The caveat: Some of the names currently look pricey, though small-caps have retreated from their near-term highs amid heavy selling over the past week or two. Investors also should bear in mind that consumer confidence numbers lately have been soft, with the September reading coming up short of expectations and falling below last month's number. "It's an area that needs watching," cautions Benjamin Easow, a buy-side analyst for Northern Trust.

On the other hand, there's reason to think that consumers have been buying despite the flagging confidence levels. Indeed, the Semiconductor Industry Association said Monday that robust consumer demand was the biggest factor propelling August sales up a robust 12.5% from last year's levels.

"Surprisingly enough, things are looking really good given some of the economic data we've had recently, which wasn't that great," says Vincent Colicchio, manager of the $19 million

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All-American Equity fund. "Right now's a great time to pick up semis that are getting hit," he maintains. "They're still overvalued but it doesn't matter. That's where the growth is. Data is going to continue to look good with notebooks and cell phones. And given the seasonality, sentiment is on the side of the stocks."

Operating by the buy-the-rumor-sell-the-news principle, he says it probably makes sense to lighten positions before the last of the good news is out, which would probably be before Christmas.

Small-Screen Small-Cap

All that said, one of the more closely watched consumer plays is 22-year-old Zoran. Best known as a chip supplier for DVDs and digital cameras, the company's product portfolio just expanded with the August acquisition of

Oak Technology

, which makes silicon for the high-definition television and digital-imaging markets.

Even before the purchase, Zoran was on a fast-growth track: June quarter revenues jumped nearly a third, albeit to a still-diminutive base of $44.7 million. The acquisition, by propelling Zoran into new markets, should open up new growth paths -- though on the downside the purchase will take a bite out of earnings over the next couple quarters. Fund managers generally salute the move despite the short-term pain, pointing out that Oak should start kicking in profits by the second quarter of 2004.

Reed Bender, manager of the $12 million

(BEGCX)

Bender Growth fund, has had a stake in Zoran for about two years now. "We look at the stock now as a very good play on digitization and the consumer move toward that direction," he says.

After a healthy year-to-date gain, the shares have suffered a fall-off from their near-term high of $26.17 on Sept. 8, though based on Tuesday's close were still up 39% year to date. (The shares took a hit on the news that the acquisition would dilute earnings and were hurt further by general pressure on tech names over the past week or so.)

At this point, Bender says he doesn't consider the stock expensive. Based on Tuesday's close of $19.57, the stock trades at less than 19 times his 2004 earnings estimate of $1.05.

Another Zoran shareholder is John Clancy, manager of the $411 million

(FTGVX)

Fifth Third Small Cap Growth fund. "Looking at the stock at $19 and change, there's maybe 10% downside but 30% upside over the next six months. I think it could easily get to $24-ish" -- around the point at which, depending on earnings momentum, he might consider taking some profits. The stock currently accounts for less than 1% of his diversified portfolio of some 170 stocks.

For the medium term, Clancy believes Zoran should have a good ride on the strength of fervent consumer buying. "I think it will have a good quarter and good first half of next year. The price points on products are favorable; DVDs are going through the same process that VCRs did, with prices coming down so people can afford them, and a much wider selection of products."

To be sure, DVD prices are dropping in part because the cost of components -- including chips -- are dropping. Over the next year, chips for DVD players could drop to as little as $5 from their current levels of $8 to $9, predicted a recent note from C.E. Unterberg Towbin. But Zoran's expansion into new, fast-growing electronics markets should help compensate, say institutional shareholders.

Steep Rise

Fund manager Clancy also has a holding in OmniVision, which makes silicon used in digital still and video cameras, cell phones, personal digital assistants and PCs. "The stock has had a really nice progression -- it's not like a parabolic rise; it looks pretty orderly," says Clancy.

In its July quarter, revenue nearly tripled from last year's levels to $46.5 million from $16.8 million, while profit rose to $6.2 million from $1.6 million.

Market watchers think it can sustain that steep upwards trajectory: On Tuesday, J.P. Morgan launched coverage on OmniVision with an overweight rating, predicting earnings growth of 66% and revenue growth of 89% in fiscal year 2004, which is now under way.

Over the past few days, OmniVision has traded down on a report in

The Wall Street Journal

that customer

Motorola

(MOT)

could

miss the deadline to ship its camera phones for the holiday season. But Clancy, who has about 1.5% of his portfolio in the shares, says he "doesn't see it as an issue" for OmniVision. "The company came out and said they don't see any slowdown, and it's not their only business. Any selloff on the MOT news is a nice buying opportunity," he says.

The downside for investors is that the shares already have seen tremendous appreciation, roughly tripling year to date as of Tuesday's $42.21 close. And it would be stretching it to call OVTI cheap, with the shares trading at 45 times the current fiscal-year 2004 consensus estimate of 94 cents and 32 times next year's estimate of $1.32.

For his part, Clancy maintains that the stock looks reasonable relative to the rest of the semiconductor industry, valued on a price-to-sale basis, which gives it a multiple of 1.2 times sales.

Wireless Wonders

Two final consumer electronics plays are

Analog Devices

(ADI) - Get Analog Devices, Inc. Report

and Silicon Laboratories, both holdings of fund manager Colicchio.

ADI has benefited from strong sales in notebooks, where it's gaining share in the power supply market; it also claims two new well-regarded families of digital signal processors that by some accounts have outperformed DSPs from Texas Instruments, says Colicchio. Another plus for ADI is that it's one of the most diverse analog companies around, which helps insulate the company from risk.

Colicchio believe the stock could hit $50 -- up from $38.02 at Tuesday's close -- assuming a 32 multiple on the next 12 months' earnings. To be sure, the stock isn't cheap, and he's recently taken some of his holdings off the table. ADI accounts for only 0.52% of his portfolio, Colicchio says, adding that he'd increase his stake on price weakness.

Another of Colicchio's picks is Silicon Laboratories, a chipmaker that draws about half its sales from the wireless market and about 22% of sales from

Samsung

. The No. 3 handset player worldwide, Samsung has been steadily closing the share gap with second-ranked Motorola.

"Silicon Labs' biggest customer is Samsung, which has been gaining share, and they're piggybacking on that," says Colicchio. "I expect them to continue to ramp with Samsung, which is clearly a key element. I wouldn't want to be in Silicon Labs if I didn't believe in Samsung."

For the moment, the stock looks dear. Based on Tuesday's close of $44.92, SLAB changes hands at an expensive 48 times the current fiscal year's consensus estimate of 94 cents and 40 times next year's estimate of $1.10.

Colicchio, who's taken profits on the stock, says it now accounts for less than 1% of his holdings, but he'd snap up shares on weakness.

Clearly, investors need to tread carefully around valuations when weighing the case for chip plays that are tied to the hot DVD and digital camera markets. Yet the upbeat prospects for consumer gadgets bode well for their fundamentals in the second half of 2003 and beyond.