Chips Off a New Block
Christopher Elliott
05/19/98
Journal of Business Strategy
Faulkner & Gray
(Copyright 1998)
The word "zoran" means silicon in Hebrew, which is exactly what Levy Gerzberg wanted to convey when he founded Santa Clara, Calif., microchip manufacturer Zoran Corp. in 1981. As the company grew, he discovered that zoran also meant "outstanding" in Mandarin and "happy boy" in Greek.
Gerzberg might find it difficult to incorporate the latter definition into his marketing literature, but thanks to a relentlessly adaptable business strategy, he'll have no trouble with the former. His plan isn't just to meet customer demands for the next-generation hardware and software that play digital sound and pictures, but to create new markets out of thin air. Or, at least, thin silicon wafers.
"My goal is to be able to go to a friend's house and say, 'you see that video player? There's a Zoran chip in there,'" says the Stanford-educated president and chief executive. But the obstacles to reaching that sort of Intel-like market dominance are formidable. With 152 full-time em-
ployees and nearly $45 million in fiscal 1997 revenues, Zoran faces competition from such influential rivals as Motorola and IBM and smaller, but no less dangerous developers, such as C - Cube Microsystems in Milpitas, Calif., and Oak Technology in Sunnyvale, Calif.
Engineering the guts of the newest CD player or VCR, which is essentially what Zoran does, is no easy task. Companies live and die by standards that often change at a moment's notice. And even when a standards group agrees on a way to, say, read digital video, it doesn't mean everyone will follow. All it takes is a software behemoth such as Microsoft, or a hardware titan like Sun Microsystems, to balk, and all bets are off.
Last summer, for example, Sony broke ranks with Toshiba and Matsushita and decided to pursue its own path toward a recordable digital video disk, or DVD. To make matters more confusing, a company backed by Circuit City Stores and a Los Angeles law firm then unveiled plans to produce a competing version of a new read-only digital videodisk called Divx. The difference: The disks cost less but can only be read once. If you want to see the movie again, you have to pay for it. Some new players now will incorporate both standards.
Fortunately, Zoran knows a thing or two about surviving Silicon Valley's volatile cross-currents. "Zoran has incredible technology, and it's smart enough to make money from it," raves Victor Halpert, an analyst with Banc- America Robertson Stephens in New York. Eight years ago, Zoran abandoned its core business and, against considerable odds, leveraged its know-how to develop components for an industry that didn't exist. In short, it became a start-up all over again. But by making continuous innovation a centerpiece of its business plan, Zoran effectively created a new market for its products. "In some cases," says Gerzberg, "we became the de facto research and development arm for our customers."
In some cases, Zoran also became the de facto visionary for the consumer multimedia industry, conceiving ideas like digital surround sound for cars and full-motion video for personal computers. But it didn't start that way.
In the Beginning
When Zoran formed more than a decade ago, its primary business was building digital signal processors (DSPs) for sophisticated electronics equipment. DPSs allowed devices to translate sound, pictures, and light into strings of ones and zeroes that computers can read. These semiconductors were specialized and very expensive. And, for about the first 10 years of Zoran's existence, supplying DSPs for high-end systems proved quite profitable. Zoran didn't just deliver the components to customers in the industrial automation, medical imaging, and broadcast equipment industry. More than half of its business came from shipping military hardware. Near the end of the 1980s, however, the high-end DSP market began to slow down as the Cold War fizzled, and the company experienced a commensurate revenue slump.
There didn't seem to be anything comparable to DSPs in the consumer market yet. But Gerzberg and his colleagues saw changes around the corner. Just as audio CDs replaced vinyl records, Zoran believed CDs might be superseded by something else that would offer multi-channel digital sound. (CDs deliver only two "channels" to your speakers, but most recordings are made on 24 tracks, meaning that there's more to a recording than what you hear today.) Could the technology developed in Zoran's youth be leveraged into the consumer market? Gerzberg believed so.
Here's why: In order to get the purest kind of sound or pictures, the information must be converted into digital information-the same zeroes and ones used in the radar or imaging systems Zoran helped build. The company already knew how to make a military computer understand these zeroes and ones, so why not try to make a personal computer translate similar information?
But there were two problems that had prevented other companies from trying what Zoran wanted to do. First, even if someone could make a computer or a video disk player or an audio system read digital signals and then play them back, there was the nagging standards problem. A disk made for one manufacturer might not work on another's products, and the problem would persist until every manufacturer agreed on a single standard. The other hurdle was technical. "Whenever you have to deal with digitized video and audio, it turns out that there is one enormous barrier," explains Gerzberg. "That barrier is the amount of data you have to store. It takes a tremendous amount of memory to store a picture, for example."
If you wanted to store a digital picture, it would take about one megabyte on a computer hard drive. At that rate, the average internal disk would fill up after just 100 photos. Likewise, a single six-channel song would take up an entire CD. To get around that, Zoran would have to develop technology to compress the information, remove selected parts of the data, store it, and then mathematically reconstruct it during playback. Think of the information as concentrated orange juice, and the mathematical equation as water.
So Zoran repositioned itself to focus on the nascent market for integrated circuits designed to compress video and audio data for commercial applications. It was a bold move that plunged the company into an earnings tailspin. By fiscal 1992, it suffered a net loss of $2.6 million on revenues of $7.3 million. The losses widened the next year to $7.7 million with revenues of only $4.7 million.
That's when things hit bottom, and for a moment, it seemed as if Zoran had taken a wrong turn. The company was consuming round after round of venture capital with little to show for it. "Basically, Zoran became a start-up in the early 1990s, from a business perspective," observes Halpert. "There was a lot of money lost in those years. Just look at the list of people who invested in the company. It's an incredibly long list."
But analyst Tejinder Singh of New York-based C.E. Unterberg Towbin, suggests Zoran knew what it was doing. "Zoran changed. It didn't just change from one decade to the next, or one year to the next, but it turns out that it had been changing from quarter to quarter," he says. "They show how important it is to respond quickly to opportunities, such as the one they had to leverage their technology."
Earnings picked up by 1995 to just under $1 million on revenues of $23.4 million. Its strategy really kicked in the next year, with revenues nearly doubling in 1996 to $44.1 million and net income of $2.3 million. Last year, while revenues declined slightly to $41 million, net income rose to $4.2 million. Singh sees more earnings growth in the future, thanks to Zoran's strategy. He expects revenues to top $70 million in fiscal 1998 and net income to reach $8 million, or about 70 cents a share. In his research, he notes that Zoran is now "very well positioned" to take advantage of demand for various digital components, adding "we are very optimistic."
Zoran's product lineup is one reason why. Today, multimedia chip sales account for between 60% and 75% of revenues, with the rest coming from software and hardware licensing.
Strategic Secrets
Why was Zoran's five-year turnaround plan successful? That is surely a question competitors must be asking themselves-particularly competitors that were in a better position to take advantage of the coming demand for digital components a few years ago. It could have something to do with Zoran's do-or-die attitude; if its shift from military to multimedia components didn't work, then the company would have surely been history. Under such pressure, executives tend to become very focused.
Focus is what Gerzberg is all about. Although he's soft-spoken and affable, the executive is at the same time all business. He displays a passion for the both technology and the business that is unusual in Silicon Valley. Maybe that's because he is a curious hybrid of academic and entrepreneur. Gerzberg is the former associate director of Stanford University's electronics laboratory, and he earned his Ph.D. in electrical engineering from that school. He's also served as chief technical officer at Zoran. Today, as a result of the turnaround Gerzberg helped lead, Zoran is considered the leading provider of compression chips for most video and audio components. In some sectors, such as software-based digital video systems, it has no rivals-yet.
One of Zoran's strategic secrets, perhaps, is in maintaining a sort of innovative tension between itself, customers, and competitors. It's called core licensing. Like technology big-guns Microsoft and IBM, Zoran sees nothing wrong with a client being a potential competitor, or for that matter, a competitor being a potential client. To use a military-industrial term, Zoran supplies the ammunition for multimedia devices. It's up to its manufacturers to fight each other over price and performance. "Our customers can compete among themselves, even though they're using the same technology," says Gerzberg. Accordingly, Zoran ships its audio chips and programming solutions to the likes of Toshiba, Pioneer, Sharp, Kenwood, and Yamaha. It sends video semiconductors to Intel, Packard Bell, Hewlett Packard, and IBM.
Never mind that IBM is a possible rival to Zoran. Big Blue has announced it intends to offer integrated circuits incorporating compression technology for certain video and audio applications. But as long as IBM is still buying, Zoran will sell. The way it sees it, even a monolithic category-killer like IBM is growing increasingly dependent on Zoran ammunition. And that's the whole point-to keep them coming back for more. "We're in the business of developing building blocks," explains Gerzberg. "The silicon chip is designed like a puzzle. Some of those building blocks are proprietary information. Others we can license. And we say to manufacturers: 'Instead of competing, let's be friends. We can collaborate.' By the time they've integrated our blocks into their systems, we have come out with the next generation of chip, and then it starts over again."
Like its time-intensive turnaround plan, this strategy is risky business. One of Zoran's customers could conceivably use Zoran technology to develop a competing product, which isn't uncommon in the semiconductor industry. Or, a bigger company could see the potential in Zoran's flagship products, pour its resources into developing a competing chip, and then undercut Zoran by selling it at lower prices.
But Zoran has a few things in place that have made it immune to those perils so far. For starters, it's got an almost irresistible, not to mention difficult-to-imitate, product line. In late 1996, the company acquired CompCore, which designs software cores for video and audio decoder integrated circuits and a software-based decompression technology. CompCore did what Zoran was doing, but it used software instead of hardware to achieve its goal. By buying CompCore, Zoran was able to offer two solutions to the digital decompression problem: silicon or software.
Zoran also devised a product philosophy called Standard Plus that it says has differentiated the company from its rivals. The idea is to comply with the accepted standards, but to provide more functions than the other chips or programs on the market offer. For example, a Sony digital camera that uses one of Zoran's circuits not only lets a photographer take digital pictures-which every other digital camera does-but it also lets the user manipulate the number of pictures that a disk will hold. If you're taking pictures of a blue sky, which doesn't require a lot of data, you may select several hundred pictures; if it's an intricate photo of flowers, then you'll be able to select fewer images.
Future Perfect
An aggressive and adaptable strategy, calculated risks, and a keen understanding of market psychology have helped Zoran thrive despite its small size and limited resources. More changes are ahead, even though it now appears that the company is well on its way to profitability. In earlier years, Zoran survived by essentially acting as an R&D outsourcer to other companies. But now Zoran is weaning itself off a reliance on these development revenues. Annual income derived from development fees slipped to about $1.7 million during the last fiscal year from $3.7 million in 1996. Zoran always doesn't charge customers for its services, because it stands more to gain from developing a technology solution for the customer and then selling the components it needs.
Zoran is also grappling with two other thorny issues: a shipping problem for some of its chips, which hurt revenues in a recent quarter, and the endemic problem of a declining average price for semiconductors. The response is vintage Zoran. "One of Zoran's subcontractors had just several days delay in the production of one product close to the end of the quarter, which caused the shipment to the customer to occur in the following quarter," says Gerzberg. "Zoran is now better prepared to handle a last-minute increase in orders by having a larger inventory consistent with the growing demand and by adding additional vendors." And to the problem of declining prices-that's the idea that chips get cheaper with time-Gerzberg says, no problem. "Whenever prices go down, the volume increases, and profits go up. Even if they don't, we're constantly reducing our manufacturing costs, and so our profits will stay relatively even."
All of which will hardly distract Zoran from its next target: the telecommunications industry. The coming convergence of computers, the Internet, and television will open new opportunities to expand Zoran beyond its present size and scope. For example, the rise of cheaper, so-called "sub-1000" PCs are expected to open new markets for a plug-in device that helps a computer handle digital video and audio. "And our goal," adds Gerzberg, "is to continue to grow."
Perhaps he'll be able to use that Greek definition for zoran after all.
Zoran's middle eastern connection
Zoran's headquarters may be in Santa Clara, Calif., but a lot of its brain power is in Haifa, Israel. That's where it operates a wholly-owned subsidiary that allows the company to participate in research and development agreements with Israel's ministry of industry and trade and the Israel-United States Binational Industrial Research and Development Foundation, which funds up to half of the incurred costs for approved projects. According to Securities and Exchange Commission filings, of Zoran's 152 full-time employees, 74 were based in Israel as of December 3l, 1997.
But the main reason the Haifa connection are the engineers-the company reported that 69 of its 90 employees involved in R&D and engineering were based in Israel. Zoran considers the stable pool of engineers in Israel one of its best assets. They bring a broad background in electrical engineering, computer science, and applied mathematics to the table. Plus the location, close to Europe, makes it an ideal place to do business.
"We have benefited from the fact that there are research and development incentive programs between the U.S. and Israel," says Levy Gerzberg, Zoran's chief executive, who has a dual U.S.-Israeli citizenship. Those include access to a well-educated labor force and interest-free loans.
But there's a downside, too. Investors tend to become jittery whenever Israel is in the news. And it's in the news a lot these days. "A lot of Israeli companies don't want to be defined as such because of the political situation," says one analyst, who asked not to be named. "If Zoran's operations in Haifa ceased, it would be adversely impacted." But Gerzberg insists the dangers of doing business in Israel are exaggerated. He says he doesn't know of any disruptions in work during the last several decades. "I believe that more working hours were lost in the U.S. watching CNN," he adds.
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