Ambarella's (AMBA 0.08%) better-than-feared results sent the chipmaker's stock flying late last month (up 37% as of this writing) -- investors were impressed by the company's "upbeat" outlook at a time when its industry is reeling from the effects of the U.S.-China trade war. Wall Street shrugged off the fact that Ambarella's revenue and earnings fell from the prior-year period, thanks to CEO Fermi Wang's belief that the chipmaker will end the current fiscal year on a high. Wang's confidence is driven by the fact that Ambarella has started mass-producing another of its computer vision (CV) chips for yet another lucrative market.
But will all of this enthusiasm last given the raging trade war going on between the world's two biggest economies? Let's find out.
Ambarella seems to be back in business
Management affirmed that the company is on its way to transitioning from a supplier of video processing chips to an "artificial intelligence video company." The chipmaker provided proof of this transition when it announced that it had started making computer vision chips for the automotive industry on a mass scale. At the same time, Ambarella's CV25 chip -- meant for the professional surveillance and driver monitoring markets -- is now generating revenue for the company. This is impressive considering that the CV25 was introduced in January this year.
What's more, Ambarella gave investors more confidence when it said that it generated pre-production revenue from more than 40 clients. This opens the door for the company to score commercial contracts with quite a few customers in the coming quarters.
Encouraged by these developments, Ambarella issued impressive guidance for the third quarter of fiscal 2020 (the ongoing fiscal year). It estimates third-quarter revenue of $65 million at the midpoint of its guidance range. This is significantly higher than the $55.4 million analyst estimate for the quarter, and also ahead of the $57.3 million revenue the company generated during the year-ago period.
So Ambarella could clock double-digit growth in the current quarter, and investors have rightly sent the stock higher. But there was one caveat that Ambarella included in its outlook -- one that Wall Street seems to be ignoring.
Don't miss this red flag
Ambarella is reliant on China for a big chunk of its revenue. CEO Wang made this clear on the latest earnings conference call, when he said: "And as several of our customers in China continue to face the risk they may be added to a U.S. government Entity List, which could limit or restrict our shipments to them." Another Ambarella executive went on to detail the level of Chinese exposure Ambarella faces, though he didn't point out a particular number. CFO Kevin Eichler clarified that out of the three CV customers Ambarella has, two are from China. Moreover, half of Ambarella's CV automotive customers are Chinese.
So investors shouldn't casually shrug off the risk posed by its exposure in that market, especially because it gets a nice chunk of its revenue from two Chinese security camera customers: Hikvision and Dahua. Morgan Stanley analysts had pointed out earlier this year that Hikvision and Dahua's individual revenue shares at Ambarella were somewhere in the high teens. It has also been reported that both of these companies have ramped up their orders from Ambarella, fearing that they may be added to the Entity List.
This could be a reason why Ambarella is now seeing a nice surge in demand and is all set to return to top-line growth in the coming months. But if the U.S. government classifies the chips that Ambarella is shipping to Hikvision and Dahua as mission-critical, or blacklists the Chinese security camera makers by deeming them to be security threats, the company will face a shortfall in its sales.
As such, Ambarella investors shouldn't get carried away by the company's latest quarterly report. They need to remain cautious, because the ongoing trade war between the U.S. and China could eventually bring this surging small-cap stock back to the ground -- and CEO Wang has already warned of such a possibility.