Blu-ray DVD Chip Maker Offers Risk, Reward

Next-generation DVD players are pricey, and that's tempered sales. But the biggest weight on the new gadget were the competing formats: Consumers didn't want to bet hundreds of bucks on a player until they could be sure that it would still be useful in a year or two. After all, Sony's lost this kind of battle before, back when VHS beat out Betamax. Now that the uncertainty has been lifted, Blu-ray player shipments should take off.

"The next-generation DVD player market in 2007 was about one million units and it was split roughly 50/50 between HD DVD and Blu-ray," says Collins Stewart analyst John Vinh, who rates Sigma at Buy. "I think the market opportunity this year is going to be closer to four or five million units. Now that the war's over obviously the majority of that is going to be Blu-ray. Sigma's got a massive opportunity ahead of it and they're extremely well positioned."

Sigma's chips power Blu-ray players from almost all the major names including Sony, Sharp and Samsung. It's quickly ramping up in some of the second-tier players, too. But that doesn't mean Sigma has the field to itself. Now that Blu-ray's the clear winner there's sure to be emerging competition from rivals like Broadcom (BRCM), STMicroelectronics (STM) and Zoran (ZRAN). On the other hand, with the Blu-ray market forecast to hit more than 10 million units by the end of next year, there should be plenty of business to go around.

"We expect Sigma to lose some market share because it's not realistic for them to maintain such strong share in such a rapidly expanding market," Vinh says. "But the market is growing so quickly we would continue to expect these guys to grow very meaningfully through the back half of the year."

Then there's the happy case that Sigma's got a lot more going for it than just Blu-ray. It also has a commanding position in set-top boxes for IPTV, the burgeoning technology that allows telecom companies to deliver TV over the Internet. Think AT&T's (T) U-verse service. As good as that Blu-ray business sounds, it's really more the icing; IPTV is the cake.

IPTV allows telecoms to bundle TV with the voice and DSL services they're already offering customers. It's gaining traction in the U.S. with AT&T but is a much bigger deal internationally, where large swaths of population have telephone lines but no access to cable. Sigma's chips power set-top boxes made by Cisco Systems' (CSCO) Scientific Atlanta division, Motorola (MOT) and UTStarcom (USTI) to name a few. Those boxes in turn are deployed by more than 20 telecom providers around the world. Sigma has about three-quarters of the IPTV set-top box market, which is projected to post a compound annual growth rate of anywhere from 30% to 40%.

That's helped Sigma post double-digit percent gains on its top line for eight quarters in a row, although that could certainly begin to slow. As Roth Capital Partners analyst Jay Srivatsa cautioned Monday, "Following the massive ramp, we expect quarterly revenue growth rates for Sigma may be more modest in the future after the steep initial growth as IPTV growth leaves the 'early adopter' phase and enters a more mature phase."

Srivatsa did maintain his Buy rating, however, so Buy calls still outnumber Holds by eight to five, according to Thomson Financial. Analysts' average price target comes to $72, which implies that shares will more than double in the next 12 months or so. Interestingly, targets range widely, from $39 to $100, so even the most conservative forecast implies appreciation of about 20%.

Then there's the bigger picture that it's not a great time to be a tech stock and an especially tough time to be a chip stock — the industry proxy Philadelphia Semiconductor Index is down a third from a 52-week high hit last summer. Making matters worse for Sigma is the worry that despite its significant head start, bigger players with much greater scale will catch up and grab market share in its key markets. Then again, all those overhangs have conspired to make shares compellingly valued. If analysts' estimates are right, Sigma trades at less than 13 times forward earnings. That offers a 70% discount to its own five-year average, according to Thomson, and looks tantalizingly discounted for a company with a long-term growth forecast of 25%.

True, there's no shortage of tech names with solid outlooks and seemingly cheap stocks that are failing to get any support in today's market. Sigma, volatile and small, looks like a higher-risk — and higher-reward — play than many of them. The fundamentals look strong and the valuation looks cheap, but it's the kind of stock you nibble at on the down days or dollar-cost-average into. If you were an early adopter who went into the red by buying the wrong high-def DVD format, a bet on Sigma could offer a Blu-ray of hope.