Sigma Designs: Too Inexpensive to Overlook

Over the last few months, Sigma Designs (SIGM) has seen it stock price fall by over 60% as the markets continue to crumble. A large part of SIGM’s sharp decline can be attributed to the discretionary nature of the end products that utilize the company’s chips. This argument does have merit, as consumer spending has been sharply impacted by the ongoing issues in the real estate and credit markets. However, does this justify such a dramatic contraction in valuation for this company? Not necessarily, as the fundamentals of the business remain strong and the future outlook is positive.

In the most recent quarter, SIGM reported earnings of 72 cents a share, up from the 11 cents in the year-ago period. The company also reported revenue of $66.2 million, which represented a 163% increase over the prior year. Both these figures substantially exceeded the street’s expectations of 55 cents on $51.8 million. As a result, SIGM shares soared to $65.43, and reached a high of $72.17 less than two weeks later. Fast-forward three months, and we find the company’s stock trading at $26.29.

Aside from broader economic concerns, has anything fundamentally changed with SIGM since the last report to validate such a sharp sell-off? Definitely not, and if anything, the outlook looks even rosier than three months ago. Up until now, there has been a battle between the two next generation DVD formats: HD-DVD and Blu-ray. Both formats offer fantastic quality compared to traditional DVDs. However, consumers have been left confused as to which type of disc player to purchase, as it was unclear which format would become the next standard in high definition DVD viewing. The last thing a consumer wants is to make an investment in a new technology only to find that it would be soon outdated or discontinued. Well that battle has come to an end as Toshiba (TOSBF.PK), the primary backer for HD-DVD, recently announced that they will be withdrawing this format from the market. They attributed this decision to the vast majority of the entertainment industry siding with Blu-ray, which is backed by Sony (SNE). As a result, it is official that Blu-ray will become the standard for the high definition DVD market.

This news is monumental for Sigma Designs as they currently have 50% market share for the chips that go inside Blu-ray disc players. Now that consumers have clarity as to the direction of the industry, they will be much less hesitant to purchase a Blu-ray player. We will see all entertainment content providers offer high definition DVDs using the Blu-ray format just as Warner Bros Entertainment already has. We will see new production by hardware manufacturers as they license the technology from Sony, because they too will want exposure to this higher margin sector of the DVD industry. All of these developments should have a dramatic positive impact on SIGM over the coming years and solidifies the future outlook for the company.

From a valuation perspective, SIGM is too inexpensive to overlook. The stock is trading at 19x trailing earnings and only 10x forward earnings. Given the company’s impressive growth rate, and even more spectacular future outlook, it appears the company is trading at a deep discount. The company managed to nearly triple revenues from 2006 to 2007, during a time when it was unclear whether this technology would prevail over competing formats. Now, the company is expected to have 2008 revenues of $220 million, representing a 141% increase over the prior full year. This revenue projection appears too low, as the confirmed shift to Blu-ray should have a substantial impact on revenues in the coming quarters. Although consumers are not expected to go out and buy Blu-ray players immediately, we do know that they will NOT be buying HD-DVD compatible players. Once we see all the major entertainment studios jump onboard exclusively with the Blu-ray format, consumers will soon follow suit, and make this the standard in DVD viewing.

Sigma will report fourth quarter earnings on March 12. I do expect the company to easily beat current estimates of 83 cents on revenue of $75.5 million. But what investors will really be looking for is the company’s guidance now that Blu-ray is victorious in the battle against HD-DVD. This may create some volatility for the stock in the immediate short term. However, investors will look back one year from now and realize how great of an investment this really was.

Disclosure: Author has a long position in SIGM

Comments

[freakyguy666:]

Aren't you forgetting something? A big chunk of their business is IPTV and there are numerous independent reports indicating that there is a backlog and there will be a negative impact in Q1 and possibly Q2. Why not wait to hear the conference call next Wednesday before jumping in? I'd rather give up a few points and know what I'm getting into. Wouldn't you?

2008 Mar 06 06:11 AM

[ngoyal:]

Thanks for the comment,

Waiting for the conference call would not be a bad idea, as I did mention the stock could experience some volatility in the near term. The company will still beat estimates (regardless of backlog issues) and raise guidance for the full year. That is why I personally bought the stock here, and plan on adding more once I hear the call.

In regards to backlog, yes, backlog can have a negative effect on the current quarter. However, this backlog can also have a positive impact on the company's guidance for future quarters, which is what most investors will be focusing on.

2008 Mar 06 08:28 AM

[coach:]

The numerous reports I have seen are that IPTV Set Top Box growth is ahead of schedule. Sigma has a monopoly on the MSTV version of IPTV deployments and half of the Linux based market, as well as a monopoly on the HD version of IPTV. CY 2008 estimates of revenue are actually $350 million as the fiscal year ends in early Feb. A higher tax rate, due to increased profitability, slows EPS growth for the year. Also not noted is the potential of the UWB technology they are rolling out this year for the wireless connection of multiple STB's in the home. It is estimated that a new install for AT&T's U-verse currently takes 5.5 hours and the UWB technology will cut it down to 1 hour or less. Wait to buy if it makes you more comfortable, but this is a great entry point because the market is discounting a good company in a bad market/economy. Last point - AT&T is the only domestic customer of Sigma. 90% of revenues come from Europe and Asia where IPTV is more established and growing rapidly, while AT&T is projecting a weekly install rate of 40,000 new subs by year end '08 (up from 12,000 current).

2008 Mar 06 08:32 AM

[seeker:]

freakyguy666, could you please give more information on any one of these numerous independent reports you mention.

2008 Mar 06 08:37 AM

[ngoyal:]

Coach, those are some great points. Although the company will face a higher tax rate, the diversity of new products, growth potential, and seemingly low expectations by the street definitely favors owning the stock at these levels. Even if there is near term volatility, the risk/reward for a long term investment is definitely in our favor. And with U.S. stocks continuing to lag, owning a company with such a large portion of it business done internationally is the way to go.

2008 Mar 06 08:44 AM

[Michael B. ...:]

the last 2 week's volume and price moves are either evidence of naked shorting, or a a consortium of major institutional holders all unwinding positions ... I'm apt to believe in #1. This is still a $40-$50 stock easily, even if guidance was down.

2008 Mar 06 09:26 AM

[seeker:]

Michael, I agree with you. This stock has been made excessively cheap by naked shorting. The shorts will make accusations of all kinds of problems, but they have nothing to back those claims. Once Sigma buys back the two million shares and you add the institutional holdings, there will be no float left for the shorts to cover from. The conceptual mistake the shorts have made is that the growth of IPTV is so strong that any inventory with STB makers can be used up in a week or two. There is no chip glut in sight anywhere. Let the earnings call happen. These shorts that have more than 8 million shares shorted will pay through their nose. There will be no share to buy back from. There are only 29 million shares outstanding and 25 million are owned by institutions. It seems that the entire remaining float of Sigma is traded everyday. This is all market manipulation. The manipulators day of reckoning is not far.

2008 Mar 06 10:08 AM

[seeker:]

Do not forget that the company has repeatedly said that the share price action is not fundamentals related. The last such statement was only last week. What more can they say just before the earnings call.

2008 Mar 06 10:23 AM

[MrT:]

hey guys-

is anyone concerned that they dealyed their earnings call?

or that they announced a share buy back in advance of earnings?

these seem like a bad sign to me, especially with 29% short interest...

i am long sigma...if they even come close to their earnings...this stock is at $40 quickly...

the blu ray player should be the christmas gift of the year---and I have yet to hear of any major chip player entering the market

hope the shorts are wrong on this one....

2008 Mar 06 11:02 PM

[ngoyal:]

MrT, thanks for the comment. Although I am not sure why the earnings call was rescheduled, I can comment on the buyback. The company came under scrutiny last week when insiders sold a chunk of shares when the stock price was already fairly depressed. In response, the company stated that this insider selling was of shares received upon exercise of a portion of stock options that would have expired on March 15, 2008 if not exercised before that date. They later announced a buyback of 2M shares, which gave notice to the market that the company believes these shares are undervalued. This buyback should provide a buffer to the downside should the stock price continue to slide.

2008 Mar 07 10:27 AM

[coach:]

The CC was not delayed. It has been scheduled for March 12 since the January 29 shareholder meeting, which is the first time a date was discussed by execs. Some sites had earnings listed for April and some said March 3, but those were guesses, not from company listing.

2008 Mar 08 08:36 AM

[turd furgeson:]

I may not be catching the exact bottom, but man, I couldn't help myself today. This stock is ridiculously manipulated and oversold. If they put up another couple of quarters like they have done for over 2 years, this is an easy double by years end....at the very least.

2008 Mar 11 12:08 AM