Ambarella's (NASDAQ:AMBA) sales footprint shrank last year, but the company got more aggressive on spending rather than less so. Operating costs jumped to 47% of sales from closer to 40% in each of the prior two fiscal years. That shift sent net profit plunging to 18% in 2016 from 25% in the prior year.
The key contributor to the expense spike was a huge jump in research and development spending that pushed the category above $100 million for the first time. Let's look at why R&D costs soared and what the increase tells us about Ambarella's business.
A worthwhile expense
Ambarella sells technology that's relatively cheap to manufacture and deliver to its customers. In fact, sales of its high-definition video and image processing chip solutions yielded a 66% gross profit last year to mark an uptick over the prior year's 65% result.
Yet these products require significant resources that need to be spent months -- and often years -- before the technology ever reaches the production stage. That's why it makes sense that research and development is the company's single biggest expense.
Ambarella knows that its competitive advantage derives entirely from its ability to push the industry forward through complex hardware and software innovations. Out of the 700 people it employs, roughly two-thirds of its workforce is engaged in the R&D realm of engineering and system design.
Through work across four research centers, Ambarella has advanced the small-factor image processing niche with a string of innovation wins in the past few years. The latest system-on-a-chip solution, for example, paired ultra-high definition processing capabilities with high frame-rate capture. Ambarella counts 55 major patents that protect its cutting-edge video processing and video compression tech today.
Elevated and going higher
At $100 million, R&D expenses amount to just under 33% of Ambarella's annual sales. That's elevated compared to larger chip rivals Intel and NVIDIA (NASDAQ:NVDA), which each spent 21% of revenue on the category last year. Ambarella is also far above these companies in its pace of R&D growth. Compare its 33% spike in 2016 to Intel's 5% boost and to NVIDIA's 10% increase.
And there are good reasons to expect this category to weigh more heavily on Ambarella's operating results in the future. Management is working hard right now to diversify its product line so that it doesn't depend so heavily on just a few niche markets like sports cameras. The push is leading it into exciting growth areas like automotive cameras and drones. However, these segments have major challenges, including established rivals that already enjoy the leadership spot on technical innovation. Ambarella's hardware didn't make it into the popular Spark drone that DJI recently launched, which highlights just how intensely competitive this market is.
Still, executives are betting that, just as they have for Intel and NVIDIA, aggressive investments in engineering research will allow Ambarella to expand its market opportunity over time. Ideally, R&D spending will then decline toward a more sustainable pace that's closer to 20% of sales than 33%.
Before that happens, though, Ambarella needs to prove it can protect its early tech leadership position in the camera industry while expanding its innovation dominance into new markets.
Demitrios Kalogeropoulos has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Ambarella and NVDA. The Motley Fool recommends INTC. The Motley Fool has a disclosure policy.