The value investor's goal is to find undervalued stocks. This doesn't mean that we ignore growth. On the contrary, we love companies that will show exceptional growth for decades. We just want to buy them at a fraction of what they're actually worth. So when we find a company with projected earnings growth of 25% trading at a price-to-earnings ratio of 10 and holding cash almost equal to half its market capitalization, it's enough to make us sit up and take notice.
The business
The company is OmniVisionTechnologies. OmniVision creates the image-sensor chips in digital cameras that take the pictures, converting light into electrical signals. OmniVision is a fabless semiconductor company. As such, it designs, develops, tests, and markets its chips, but it outsources its manufacturing to Taiwan Semiconductor (NYSE:TSM). Consequently, it has lower capital requirements than many of its competitors do.
These image-sensor chips have a variety of uses, but OmniVision's biggest market is mobile phones, a market projected to grow 25% to 30% annually over the next few years. OmniVision is the leader in this market, shipping 89 million chips in the year ending in January 2005. As such, OmniVision's chips are in mobile phones from all the top mobile phone manufacturers. Samsung is a particularly noteworthy customer, considering that it sells its own line of image-sensor chips.
Valuation
One of the perks available to subscribers of our Motley Fool Inside Value newsletter is a discounted cash flow calculator, which can be used to estimate the value of most stocks. If you plug expected growth estimates into this calculator, OmniVision's valuation is compelling, verging on ridiculously cheap.
Analysts predict that the company will grow earnings at a rate of 25% annually over the next five years. But analysts tend to be optimistic, so let's assume that OmniVision grows by only 20% annually for five years, and a mere 3% a year thereafter. If we use a conservative discount rate of 15% and add OmniVision's substantial cash hoard, the shares have a fair value above $25, significantly more than the stock's current price in the mid-teens.
Even if you slash OmniVision's growth projections substantially to a mere 3% a year, the company is still worth $16 to $17 per share. So if OmniVision is simply able to grow its earnings at the rate of inflation, then the company's undervalued. But despite this apparently low valuation, 38% of the float is short. So why is this company trading so cheaply, and why do so many people hate it?
The issues
The media seems focused on a Securities and Exchange Commission investigation that turned up nothing. It's also focusing on inventory issues, tax-rate issues, and the revolving door on the CFO's office -- OmniVision had four CFOs over a two-year span. All of these topics make great headlines for those analysts who focus exclusively on the negative. But, really, I see all these issues as secondary. They're red flags -- issues that need to be examined by anyone considering an investment. But they're not the company's biggest problem.
The big problem is the market. It's a market with potentially brutal competition and few technological competitive advantages. OmniVision has patents, but patents tend to be a relatively untrustworthy barrier in this industry. Thus far, OmniVision has been successful by designing a simple single-chip image sensor with low power requirements and by developing sensors in a wide range of resolutions.
But these sorts of technological competitive advantages are fleeting. The company has to constantly expend resources to improve its product, and the minute that it falters, even briefly, the competition will be there to take advantage of the situation. And these aren't weak competitors. We're talking multibillion-dollar companies from diversified consumer products companies like Kodak (NYSE:EK) and Sony (NYSE:SNE) to semiconductor companies like MicronTechnology, STMicroelectronics (NYSE:STM), and NEC (NASDAQ:NIPNY) -- all businesses with significant resources.
I don't see it as a coincidence that many of these competitors also manufacture memory chips, a highly commoditized product in an ugly market. If you look at Micron, you'll see that historically, it has frequently accessed capital markets just to get enough money to survive the intense price competition and upgrade to the next generation of technology. This constant need for capital means that there's little left for shareholders, one reason why Micron has been an atrocious investment over the past decade. So if the image-sensor market is headed in this direction, it will be terrible for OmniVision.
Should the market develop that way, OmniVision will be faced with a tough choice. It can reduce its margins -- and its profits -- in an attempt to maintain market share, or maintain its margins at the cost of market share, a path that, over the long term, will relegate it to a niche position. There are some signs already that this may happen. OmniVision's margins are declining, as is the company's backlog of orders.
Bulls, on the other hand, point to OmniVision's acquisition of CDM Optronics -- with its patented Wavefront Coding technology -- as evidence that OmniVision is heading down the right path and differentiating its technology. Wavefront Coding algorithms increase the depth of field and decrease optical aberrations in an image. Plus, even in a commoditized market, there can be the opportunity to profit if you buy when the market is overly pessimistic. Investors in flash-memory producers SanDisk (NASDAQ:SNDK) and LexarMedia (NASDAQ:LEXR) have done quite well over the last few months.
The Foolish final word
Without a doubt, OmniVision is totally undervalued if it achieves growth close to analysts' estimates. But should image sensors become a commodity product, squeezing profits out of this market will be challenging. In such a scenario, it wouldn't be surprising to see OmniVision's earnings fall, even in a market that's experiencing rapid unit growth. Such a scenario has played out in the memory market for years. Thus, the attractiveness of the stock really depends on your tolerance for risk and the extent to which you believe image sensors will be commoditized.
So, while I love the price, I hate the business. At Inside Value, we're looking for companies with huge competitive advantages -- stocks that are almost certain to grow relentlessly for years. OmniVision's price is great, but growth is far less likely than for the typical Inside Value pick. If you're interested in seeing what we do consider dirt-cheap bargains now -- or if you just want to work out the value of a stock using our discount cash flow calculator -- we're offering a 30-day free trial.
This article was originally published on Oct. 14, 2005. It has been updated.
Richard Gibbons, a member of the Inside Value team, wishes his mobile phone had a camera so he could become an opportunistic member of the paparazzi. He does not own shares in any of the companies discussed in this article. The Motley Fool has a disclosure policy.
