What's going to be in your Christmas stocking this year? Will it be a DVD player or a digital camera? For quite a number of people around the world, the answer is yes. Consumers started buying DVD players in earnest in 2001 and the adoption rate has been one of the fastest ever for a consumer product. Digital cameras have yet to be snapped up at the same pace, but this will happen as prices drop to $200 to $300 for a camera with good resolution. Zoran Corp. (ZRAN--Nasdaq) is one of the companies benefiting from the analog-to-digital trend in consumer electronics.

Zoran provides the semiconductors and software that decompress and compress data in DVD players and digital cameras. The company was founded in 1981 to focus on military and high-end video and audio applications, but it changed its focus to the consumer mass market. Zoran offers two primary lines of products with associated software: the Vaddis chip for DVD players and Coach (Camera On A CHip) for digital cameras. DVD-related sales accounted for 77% of last quarter's sales; digital-camera-related sales made up 15% of sales, with PC video and audio contributing the remaining 8%.

MPEG-2 is the compression technology that lets a DVD contain a movie in high-quality resolution. As the compressed data is read from the DVD, it has to be decompressed to produce a TV signal. This is what Zoran's chips do.

The market for DVD players has grown from 2.4 million units sold in 1998 to an estimated 50 million units this year, with growth expected to continue for a while. The next technology leap will be the introduction of affordable mass-market DVD recorders. These sell for $500 or more today. DVD recorders require additional intellectual property because the chip now has to perform both decompression and compression of data. This is an area where Zoran appears to be ahead of the competition.

And competition is fierce. In 2001, Zoran supplied about 25% of the world market of DVD-player manufacturers that don't make their own chips. Competitors include several Taiwanese companies such as Mediatek and ESS Technology. The Chinese market also has attracted competitors that might build an inferior product but compete with lower prices.

Zoran faces a number of risks other than competition, including risks from customer and geographic concentration. The company derives 85% of its revenue from sales to Asian companies. Both China and Japan are very large markets for the company. On the customer front, Fujifilm, which acts as Zoran's sole distributor in Japan, accounted for about 29% of the company's total revenue in 2001. Fujifilm in turn sells Zoran's chips to Sharp, Toshiba, and others. Furthermore, the heavy reliance on the DVD market means that any slowdown in the market or product glitches could have a very negative impact on Zoran.

As a growth stock, where revenue grew 30% quarter over quarter last quarter and pro forma earnings per share grew even faster, a valuation of 21 times forecasted 2003 earnings per share seems reasonable. The future for analog-to-digital conversion should continue to shine bright for quite some time.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected].

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