I used to be considered an "early adopter." When the latest tech gadget was introduced, I was right there at the front of the line to get one of my very own. I'm afraid age has mellowed me, though. I bought my first DVD player last year, and I haven't even gotten around to considering an iPod.

When it comes to investments, though, I'm still interested in technology and am constantly on the lookout for companies with excellent potential, especially if they can be purchased at a reasonable price. When PortalPlayer (NASDAQ:PLAY) showed up on my screens a few weeks ago, I decided to take a closer look.

Company background
PortalPlayer is a fabless semiconductor company. No, I didn't mean "fabulous," although I am hoping to feel that way about the company after I've owned the stock for a while. Fabless semiconductor manufacturers are those without fabrication capability. They've decided to concentrate their efforts in design and innovation and contract out the manufacturing function to others. Investment requirements are obviously lower, and the companies can still expect to bring products to market in a timely fashion.

PortalPlayer is a very young company, founded in 1999 with a staff of six. The growth since then has been spectacular indeed. PortalPlayer began to generate revenue in 2001, pulling in $1.9 million. In 2005, the company posted revenues of $225.2 million. How is that type of growth possible?

The company's progress has been spurred by the success of its primary customers (i.e., more than 90% of sales), Taiwan-based Inventec and Hon Hai, which produce most of Apple Computer's (NASDAQ:AAPL) hard-drive iPods. PortalPlayer's product line consists of system-on-a-chip (SoC) technology that is used in personal media players like the iPod. These players have large storage capability using hard disk drives or flash memory and, until recently, have been used mainly as audio players. Recent product introductions have moved into the video area, both with photos and other mainstream video products like television programs and movies. Customers can't seem to get enough of this type of technology, as evidenced by the great success of the video cell phone market -- a product that, I must confess, didn't exactly cause me to rush to the cell phone store. The only limit to growth now, it appears, is the number of arms available to hold cell phones, iPods, and other personal media devices.

One-trick pony
PortalPlayer clearly has great momentum in this market and should participate fully in its growth. Of course, there are risks here as well. With Apple products representing more than 90% of sales for this company, there is a definite need for diversification in the customer list. The company realizes this fact and has recently announced a whole new product line that works on notebook computers. This technology works with the new Microsoft (NASDAQ:MSFT) operating system, Vista, in an application called Windows Sideshow, which will enable users to have immediate access to emails, organizer functions, and media content through a small screen in the lid of a notebook computer. Although this application is always on, power usage is minimal and can be used for "tens of hours of playback even after the battery runs too low for the notebook to operate." This seems to me to represent an interesting new opportunity for PortalPlayer.

In another, more recent announcement, Portal Player and Icera previewed a new class of portable multimedia device that uses broadband cellular networks to deliver content wirelessly to the customer. There has been some speculation about the possible introduction date of what would be a new wireless iPod.

Valuation
I would expect that all of this potential, combined with the excellent, though short, record of this company, would command more than a price-to-earnings (P/E) multiple of 15.7 (after adjusting for one-time gains). But investors are obviously concerned about the singular nature of the company's customer list. The semiconductor industry as a whole sells at an average P/E multiple of 25.9, almost 65% higher than PortalPlayer's adjusted multiple. The company also looks inexpensive based on other valuation metrics -- price to sales, price to book, and price to cash flow. This low equity valuation is even more noteworthy when you consider that PortalPlayer is debt-free.

Although PortalPlayer sells at a large discount to the industry, it actually does better than the industry in terms of operating and net profit margins, and its 28.7% return on equity is also well above the industry's 4.7% figure. When a company sports a lower-than-average valuation and higher-than-average operating metrics, its stock is worth a further look.

The stock offering that wasn't
What about the capital structure? With a current ratio of about 5 and no debt, I think the company is in pretty good shape. So why did it attempt a stock offering last October? That question has not been answered. Perhaps the company was contemplating an acquisition. In any event, management saw the error of its ways and cancelled the offering less than a month later. No doubt this episode continues to bother some investors who may be worried about future stock offerings and the resulting share dilution.

It seems clear (at least to me) that if PortalPlayer had a diversified customer list and a longer track record, its stock would command a considerably higher price. But looking out a few years, we could be seeing a company that has satisfied those requirements, at least in part. At that time, earnings could be considerably higher than current levels, and multiple expansions will occur from these levels. I think the company will be tied to the fortunes of Apple for some time to come, but I could think of worse fates. Given what I perceive to be the current risk/reward ratio, I'm optimistic about the prospects for PortalPlayer.

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Fool contributor Richard Moore continues to wait for the ultimate technology gadget before spending any of his hard-earned money. He owns shares in PortalPlayer but none of the other companies mentioned. He welcomes your feedback at richard@theastuteinvestor.com. The Motley Fool has an ironclad disclosure policy.