The Motley Fool Take

By David Meier

February 11, 2005

Yesterday, PortalPlayer (Nasdaq: PLAY) shares got burned to the tune of a 17% decline, falling $3.47 to $16.75. If you own an Apple (Nasdaq: AAPL) iPod or any other hard-disk-based portable music player, chances are you`re jamming thanks to a PortalPlayer product. That`s because PortalPlayer supplies Apple, iRiver, Samsung, and Sony (NYSE: SNE) with miniature hard drives complete with control software -- they`re referred to as ``systems on a chip.`` Given the craze for portable music players -- even I have one, and I`m far from a gadget geek -- PortalPlayer seems to have been in the right place at the right time.

Year-end results show that PortalPlayer nearly quadrupled its revenues to $92 million. And according to CEO Gary Johnson in an interview with CBS MarketWatch, IDC Research expects the number of players hitting the market in 2005 to increase from 14 million to 20 million. In other words, the company looks to have plenty of room to grow.

Also on the growth front, Johnson spoke about bringing picture and video technology capabilities to the players. That means being able to cram even more stuff onto the chips and supplying them to his customers. In the world of technology convergence and miniaturization, people apparently want to be able to listen to music, record sounds, take pictures, and shoot video all from one product. Makes sense. Nokia (NYSE: NOK) and Motorola (NYSE: MOT) have been supplying cell phones with video capability for a while now.

But as Fools, we know better than to invest before kicking the tires. And that means looking at the financials to see what going on. A company has to create value for its shareholders to be worthy of investment.

Looking at PortalPlayer, three things jumped out at me. The first was stock-based compensation. Yes, I`m glad to see it on the income statement. But I was surprised that it was 15% of gross margins. I`m sure the employees deserve it, but shareholders just lost 15% right off the top. Seems a bit excessive to me. Why not pay the employees in cash and see whether they buy shares on their own?

The second thing was dilution. There were 4.2 million basic shares outstanding used to calculate earnings per share of $2.46. But there were 18.1 million diluted shares. To me, that means stock-based compensation costs are not going to be going down anytime soon.

Finally, the company does not have much in the way of plant, property, and equipment. That`s good, because who wants to make heavy investments in factories and machines? PortalPlayer contracts that out to others. But the tradeoff is high working-capital requirements. Accounts receivable was 21.7% of sales in 2004. As you might guess, Apple probably negotiated some great payment terms from PortalPlayer. And when you recognize that research and development, the innovation engine, was 16% of sales, you realize that 44% of sales went to customers and employees. I guess that`s the cost of doing business in a high-tech environment. And maybe that`s why the stock is 50% below its all-time high and why it currently trades below its November initial public offering price of $17.