CurrentOfferings.com Story:

PortalPlayer's Bid to Join iPod's Party

By Alex Salkever, BusinessWeek, October 20, 2004

The outfit that puts the chips in the music player has no profits, lacks a contract with Apple, and may face competition. Expect a hot IPO

On Oct. 13, Apple (AAPL ) reported stellar sales of its iPod music player for the latest quarter, which ended Sept. 25 and saw just over 2 million of the diminutive hard-drive based devices fly off the shelves. That's music to the ears of PortalPlayer, the Santa Clara (Calif.) company that designs the integrated circuits and software powering both the iPod classic and the iPod mini.

PortalPlayer filed to go public in August. Based on the iPod's sales momentum, the outfit should be one of the most anticipated tech IPOs of 2004, analysts say. The filing didn't indicate the likely date of the offering or a share price, although analysts expect it to happen relatively soon, since most IPOs are undertaken within six months of their filing dates.

FAR-SIGHTED GAMBIT. Should investors dive into this one? Not so fast, analysts say. No one doubts that PortalPlayer's technology is innovative, but the business of designing semiconductor chips is dicey. What's more, the concern may have trouble protecting its intellectual property, and competition is building.

And then there is the fact that, despite iPod's runaway success, PortalPlayer still hasn't managed to turn a profit. Buying in at any price could carry a high risk, since the outfit relies on Apple for the vast majority of its sales. Citing the mandated quiet period ahead of a public offering, PortalPlayer declined to comment.

Founded in 1999, PortalPlayer is a 134-person business that had the foresight to realize the hard-drive music player market would light up like a Christmas tree. "They were early to market with the type of chip Apple was looking for. They were the first to really focus on a software and integrated chip that gave a really good design for a hard-drive player," explains Cindy McCurley, an analyst at tech tracker In-Stat/MDR, who believes the hard-drive music-player market can sell 10.4 million devices in 2004.

CUTTHROAT NORMS. The hard-drive player market's revenues will grow 183.6%, from $811 million in 2003 to $2.3 billion in 2004, estimates IDC analyst Susan Kevorkian. She also believes shipments of HDD-based audio players will grow from 2.67 million units in 2003 to 25.46 million units in 2008, an annual compound growth rate of 57%.

The market's rapid growth has fueled soaring revenues at PortalPlayer. It had revenues of $1.9 million in 2001. That rose to $20.9 million by 2003 and should hit $37 million in 2004. In the first six months of the year, total revenues stood $22.2 million, and iPod sales continue to accelerate. "If you take this as a flat growth curve, the company already has a $112 million-per-year run rate," says David Menlow, CEO of IPO Financial Network.

Being first and selling the most is a good start -- but no guarantee for the future. PortalPlayer -- a so-called fabless chip outfit -- is in two cutthroat businesses, consumer electronics and semiconductor design. In its IPO filing, PortalPlayer admits that 89% of its revenues came from Inventech, the third-party manufacturer building iPods for Apple in China.

NO CONTRACT. PortalPlayer is up front about this risk. In the filing it states, "We currently depend on one customer for a high percentage of revenue and the loss of...this customer would significantly reduce our revenue and adversely impact our operating results."

PortalPlayer does supply chip designs to iPod competitors, including Aiwa, Philips (PHG ), RCA, Rio, and Samsung. But until those customers get more traction in the digital music-player market, PortalPlayer will lack customer diversity and remain exposed to Apple's decisions.

Apple CEO Steve Jobs "is a tough negotiator...we have seen that with Disney (DIS )," notes Tom Taulli, an IPO expert with Currentofferings.com, who adds that PortalPlayer's "margins may compress because of that." In fact, PortalPlayer has yet to strike a long-term contract with Apple and operates on a short-term, purchase-order basis. That's not unusual, but it does mean that Apple has the potential to bring PortalPlayer's gravy train to an abrupt halt.

PLAGUES OF LAWYERS. Chip experts say it would be difficult for Apple to throw over PortalPlayer for a competitor, a move that would entail rebuilding iPod's innards virtually from scratch. But rising competition from Sigmatel (SGTL ), Telechips, and even chip giant Intel (INTC ) could lead to competing offerings down the road. Those might entice Apple to think differently about its chip-design supplier.

Meantime, another tricky aspect of PortalPlayer's business is intellectual property. In the business of designing cutting-edge semiconductors, suits are endemic, often exerting a huge drag on the bottom line as legal costs mount.

Witness the legal tribulations of Rambus (RMBS ), another high-profile fabless chip outfit. Rambus' stock has gone from trading at around $35 range in January, 2004, to the $16 range today amid unending rounds of legal battles over who owns the technology. Industry watchers say Apple, in particular, zealously guards the intellectual property around its devices. That could make it harder for PortalPlayer to capitalize on the iPods' success and diversify its revenue stream.

Beyond its relationship with Apple, whether PortalPlayer has the patents to keep its technology unique and defensible in the face of rivals is questionable. "Long-term success [in the fabless chip business] requires building a library of intellectual property. I don't know what, if any, IP is held by PortalPlayer. Their music-player chips are all based on industry standards that PortalPlayer doesn't control." says Peter Glaskowsky, the chief systems architect for chip-builder MemoryLogix.

BROADER HORIZONS. Underlying all this uncertainty is PortalPlayer's lack of profits. The outfit expects to lose $5 million in 2004. That that is well down from past losses. But considering how well the iPod is selling, some analysts worry that maybe Apple is paying very little for use of the chip design. "I would think that they should be closer to profitability than they are," says Taulli.

None of this is to say that PortalPlayer doesn't have a plan. In its IPO filing, PortalPlayer indicates an intention to diversify its business. According to In-Stat/MDR's McCurley, it has an upgraded line of chip designs in the coming months that could allow it to better compete in the hot digital-camera market and make a bigger splash in the very young, but promising, portable digital-video player market. PortalPlayer may also plan to acquire rivals, thus buying growth and intellectual property with the IPO's proceeds.

Regardless of the risks, investors impressed by the iPods' popularity will likely embrace PortalPlayer. Over the long haul, however, unless PortalPlayer addresses the risks it faces, it seems an unsure place to bet on the digital jukebox.