The reluctant contrarian:
There's value in tech, if you know where to look

by Briton L. Ryle

I know, nobody wants to hear about tech stocks. I don’t really want to write about them. But the contrarian in me says that tech is the best place to look for bargains at the present time.

As it happens, I still follow the tech sector, both as a consumer and trader. The trader in me has had a lot of success shorting tech stocks over the last year. Just ask any of my Taipan Traders. They’ll be happy to tell you how much they’ve made buying put options on companies like Intel, Novellus, KLA-Tencor and QLogic.

As a consumer, I’ve been having a lot of fun with digital video. My wife and I have had a digital camcorder for a couple years now. We make videos and stills using Pinnacle Systems software. Videos of the kids, I should probably add.

Digital video is the only technology out there that people actually want. But I wouldn’t call it the “killer app.” I’d call it the “only app.”

The virtuous circle

Digital video has already created a whole new consumer electronics market for cameras and DVD players and burners. I’ll even go so far as to say that digital video has the potential to spark a surge in PC sales in the final months of 2002, as people upgrade their systems with faster processing and more storage.

It could even push adoption of high-speed Internet access, because people will want to email their home digital movies and pictures to friends and relatives. But I don’t want to get too crazy here.

The digital revolution

You remember record albums, don’t you? Well, I still have most of my old LPs. The covers are tattered and the vinyl is scratched. And finding parts for my turntable is a labor of love.

Of course, I do own some CDs. But I didn’t give in without a fight. In fact, it probably took five years from the introduction of the CD before I shelled out US$18 bucks to own one. And I still remember feeling a little dirty afterwards.

Because, let’s face it, CDs were a record company ploy from the start. What better way to boost sales than to force audiophiles to buy their entire music collection all over again?

I’m willing to concede that CDs have many advantages over vinyl LPs. CDs are more durable. They’re more portable. And I never did figure out a safe way to play records in my car.

Forgive me, father...

As a consumer, I’m resistant to changes in technology. Upgrades always cost money, and the latest technology will always be cheaper six months down the road. In fact, I’m going to make a confession: I don’t even own a cell phone.

And the reason is strictly financial.

As soon as I sign a two-year cellular service contract, I know the rates will drop by 50% and I’ll feel like an idiot. Not that I haven’t had ample opportunity to reflect upon my I.Q. while waiting for a kind motorist to pull over and call a tow truck for my broken-down car.

There. I’m glad I got that off my chest.

As an investor, though, it’s a totally different story. I personally made over 200% on the Nokia stock I bought in 1999. And I made a similar killing on the Leap Wireless stock I bought at around the same time.

The trend is your friend

Believe it or not, this rant has a point. You don’t have to be part of a trend to recognize one—and profit from it. In fact, I’ll go out on a limb and say that, as an onlooker, you might be in a better frame of mind for profiting than the bandwagoneers.

Because two of the most important characteristics of successful investors are dispassion and skepticism.

Now, whether the digitization trend is a false one is up for debate. When I see how much the DVD section at Blockbuster has grown in the last few months, I tend to believe digital video is for real.

And it’s my opinion that DVD plays will be very profitable for the next couple of years, for two reasons: cost and momentum. Ask people why they don’t buy the coolest new electronic toys and most will say cost is the biggest hurdle. Cost is a primary barrier to widespread acceptance of new technology.

But DVD players are getting cheaper every day. You can find them for US$80 bucks these days. And anecdotal evidence suggests that lower prices are having the desired effect.

That's a big snowball

DVD player sales doubled each year from 1998 to 2000. Annual sales are strongest between September and December. There was a massive spike in sales numbers last fall. And I think this fall could be even better for DVD player sales.

The other driver for DVD penetration is momentum. To explain, I refer to the old “fax machine” story. In general, people assume that scarcity and value have an inverse relationship. In other words, the rarer a thing is, the more valuable it becomes. And with commodities, that’s probably true.

But technology is different. Technology becomes more valuable as it spreads. One fax machine is worthless. Once you have two, you can at least fax stuff to one other person. But when you get thousands of fax machines, faxing becomes so valuable that you start seeing fax numbers on business cards.

And that’s what consumer electronics giants like Sony want to see. They want consumers to believe that they must have a DVD player. And they want DVD players to be cheap enough that anyone can afford one.

But it’s not just the box makers who want DVD to succeed. I believe converting from videotape to DVD is good for companies like Blockbuster, too. DVDs are smaller and more durable than VHS tape. Therefore, storage and replacement costs drop, and profit margins rise.

Digital video will completely replace videotape within three years

Analysts say that half of American homes will have a DVD player by 2003. Some 400 million DVDs were sold in 2001, compared with roughly 227 million in 2000.

Now, analyst projections of the fickle tastes of consumers are all well and good. But a better gauge comes from inside the industry. And it appears that Blockbuster is betting big on DVD.

In 2001, the rental giant already got 20% of its revenues from DVD rentals. That’s up from just 7% in 2000. It expects DVD to account for 30% of revenues by the end of 2002, and 50% by the end of 2003.

As you might expect, Blockbuster’s taking the DVD plunge. It took a US$450 million charge to drop a quarter of its videotape inventory. And it’s accelerating its video amortization schedule from three years to nine months. Because it makes sense to pay for something before you send it to the dustbin.

ESS Technology

ESS Technology (ESST:NASDAQ) is a chip company. And like most chip companies, it’s been having a tough time over the last year and a half. Revenues peaked at US$310 million in 1999. They bottomed at around US$275 million in 2001.

Normally, declining revenues are a big red flag. But ESS Technology is a cyclical business, and 2001 looks like the bottom of the cycle. The next cycle will be driven by the proliferation of DVD players.

ESS is the leader in digital video chips. It makes chips for several different digital video standards. In the United States, the standard is DVD. And ESS controls about a third of the market. In China, it’s super video compact disk. ESS has 40% of that market. Finally, there’s the video compact disk, popular in “emerging markets.” ESS controls 70% of this market.

Digital video is still an emerging standard, which is why ESS Tech doesn’t carry the valuation of an industry leader like Intel or Maxim Integrated. ESS trades at 1.5x sales, 2x book and carries a paltry P/E of 9. Plus, it has US$4 a share in cash.

ESS Tech returned to profitability in the third quarter of 2001. And it hasn’t looked back. For the six months that ended June 30, 2002, revenues rose 43% to US$165 million. Net income was US$33.7 million, compared to a loss of US$13 million in the same period in 2001.

ESS is projecting third-quarter revenues between US$85 and US$90 million. That will put the company on pace to do around US$335 million in revenues for fiscal 2002. And my estimate doesn’t take into account any upside surprise from the fourth quarter, which will include Christmas DVD player sales.

The stock has been battered lately. But not because of the market. ESS has been one of the better performing NASDAQ stocks. It was a Barron’s article questioning the company’s growth projections that took the stock from US$17 to US$11 in a matter of days.

ESS Tech responded to Barron’s by reaffirming guidance and announcing a five million share buyback.

If you can get ESST under US$13, you should do it. In light of the booming digital video market and ESS Tech’s leadership role, I believe a one-year price target of US$23 is very reasonable.