I've recently discussed Ambarella's (NASDAQ:AMBA) business model, the risks it faces, and the potential catalysts on its horizon. The stock has rebounded 60% over the past six months on the belief that action camera sales will accelerate in the second half of the year, but it remains down almost 10% over the past 12 months.
The Ambarella bulls still believe that the stock has room to run, but I strongly disagree. Today, I'll counter three commonly cited but flawed ideas for buying Ambarella.
1. Expecting drones to save the day
Most of Ambarella's revenue comes from image processing SoCs for action cameras, security cameras, and in-dash cams. All three businesses are under pressure from cheaper Chinese rivals or Qualcomm (NASDAQ:QCOM), which offers mobile-based SoCs for stand-alone 4G connectivity.
However, the bulls note that Ambarella's SoCs are also used by many drone companies, including market leader DJI Innovations. If the consumer and commercial drone markets take off, it's assumed that Ambarella's sales to drone makers, which only accounted for about 10% of its sales at the beginning of 2016, will increase and offset weaker growth in its other product categories.
However, many commercial drones will likely require stand-alone 4G connections to autonomously fly over long distances. For this market, Qualcomm's Snapdragon Flight platform -- which includes an application processor, 4G modem, Wi-Fi, Bluetooth, and a GPS on a board the size of a credit card -- will be more cost efficient than Ambarella's image processing SoCs, which require some of those components to be purchased separately.
2. Expecting GoPro to lift its holiday sales
GoPro (NASDAQ:GPRO) is Ambarella's biggest customer, and Pacific Crest estimates that the action camera maker's orders will account for 25% of its top line this year. As a result, the two companies' sales often rise and fall in tandem.
Analysts expect GoPro's revenue to fall 14% this year, compared to 16% growth in 2015 and 41% growth in 2014. Ambarella's revenue is expected to fall 2% this year, compared to 45% growth in fiscal 2016 and 39% growth in 2015.
To hit those fairly low growth targets, GoPro and Ambarella still respectively need to post 54% and 36% sales growth during the holiday quarter. That growth is expected to be fueled by GoPro's Hero 5 cameras and Karma drone. But since the Karma is expected to be an accessory for all GoPro cameras, Ambarella will likely only benefit from sales of the Hero 5.
That's bad news, because the leaked specs of the Hero 5 indicate that it will barely qualify as an upgrade from the two-year-old Hero 4 Black, with the same highest quality video mode of 4K at 30 fps. With many cheaper and more innovative cameras on the market, customers could refuse to pay $400 to $500 for the Hero 5. As a result, GoPro's holiday quarter sales could miss estimates and take Ambarella down with it.
3. Expecting a buyout
With a "best in breed" reputation in image processing SoCs and a low enterprise value of $1.85 billion, some Ambarella bulls believe that the chipmaker will be bought out by a larger player like Qualcomm. However, it seems like Qualcomm already has a competitive edge against Ambarella with its 4G-integrated solutions.
Moreover, Ambarella isn't fundamentally cheap. It trades at 50 times earnings, compared to the average P/E of 26 for semiconductor equipment companies. Its EV/Sales ratio of 7 also indicates that a buyer wouldn't be getting much revenue per dollar spent on the company, especially after factoring in an acquisition premium.
Qualcomm can also sign partnerships or patent licensing deals with Ambarella's rivals Hisilicon, Dahua, Novatek, and Axis to improve its own Spectra image processor. Doing so would likely be simpler and cheaper than buying Ambarella and inheriting its many problems.
The key takeaway
Ambarella is a small supply chain player which could see its SoCs commoditized by much larger chipmakers in the near future. The company soared on the coattails of GoPro's early success, but now it's struggling to prove that it can survive without its biggest customer's action cameras. The bulls might believe that drones, the Hero 5, or a takeover could lift Ambarella, but I believe that the competition remains too tough and that its valuations are still too high relative to its growth potential.
Leo Sun owns shares of Qualcomm. The Motley Fool owns shares of and recommends Ambarella, GoPro, and Qualcomm. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.