Jon Markman

SuperModels5/31/2006 12:00 AM ET

Zoom in on digital-camera plays

Investors can still get a great angle on the digital-photo boom. Watch these two companies that make the semiconductors and software for digital cameras.

By Jon Markman

Picture this: A world without film cameras.

It's a little hard to believe, but it's entirely likely that children under the age of 2 will grow up without ever seeing a film-based single-lens reflex camera, the kind that make delicious whirring noises and don't have instant-delete buttons. Everywhere you look, they are being phased out and shut down as people have switched en masse to digital cameras and camera phones.

Just last week, the industry's largest manufacturer, Canon (CAJ, news, msgs), announced that it would halt development of new film cameras and devote all its resources to digital cameras. A couple of months ago, supersized peers Konica, Minolta and Nikon said much the same. As a result, faster than you can say "cheese!", the sexy, solid, mechanical film camera of our youth is going the way of the typewriter, the rotary phone and the phonograph. And in its wake, a new market of vast proportions is shaping up.

Investors have to pay attention when changes of such long-term magnitude occur. It's not like you haven't noticed that digital cameras are so cheap it's no big deal to buy a $50 model for a child's birthday. But you may not realize it's still early enough in the product cycle to make a lot of money as an investor.

Posing with Mao

It's sort of like buying into the PC industry in the early 1990s, when Dell Computer (DELL, news, msgs) was still a pup, and Intel (INTC, news, msgs) and Microsoft (MSFT, news, msgs) were large but not gigantic. If you think about it, PCs were already well established as a product in 1992, but Dell shares were going for $1 split adjusted, Intel went for $2 and Microsoft for $2.50. All are up nearly 10 times or more since then, as the industry has gone from being peripheral to central in the home and workplace. (Microsoft is the publisher of MSN Money.)

It may not seem as if there's anything so essential about a digital camera, but they have become ubiquitous. When I traveled in China recently, they were at least as widely brandished as cell phones, and perhaps more so. Regardless whether a native tourist was a wealthy party member or a rube from the sticks, he had a camera at the ready to snap photos of anything that moved -- or not. It actually makes sense, as they may not have had anyone to call while standing in line in Tiananmen Square for two hours to see the petrified body of Chairman Mao, but they sure as heck wanted to record the moment for the folks back home.

Digital cameras, like cell phones, have become so commoditized a product that the big money is not being made in the shares of manufacturers like Canon and Eastman Kodak (EK, news, msgs), but rather in the shares of companies that reliably supply patent-protected semiconductors and software. This is getting to be a volume business -- just like mobile phones, but with fewer competitors. There are just two top U.S. providers -- OmniVision (OVTI, news, msgs) and Micron Technology (MU, news, msgs) -- and both are a lot more attractive today than they were a month ago, before the broad market sell-off.

Betting on camera phones

OmniVision slid almost 30% in a week and a half in the middle of May, and has since recovered a bit. Which is pretty amusing, in a twisted way, since over that time its business prospects actually improved. OmniVision's main product is an image-sensing device called the CameraChip. The formal name for the baseline technology is "complementary metal oxide semiconductor," or CMOS. But all you really need to know is that it's a piece of metal and glass that puts a lot of high-performance camera functionality in a tiny package. OmniVision sells these to a long list of customers, who put them in everything from low-cost plastic cell phones, video games and surveillance systems to chic titanium-body cameras.

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Omnivision will report earnings for its fiscal fourth quarter on June 15, and I think it will come in slightly above consensus, at 39 cents a share on $126 million in revenue. Shares should get a lift when the company updates its earnings guidance for the second half of the year and explains how the surprising strength of sales growth has led to much more robust cash flow than skeptics believed possible. It's already sitting on $5.72 a share in cash. Subtract out that cash and the stock trades at the low, low price-to-earnings multiple of 15 times 2007 estimates. That's about 25% lower than comparable high-tech manufacturers, most of whom are not facing OmniVision's great prospects. There are new competitive threats from the likes of Samsung and Toshiba (TOSBF, news, msgs) Toshiba overseas, and Micron here, but that's still too steep a discount.

OmniVision is making great strides in the automotive and security arenas with low-cost image sensors as well, but its bread and butter in new sales come from all the advertising you've seen by carriers like Verizon Communications (VZ, news, msgs) to encourage consumers to upgrade call-only phones into ones that take pictures or show videos. There's also been a successful push to encourage folks with low-resolution camera phones to upgrade to 1-megapixel models with enhanced quality, such as the Motorola RAZR and Samsung Blade. And next on the horizon will be a holiday promotion to hype people into wanting 2-megapixel camera phones that easily take the place of a conventional digital camera -- a product for which OmniVision is the leading low-cost provider.

More than a memory play

The biggest impediment to OmniVision's growth is Micron, which is the industry's 800-pound gorilla with about 35% of the market. Long known primarily as the leading maker of random access memory, or RAM, for personal computers, Micron a few years ago branched out into more profitable products such as image sensors. By the middle of next year, Micron will have four new fabrication plants making both image sensors and flash memory. As the mix tilts toward image sensors, Micron's gross margins will get a huge boost, as RAM chips bring margins into the mid-teens while image sensors garner upwards of 40%. Although an increase in product would appear on the surface to threaten the profitability of the industry, it is only expected to meet demand from all the cameras, mobile handsets, cars, video consoles and security devices that are creepily keeping an eye on us. Micron does not just make cheap sensors. It recently rolled out the world's smallest 8-megapixel image sensor, a very high-quality device that is expected to revolutionize the business due to its low cost.

Micron will also benefit from the rollout of the new Windows Vista operating system by Microsoft later this year and next, as the sophisticated software is expected to lead consumers to buy a lot more memory: 1 to 2 gigabytes of RAM is expected to become a standard, up from 512 megabytes, or about a fourfold increase. If you believe, as I do, that Micron can earn as much as $1.40 in 2007 from all these efforts, it is going for a forward price-earnings multiple of just 12, which is laughable for a company growing in excess of 20%. Multiply that number by a more reasonable P/E, such as 20, and you get a potential price of $26, or about 60% higher than the current quote.

Excuse me if I say it would be a snap to profit from these two companies. You don't need to pick one. Take them both, and shoot for the sky.

Fine Print

To learn more about Micron's products, visit this page and this page. … To learn more about OmniVision, read this overview page and also this page to see its face-recognition products, this one to see camera-phone products and this page to learn about the technology. ... To see the Motorola RAZR, check out this page. … As you might expect, there are blogs devoted to camera-phones. The best one is Reiter's Camera Phone Report, but there's also www.livingroom.org.au/cameraphone and Picturephoning.

Jon D. Markman is editor of the independent investment newsletters Strategic Advantage and Trader's Advantage. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Markman did not own or control shares of companies mentioned in this column.

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