ZORAN

Zoran Corporation (ticker “ZRAN”) is a fabless chip manufacturer which sells integrated circuits and embedded software to OEMs for use in smart phones, digital cameras, digital televisions, set-top boxes, DVD players and multi-function printers. 

The stock trades for about $8.20 per share (49.0mm shares out = $402mm). Zoran has no debt and pro forma for the closing of the Microtune deal in November 2010, should have about $250mm or $5.10 per share in cash.  This means that the TEV (total enterprise value) is only $3.10 per share or $153mm.  The reason for this low valuation is that Zoran has been bleeding cash, and the management announced on October 26^th that the fourth quarter was going to be a disaster, with Revenues of $60-65mm (vs. consensus $95mm). 

all;">So, why is this interesting? Is it cheap, or a value trap?

This is a classic situation which I look for, in which a company appears to make no money, or lose money, but the reason for poor performance is an underperforming division which is “hiding” the profitable pieces.  In the case of Zoran, the Printer business (16% of Revenue) and the Digital Camera business (50% of Revenue) are quite profitable, but DVDs (11% of Revenue) and Digital TV (DTV) (23% of Revenue) are bleeding money. (These numbers are before the November 2010 acquisition of $92mm Revenue Microtune for $80mm net cash).  In theory, the losses can go on for some time. 

Catalysts

But there are catalysts.  I originally wrote this report in late November for my application to VIC when the stock was at $7.  At the time, the fourth quarter was such a disaster, that it was clear that management has been given marching orders to restructure the company such that they became at least breakeven.  The plan was to be announced by yearend.  Since then, activist investor Ramius (an affiliate of publicly traded Cowen Group) filed a 13D (original filed November 1, 2010, 13D/A filed November 18, 2010) indicating 3.525mm shares owned (7.0%) with an average purchase price of $6.54.  Ramius is now up to a 9.3% position, and is soliciting written consents to remove and replace the entire board.  They need a majority of consents within a 60 day period which at this point begins December 6, 2010 (the date of the first consent), but which date will almost certainly be extended to a later 60 day period in order to allow more recently acquired shares to issue consents.

In my opinion, this was a great idea with the stock at $7.00 prior to this development, but it is even better idea with Ramius soliciting consents, even though at $8.20 the stock is 17% higher. 

Ramius has not laid out exactly what they plan to do, but clearly it involves eliminating losses in DTV and DVD, and possibly maximizing the value of those pieces through a sale.  (It is unlikely the Company would receive significant proceeds from a sale of these divisions but it would stop the bleeding.)  It is possible that recently acquired Microtune will also be monetized or restructured in a way to improve profitability.

Summary of The Business

I am not a tech expert, so much of this is gleaned from Company filings.

Zoran is a fabless chip manufacturer of ASIC (application specific integrated circuits) and SOC (system on a chip) semiconductors sold to OEMs for use in digital televisions, set top boxes, DVD and Blu-Ray players, digital cameras, and multifunction printer products.  The Company uses digital signal processing (DSP) and compression technologies to develop solutions to improve image and sound quality to end users.  Zoran had 1,243 employees as of year end 2009 (550 R&D, 543 marketing, 116 admin, 34 manufacturing/quality control).  368 are in Israel (mostly R&D in Haifa), 195 are in Sunnyvale, CA, 130 are in Burlington, MA, 307 are in China, and the 243 are spread out in Europe and Asia. 

Note the small number involved in manufacturing – as a fabless chip company, manufacturing is contracted out to Taiwan Semiconductor (TSMC), Tower Semiconductor, and also LSI for certain laser printers. If the decision is made to eliminate product lines, it is much less costly than for a manufacturer that needs to shut manufacturing capacity.

Zoran has four product families (DTV, Mobile, DVD, Imaging) but only breaks out operating income for Imaging, the other three segments are grouped in “Consumer”. 

DTV = ASICs and SOC for digital televisions, set top boxes

Mobile = digital camera processors for digital cameras and camera apps in mobile phones

            Zoran has stated it has about #1 market share (33%) digital camera (#2 = 7%)

DVD = SOC solutions for red laser and Blu-Ray DVD players

Imaging = chips and software for consumer and enterprise printers, high market share

                 Much of imaging revenue is very high margin royalty and licensing fees.

                        3 mths Sep 2010                     9 mths Sep 2010

                        REV     OpInc                          REV                 OpInc

Camera:             50                                           

DTV                  23                                         

DVD                  11                                                                                         

Consumer           84      - 9.6                             239                  -26.8

Imaging            16         4.0                             45                     11.9

  Total              99.3     -5.6                              283.1               -15.2

Total                99.3                                        283.1                                                    

Gross Margin   52.4%                                      51.9%

R&D                30.2%                                      30.1%

SG&A             27.8%                                      27.1%

Op Inc             -5.7%                                      - 5.3%

Op Inc             -5.7MM                                   -15.2MM

Once again, because Zoran is fabless, depreciation and capex are both low (each about $5mm for 9 months ended September 2010).

Note that if Zoran begins to make money, they have as of year end 2009 NOLs of $162mm for federal, $39mm for state tax, and $143mm for foreign jurisdictions. 

Competition

Camera:           In house Japanese OEMs, Ambarella, Fujitsu, Novatech, Sunplus, TI

DTV:                Broadcom, M-Star, Mediatek, ST Micro, Trident

DVD:               MediaTek, Sunplus

Imaging:            Adobe, Conexant, Global Graphics, Marvell, in house captives

What is the source of recent problems and the anticipated fourth quarter shortfall?

Zoran announced Q3 earnings on 10/25/10.  Although Q3 Revenues were pretty much in line at $99.3mm, management estimated that Q4 2010 will be $60-65MM, with 52-53% gross margins.  Zoran is stating that Digital Camera and Imaging is OK, and the the primary source of the Q4 shortfall is DTV, with some inventory buildup in DVD as well.

Zoran is citing price declines in DVD due to excess inventory in red laser systems, share loss at OEMs (as Toshiba goes for a 2^nd source in DTV), and market share gain of first tier players like Sony in DTV at the expense of Zoran’s customer Funai.

Microtune

Zoran closed in November 2010 the acquisition of Microtune, a manufacturer of chips used in tuners, amplifiers, demodulators and receivers, for use the cable, DTV, digital TV and automobile entertainment market.  Microtune has about $92mm/year in Revenue and is approximately breakeven on an operating basis. The deal cost, net of Microtune’s cash, was about $80mm.  Zoran dropped from $8.22 to $7.39 (down 11.2%) on September 8, 2010, the day the deal was announced. The reason for the fall was probably mostly due to the reduction in the “cash floor” for a company which is losing money, and not necessarily because investors hate the deal.  Acquisitions are always a risk for any situation like Zoran, which is based on the thesis that there is limited downside due to the cash floor.  Note that Ramius was on the board of Microtune prior to the acquisition by Zoran, and they have stated their view that they believe Microtune’s core cable set-top business has $18mm in operating income, but that this income has been swamped by its own R&D spending on DTV.

Bottom line – what is Zoran worth, and what is the risk/reward?

Zoran has (post the Microtune deal) about $5.10 per share in cash.

The Imaging business has about $60mm in Revenues and 25% Operating margins ($15mm OpInc). At 6-7x Operating income, this could be worth $90-100mm (49mm shares so about $2/sh).

Zoran doesn’t break out the Digital Camera business, but does say it is profitable. Several recent sell-side report estimate Camera Revenue of $170mm and 18-20% EBITD margins. Assume 26mm OpInc x7 = $180mm value = $3.60/sh.

Microtune cost them $80mm or $1.60 per share. Presumably it is worth close to that, so we can conservatively value Microtune at $1.25 per share.

Total = Cash        5.10

             Imaging  2.00

             Camera   3.60

              Tune       1.25

DTV (100 Rev)   0.00

DVD ( 40  Rev)   0.00

 Total                  11.95 (up 46% from $8.20)

NOTE THAT I AM ASSUMING ZERO VALUE FOR DTV AND DVD, DESPITE SIGNIFICANT R&D SPENDING OVER THE PAST FEW YEARS, AND POTENTIALLY VALUABLE INTELLECTUAL PROPERTY ASSETS.  On the other hand, I am also assuming full value for the cash.

Downside – traded at $6.18 after Q3 EPS, $5.10 per share in cash – we will assume downside of $6 (or down 27% from $8.20).

On this basis, the stock could be up 46% or down 27%. While this may not seem extremely compelling, I would argue that one way or the other, this company must be restructured.  They are either going to do it themselves or it will be done for them.

It is notable to look at some quotes from the October 26^th conference call:

“So we are going to react to this.  Things are not going to be as usual.  We are looking at what businesses we should invest in, where to downsize…We see all kinds of new vectors both in the imaging, the printers and the cameras, and even in TV, but we have to do it in a very selective manner, and of course set-top boxes.”

“…you can expect that we’ve made a fairly substantial investment in TV.  And probably if you look, if you count head count as the indicator, that group has the largest head count.  And then the other two businesses, the COACH business and Printer Imaging business, they’ve got smaller head count.  And of course they are – right now, they’re our profitable businesses.”

These statements were made before Ramius began their consent solicitation. In response to the consent solicitation, Zoran is now projecting that their DTV business will become profitable by mid 2011, and they will stop spending more money than necessary on the DVD business which will be milked for cash flow.

Zoran is now in a position where they must argue that OK, if we shut down DTV, the stock is worth in the low teens. They must convince shareholders that after all the money that has been spent on R&D here, it would be foolish to give up now, because the stock will ultimately be worth in the high teens once Zoran starts getting design wins. They will plead with investors to give them a chance, another 9-12 months, to show progress in DTV before forcing them out the door.  It is possible that they will be successful with this argument before investors, but even if they are successful, they are going to have to be much more aggressive on cost cutting, which should reduce or eliminate the downside scenario. 

It seems likely that Zoran will eliminate its DVD losses, and will not exit DTV but will reduce spending and focus on areas on the higher end where  the business is less commodity-like.  There is a big difference between a company with $5.10 per share in cash which is bleeding cash, and a company with $5.10 per share in cash which is profitable.  Profitability here seems readily achievable since it involves mostly cutting R&D and not increasing revenues.

CONCLUSION - This is a great risk reward situation, with a catalyst.