Description

First, I apologize for recommending a company that has previously been recommended at VIC, but it’s been almost 21 months since someone else recommended it. The stock price hasn’t changed much in 21 months. But I feel that NeoMagic is closer than ever to a big increase in the stock price. NeoMagic definitely deserves a second look.

NeoMagic is the rare company trading at close to its cash value. For the quarter ending April 30, 2002, total cash (includes cash, cash equivalents, short-term investments, and restricted cash) was $81.2 million. With 28.1 million shares outstanding that comes to $2.89 cash per share. Book value is $3.41 per share. The stock closed on Friday May 24 at $3.13 (giving us a market capitalization of $90 million).

Cash has been conservatively managed. January 2002, total cash was $86.9 million. Book value was $3.51 per share. The burn rate is very slow.

So you may be asking, who cares if the stock is trading close to its breakup value? Obviously the market doesn’t expect very much from NeoMagic, otherwise the stock price would be significantly higher.

Let’s review the history of NeoMagic. NeoMagic started out with the idea of creating more energy efficient graphics chips. By embedding both DRAM and graphics processing on a single chip, size and energy use are both minimized. This isn’t so important for desktop computers, but in order to produce small notebook computers, manufacturers must use small energy efficient chips. NeoMagic had some success serving the notebook computer market. Sony used NeoMagic chips in its subnotebook computers. But NeoMagic lost ground in the notebook market. Small chip size and low power use weren’t the most important things after all. Other manufacturers beat NeoMagic to market with more powerful graphics chips. They weren’t quite as energy efficient as NeoMagic’s offerings, but processing power was more important.

In 2000, NeoMagic announced a strategic withdrawal from the notebook computer market and announced that it planned to use its technology and know how to design chips for devices smaller than notebook computers: PDAs, cell phones, and personal entertainment devices. The stock price plummeted and NeoMagic has been trading at close to its cash value ever since.

Has anything changed in two years? Yes it has. Two years ago, the new products were only a pipe dream. But it looks like NeoMagic has finally delivered on its promises. NeoMagic now has a lineup of low power application processor chips. NeoMagic has announced 14 design wins from 10 different manufacturers. The design wins are in all three market segments that NeoMagic has targeted.

Why hasn’t the stock taken off? Hardly anyone follows it any more. No analysts follow it. Trading volume is quite small. NeoMagic’s press releases say little about what the company is doing. Most of the information is in the conference calls, which few people listen to. The CEO is a low key person who never hypes the stock. Investors are taking a “show me the money” attitude.

Furthermore, NeoMagic’s products are not exciting. People are excited about Intel’s new XScale microprocessor, which runs at 400 to 600 mhz, and will power the next generation of PDAs running the Microsoft Windows CE operating system. NeoMagic’s fastest chip (based on the same ARM core as Intel’s), the MiMagic NMS7210, only runs at 100 mhz. Not very exciting.

Boring can still be very profitable for a small company like NeoMagic. Intel’s high end chips will sell in devices that cost $600. Few consumers are willing to pay $600 for a cell phone or a videogame. NeoMagic is targeting lower priced units for which there is a much bigger market. It’s not just the speed of the CPU that counts, but the entire package. The goal is to design devices that are small and use little battery power, but deliver the features that customers want. The market for these devices is predicted to be 200 million units a year within two or three years. NeoMagic has a good chance of capturing a big chunk of this market. It is crucial that chips powering these devices use little power, and this is where NeoMagic excels. If NeoMagic sells 50 million chips a year at $10 a chip, then that’s $500 million of sales a year. Growing semiconductor companies trade at a price/sales ratio of 2 (yes I know it seems high to us value investors, but that’s what they trade at), so it’s certainly within the realm of reason that NeoMagic is a ten bagger at its current stock price.

I can’t guarantee you that NeoMagic will be a ten bagger. Probably, it’s more likely that NeoMagic will fade into obscurity, eventually selling out to a bigger company for around the current stock price. But given its cash on hand and history of conservative spending, I think the downside risk is quite low for what’s essentially a startup venture. The upside potential is huge.

Neomagic will be announcing actual products using its chips any day. During the last conference call, Prakash Agarwal, the CEO (and 7.4% owner) explained that they are eager to announce the companies and products that will be using NeoMagic chips, but they have to wait for their customers to announce the products first. The implication is that any day good news will be released.

Also of interest for investors is a patent infringement lawsuit that NeoMagic is pursuing against Trident Systems. The trial court ruled in favor of Trident, but the appellate court has remanded for further proceedings. There is the possibility of a windfall from this lawsuit, but it’s not the reason I recommend this stock.

My greatest hope for NeoMagic is that Sony will announce a product to compete with the handheld Nintendo Gameboy, and that it will use one of the new NeoMagic chips. We know that Sony has a past relationship with NeoMagic. I know this is a longshot prediction, but it doesn’t hurt to hope, so long as there is little downside risk. And it makes a lot of sense for Sony. Such a device would require only a minimal amount of R&D for Sony. Using an off the shelf chip (NeoMagic) and operating system (Windows CE), Sony has an instant competitor to Gameboy. Windows CE is very easy to program because Microsoft already has excellent programming tools available for free. Game developers would be eager to produce products for such a new handheld gaming system. And it would give Sony another venue in which to push its proprietary Memory Stick technology. Sony is one of the few companies that have the marketing power to compete against Nintendo.

Catalyst

Products using NeoMagic chips will be announced soon. Every quarter for the foreseeable future will have higher sales than the previous quarter.