Currently there is alot of discussion about whether the current Wall Street credit crunch, will spread to the “real” economy. Generally, Wall Street’s paper economy is quite divorced from any reality, and hence major downturns in Markets do not cause significant ripples to other unrelated “real” sectors of the economy. However, the current sell-off may very well be an exception.

Case in point: Zilog (ZILG), a fabless semiconductor company, that at first glance would seem quite immune from happenings in the credit markets. Last week, however, the company reported a significant revenue decline both year-over-year and quarter-to-quarter. The reason given: a slowdown in housing.

As CEO, Darin Billerbeck, explained:

“The sales decline for the quarter was disappointing and reflected a generally soft demand overall. The North American home security market was slow due to the decline in new housing starts which impacted the end consumption of certain of our legacy products.”

The stock has taken a dive since the earnings report and has now fallen nearly 40% from its high reached back in June. Of course, the key question, now is what to do with ZILG after this decline? The answer, as always, is to stay positive and focus on the fundamentals. As we have stated in past posts, small cap stocks are simply getting mauled in the current market downturn. The key thing is recognize that the selling is primarily driven by overleveraged hedge funds and other panicky investors. The declines have little to do with the underlying financial health and potential of these companies.

In the case of ZILG, despite the sales decline, the company still managed to generate some cash during the quarter and ended the quarter with nearly $20 million in cash and no debt. Hence, the company has absolutely zero financial risk at this time, and therefore can be bought on dips.

Furthermore, the sales dissappointment was entirely related to the company’s legacy product line, which does not represent the future of the company. Importantly, the company’s newer embedded flash 8-bit products were up sequentially 19 percent and 52 percent year over year. In addition, the company is making excellent progress in bringing to market its 32-bit ARM based products for the secured transaction market. Both the Flash and ARM-based products represent substantial growth opportunties for ZILG over the next few years. Unfortunately, these newer product lines are still only a small portion of ZILG’s total revenue and hence their financial impact is not yet felt in the company as a whole.

However, we still remain confident that the company has the right management team in place, and the necessary financial strength, to generate significant revenue growth from the new Flash and ARM product lines in the coming years. As we’ve mentioned in the past, new CEO,Mr. Billerback was a former co-head of Intel’s $2 billion Flash division and we remain confident that he has the skill set and connections to greatly expand ZILG’s business in its new target markets.

Moreover, the valuation of the company does not in the least bit reflect the potential of these growth opportunities. At current prices, ZILG’s Enterprise Value is a miniscule $43 million, which when measured against our low-end base scenario of $60 million in annual revenue, implies an EV/Sales ratio of 0.7X. On a more normalized revenue run rate for ZILG of $80 million a year, this would translate into a ludicrous 0.5X EV/Sales. As such, we still expect that as the company’s Flash and ARM products ramp up in 2008, the stock’s valuation could jump significantly, as investors assign a more normalized valuation to the company in line with industry comps.

Please Note: We hold a position in ZILG. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.