Shares of Ambarella (NASDAQ:AMBA) have surged more than 50% over the past three months on expectations that demand for its image processing SoCs would rebound in the second half of the year. But even after that rally, Ambarella remains down nearly 50% over the past 12 months, and it seems unlikely to rebound to 2015 levels for five simple reasons.

Ambarella's A9SE SoC for action cameras and drones. Image source: Ambarella.

1. Plunging sales growth

Ambarella sells SoCs (system-on-a-chip) for action cameras, security cameras, dash cams, drones, and other devices. However, its sales growth has hit a brick wall over the past few quarters due to diminished demand for action cameras and competition from cheaper competitors.


Q1 2016

Q2 2016

Q3 2016

Q4 2016

Q1 2017

YOY Sales growth






Source: Ambarella quarterly reports.

Looking ahead, analysts expect Ambarella to post less than 1% top line growth in the second quarter and finish the year with a 3% sales decline -- down sharply from 45% growth in fiscal 2016 and 39% growth in fiscal 2015.

2. Contracting margins

In the past, Ambarella had a first mover's advantage in image processing SoCs, and was widely regarded as a "best in breed" brand. That's why action camera leader GoPro (NASDAQ:GPRO), drone king DJI Innovations, and top surveillance vendor Hikvision all use its SoCs.

Unfortunately, cheaper Chinese rivals have started gaining ground on Ambarella, especially in the security market. That competition, combined with lower revenue and higher R&D expenses, dented its operating margins over the past few quarters.


Q1 2016

Q2 2016

Q3 2016

Q4 2016

Q1 2017

Operating margin






Source: Ambarella quarterly reports.

3. The decline of GoPro

The recent bullish enthusiasm for Ambarella stems from CFO George Laplante's claim that the wearable cameras market would recover in the "second half of the year" during last quarter's conference call. Unfortunately, I believe that Ambarella is heavily basing that claim upon GoPro's overly optimistic forecast for its holiday quarter. Pacific Crest estimates that GoPro's orders will still account for 25% of Ambarella's sales this year, although it has tried to diversify its top line with deals with other customers like Xiaomi.

Last quarter, GoPro claimed that the launches of the Hero 5 camera and Karma drone during the holidays would bring the company back to profitability following a year of quarterly losses. However, GoPro must post roughly 40% to 80% sales growth during the holiday quarter to achieve that goal, which could be very tough considering how competitive the action camera and drone markets have become over the past year.

Image source: GoPro.

4. The rise of Qualcomm

To make matters worse, Qualcomm (NASDAQ:QCOM) is now challenging Ambarella with mobile chips with integrated 4G connectivity. Since Ambarella lacks that feature, its customer must buy a separate 4G modem (likely from Qualcomm) to create cameras with stand-alone Internet connections.

Qualcomm's more cost-effective combo is already used in a few 4G action cameras like BenQ's QC1 and 4GEE's Action Cam. Ambarella admits that Qualcomm has been talking to its customers, but seems confident that it can stay ahead in terms of price and performance. That might be true for now, but Qualcomm could use its scale and deeper pockets (it spent $1.27 billion on R&D last quarter, versus $24.5 million at Ambarella) to marginalize the tiny underdog.

5. Unrealistic valuations

Due to all these red flags, analysts expect Ambarella's earnings to fall 28% this year but possibly rebound 22% next year. Those numbers make its trailing P/E of 33 and forward P/E of 20 look pretty lofty. Ambarella's trailing P/E is also higher than the industry average of 26 for semiconductor equipment and materials companies.

Looking further ahead, analysts expect Ambarella to post 14.5% annual earnings growth over the next five years. That sounds decent, but it only gives Ambarella a 5-year PEG ratio of 1.7. Since a PEG ratio under 1 is considered undervalued, Ambarella doesn't look that cheap relative to its long-term earnings growth potential.

Why you should sell Ambarella

Ambarella might be considered a "best in breed" player today, but the chipmaker is simply too small to survive a long-term war against Qualcomm and lower-margin Chinese rivals. Its heavy dependence on single customers like GoPro or logistics supplier WT Microelectronics -- which generated 74% of its sales last quarter -- make its business too top heavy. Lastly, its valuations are disconnected with past growth and future expectations.

Therefore it's hard to see Ambarella bouncing back much further, and the stock's three month rally could peter out as fundamental gravity kicks in.


This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.