Shares of Ambarella (AMBA -1.52%) have slumped more than 40% over the past 12 months on concerns of slowing sales, contracting margins, and rising competition. But after that steep decline, do the risks still outweigh the potential rewards? Let's examine Ambarella's growth, valuation, cash position, and competitive threats to decide.
Image source: Ambarella.
Slowing sales growth
Ambarella's sales growth and profitability have weakened considerably over the past year. Sales fell 19% annually last quarter, compared to 5% growth in the previous quarter and 74% growth a year earlier. Analysts expect the chipmaker to post a 3% sales decline for the full year, down from 39% growth in 2015.
The main weight on Ambarella's top line is the action camera market, which lost momentum over the past year as GoPro (GPRO -2.00%) failed to impress new customers with its existing cameras. Ambarella has tried to diversify away from action cameras with SoCs (system on chip) for drones, security cameras, and dash cams, but Pacific Crest estimates that GoPro's orders will still account for about a quarter of its sales this year.
But assuming that GoPro's new Hero 5 and Karma drones post decent sales this holiday season, analysts expect Ambarella's sales to rise 19% next year. Higher sales of drones from DJI Innovations, another key Ambarella customer, and investments in new markets like connected cars should also support that growth.
DJI's Phantom 4. Image source: DJI.
Weak margins and profitability
However, cheaper competitors in China have put pressure on Ambarella's margins, especially in the security camera market. The company has also been spending heavily on research and development to maintain its reputation as the "best in breed" manufacturer of image processing SoCs. Those pressures reduced its operating margin to just 2.4% last quarter, compared to 13.4% in the previous quarter and 28.6% a year ago.
As a result, Ambarella's GAAP net income plunged from $18.9 million a year ago to just $1.8 million last quarter. On a non-GAAP basis, which excludes stock-based compensation and other expenses, net income still fell from $23.7 million to $11.4 million. Analysts expect those declines to result in a 28% drop in non-GAAP earnings for the full year. However, if the aforementioned tailwinds from GoPro, DJI, and others lift Ambarella's top line, its earnings might rebound 22% next year.
An average valuation with a solid cash position
Looking further ahead, analysts expect Ambarella's earnings to rise 15% annually over the next five years. That gives Ambarella a five-year PEG ratio of 1.8. Since a PEG ratio under 1 is considered undervalued, we can't consider the stock cheap relative to its earnings growth potential.
Ambarella's cash and equivalents stayed almost flat sequentially at $268 million last quarter, but represented a 36% increase from the prior-year quarter. The company's marketable securities, which can be quickly converted to cash, rose 40% sequentially to $56 million, and it has no long term debt. Therefore, the chance of Ambarella burning through too much cash or issuing secondary offerings is extremely low.
Competitive threats and buyout potential
In addition to Chinese rivals, Ambarella must fend off Qualcomm (QCOM -1.88%), which has been aggressively moving into the image-processing SoC space with its mobile-based SoCs. Qualcomm's key advantage is that it can integrate its 4G modems with the processors to let OEMs create connected cameras or drones which don't need to be tethered to smartphones.
Those same OEMs would need to buy an image-processing SoC from Ambarella and a baseband modem (likely from Qualcomm) separately to create the same product -- which would likely be less cost-effective than Qualcomm's approach. Several smaller action camera makers already use Qualcomm's SoCs instead of Ambarella's, and the mobile chipmaker is reportedly trying to lure GoPro and DJI away from Ambarella.
Qualcomm's moves are troubling, but they also highlight Ambarella's value as a takeover target. Qualcomm's mobile SoCs still can't go toe-to-toe with Ambarella's SoCs yet, so it would make sense for Qualcomm to simply buy Ambarella and integrate its tech directly into its cameras, drones, and other devices. Intel, which is diversifying away from the PC market, could also buy Ambarella to enhance its depth-sensing RealSense cameras and drone-based Atom chips.
So how risky is Ambarella?
In my opinion, Ambarella's risks still outweigh its potential rewards. The company's near-term future depends heavily on GoPro making a comeback this year and for drone sales to take off. I've previously expressed my doubts about GoPro's future, and there's a strong chance that drone makers could favor Qualcomm's all-in-one Snapdragon Flight platform over Ambarella's stand-alone SoCs.
Ambarella's cash position is strong, but its valuation suggests that the stock needs to fall further before becoming a bargain. If Ambarella falls another 50%, reducing its forward P/E to 11 and its PEG ratio to 0.9, I'd consider buying it. But until that happens, the stock is simply too risky to own.
