OmniVision Technologies (NASDAQ:OVTI) makes digital imaging sensors for digital cameras. Their chips were installed in the lion's share of mid-range digital cameras during the first wave of the digital camera boom. From 2000 through 2003, OmniVision continually exceeded earnings estimates, posted solid profit margins, and exhibited strong growth.

OmniVision was a Wall Street favorite -- rising nearly 2600% between October 2001 and December 2003 to a $2 billion valuation. Then came 2004. In eight months, the company lost 70% of its value and now posts a market cap of $717 million. Despite the decline, OmniVision has maintained strong earnings and has a P/E ratio near 11 -- about half the 19.8 industry average. They have also remained debt-free and have improved their cash position with strong free cash flow. Throwing everything together, and tossing in analyst-expected growth, OmniVision's enterprise value to free cash flow to growth (EV/FCF/G) ratio sits at a very attractive 0.65. This means Omni could see a lot more growth than the market is giving it credit for.

It looks like a promising company. But we need more than the numbers. Let's see where OmniVison came from, what went wrong, and what they are doing to fix it.

Temporary blindness
OmniVision failed to keep up with rapidly changing technology. The company hasn't released a new product in over a year, and its existing sensors don't provide the resolution mainstream digital cameras now offer. On June 9, OmniVision delayed the release of its fiscal 2004 financial statement and said it would restate past earnings. Nothing riles investors more than restated earnings (thanks to Enron, WorldCom (NASDAQ:MCIP), and others). The stock took a nosedive. Within two weeks, at least 14 firms had filed class action lawsuits against the company on behalf of burned investors. To make matters worse, OmniVision lowered earnings estimates for their next quarter.

That about does it for the bad news. Here is the rest of the story.

When OmniVision restated its fiscal 2004 earnings, it actually restated earnings higher than previously reported. We don't know the details, but in a best-case scenario, OmniVision might have simply been too conservative in recognizing revenue. In the worst case, something more fishy might have been going on, but I won't get into such speculation. Regardless, OmniVision is now under the microscope, and we can hope, if not presume, that they will make determined efforts to report earnings appropriately.

At first glance, the competitive landscape seems crowded. Large players such as Matsushita (NYSE:MC), Sony (NYSE:SNE), Motorola (NYSE:MOT) and NationalSemiconductor (NYSE:NSM) have significant businesses in chips and imaging systems. But these companies have left room in emerging markets for smaller players such as OmniVision and ESSTechnologies (NASDAQ:ESST). Certainly the big guys are no longer oblivious to the potential of these markets. But when they see small companies raking in cash, they may be more apt to acquire than to compete.

This benefits Omnivision for two reasons. First, OmniVision could be an attractive acquisition target. Regardless of whether they are actually acquired, this outside interest should boost demand for the stock. Second, although they are slightly behind the market, they have relatively little direct competition from these emerging markets. This gives them some time to get back on track.

The difference is in the megapixels
And OmniVision is working quickly to do just that. Last month, they announced a new product line. Their OmniPixel chip will replace their CameraChip as their key offering to the digital camera market. The OmniPixel chip will eventually allow resolutions up to five megapixels (the CameraChip maxed out at three). As OmniVision transitions their manufacturing capabilities to this next generation, they expect production capacity to decrease -- thus the lowered earnings estimates. OmniVision expects earnings to rebound in the third quarter of fiscal 2005 as their new lines start to gain recognition in the market.

In the mean time, OmniVision is doing a reasonable job with what they have. It has found strong demand for its lower-resolution chips inside camera phones. In the last quarter, sales to camera phone manufacturers accounted for a whopping 80% of the company's revenues. This is good for many reasons. Among them, consistent demand has allowed OmniVision to keep inventories from building up. Second, they have been able to increase market share in the growing camera phone market.

Investing in OmniVision is investing in its next-generation chip. Will they be able to retain and improve on their market share? It seems like a safe bet -- and here's why. First, they've done it before. They know the industry and have an existing customer base. Second, their chips cost less and require less battery power than some of their customers' more expensive, higher-resolution chips. Third, OmniVision has found new markets -- like camera phones -- to help keep cash coming in during their transition. And finally (and very importantly), OmniVision has almost $250 million in cash on hand -- that's $4.40 per share -- and no debt. With pockets that deep, OmniVision is well positioned to handle the inevitable bumps in the road.

Now that's a pretty picture.

OmniVision could be a great value for a high-flyer. If you're looking to add some growth to your portfolio, Fool co-founder David Gardner is soon launching the ultimate growth stock newsletter. Be the first to get the details.

Related Fool commentary:

Fool contributor Jim Schoettler lives with his border collie in a San Francisco closet. If you don't email him, he cries himself to sleep at night. Jim owns shares of OmniVision Technologies.