It's been a brutal year for Ambarella (AMBA +1.15%) investors. The chipmaker's stock plunged nearly 40% over the past 12 months, and currently hovers near a 52-week low. But investors looking at Ambarella's top and bottom line growth might initially be baffled since it posted positive year-over-year revenue growth over the past four quarters while beating analyst estimates on the top and bottom lines.
But looking ahead, analysts expect Ambarella's revenue and non-GAAP earnings to respectively fall 5% and 35% this year -- compared to a 2% sales drop and 12% earnings decline last year. Those numbers look dismal for a stock that trades at 24 times earnings, which is higher than the industry average P/E of 23 for semiconductor equipment makers.
Source: Ambarella.
However, some contrarian investors might be wondering if the market has been too hard on Ambarella. To figure that out, let's examine the chipmaker's core business, challenges, and potential catalysts.
Understanding the business and the headwinds
Ambarella manufactures image processing system-on-chips (SoCs) for cameras. Its top customers include action camera maker GoPro (GPRO +7.05%), drone maker DJI Innovations, and security camera maker Hikvision. The stock surged to all-time highs in 2015 on enthusiasm for GoPro cameras, but it dropped as GoPro's sales declined.
Ambarella's revenue rose 10% annually to $71.6 million last quarter, with 16.3% growth in non-GoPro revenues. But looking ahead, Ambarella CFO George Laplante warned of a "substantial decline" in GoPro revenues -- either due to lower camera sales or GoPro's long-rumored shift toward rival suppliers like Qualcomm (QCOM +7.46%).
DJI's Spark drone. Source: DJI.
In the past, Ambarella bulls pointed out that the chipmaker could pivot toward drones to offset its softness in action cameras. Unfortunately, Laplante expected the drone market "to be down" for the current quarter, as DJI's cheaper Spark drone (which reportedly doesn't use an Ambarella SoC) punishes higher-end drones that use Ambarella's chipsets -- like DJI's own Phantom. To make matters worse, persistent rumors suggest that Qualcomm is still trying to pull DJI away from Ambarella.
The bulls might also believe that chipsets for VR cameras or driverless cars will save Ambarella -- but Laplante warned that the VR market faces "slower-than-expected growth" this year. Pacific Crest analyst Brad Erickson also estimated that Ambarella's computer vision chips for autonomous cars probably wouldn't generate significant revenue "for three to four years."
Keep an eye on Ambarella's margins...
Ambarella's margins are also deteriorating. Between the second quarters of fiscal 2017 and 2018, Ambarella's non-GAAP gross margin dropped from 67.1% to 63%. GAAP gross margin fell from 65.6% to 63.2%. Ambarella attributed that decline to the expansion of its lower-margin security camera SoC market in China, which faces tough competition from cheaper Chinese chipmakers.
Ambarella's total operating expenses also rose 15% annually, led by a 16% jump in R&D costs. As a result, its operating margin contracted from 14% to 7%. That figure will keep dropping as Ambarella's rising expenses keep outpacing its revenue growth.
What's Ambarella's turnaround plan?
Ambarella's main strategy is to keep investing in R&D to retain its reputation as the "best in breed" provider of image processing SoCs. This means bigger investments in its CV1 computer vision chip, which could power more autonomous drones and cars, and better panoramic technologies for security cameras.
Source: Getty Images.
It's also striking deals with other drone makers to reduce its dependence on DJI, and partnering with automakers to provide SoCs for integrated dash cams.
These are all smart moves, but they don't guarantee its survival against bigger foes like Qualcomm or cheaper Chinese chipmakers.
Ambarella is also buying back a lot of stock. It spent $29.9 million last quarter buying back 595,770 shares, but that was poorly timed; the stock plummeted more than 22% after its second quarter earnings report on Aug. 31. Moreover, insiders don't seem confident about Ambarella's prospects -- they sold over 153,000 shares over the past 12 months, but didn't buy a single share on the open market.
The verdict: Stay away from Ambarella
I've told investors to avoid Ambarella before, and my opinion hasn't changed. I personally admire CEO Fermi Wang and his development of video compression codecs and top-tier image processing SoCs, but Ambarella's business model is fundamentally flawed.
It relies too heavily on a few major customers that have questionable loyalties, its primary markets of action cameras and drones are losing momentum, and its margins are crumbling. I think a best-case scenario for Ambarella would be a buyout, but I doubt that suitors will appear at its current valuations.
