Ambarella (NASDAQ:AMBA), which produces image processing SoCs (system on chips) and computer vision chips, isn't usually mentioned in conversations about artificial intelligence (AI) chips, which often revolve around bigger chipmakers like NVIDIA (NASDAQ:NVDA).

Nonetheless, Ambarella's management mentioned "AI" over a dozen times during its latest conference call on Sept. 2. Let's take a closer look at Ambarella's AI efforts, whether or not they'll support its long-term growth, and if they make it an underappreciated play on a high-growth market.

The evolution of Ambarella's business

Ambarella initially caught Wall Street's attention by supplying image processing SoCs to GoPro (NASDAQ:GPRO). GoPro's growth boosted Ambarella's stock price to nearly $120 by mid-2015, but those gains faded as GoPro's growth stalled out.

A profile illustration of a neural network inside a robot's head.

Image source: Getty Images.

Over the past five years, Ambarella pivoted away from action cameras and focused on the growth of the security and automotive camera markets. It also continued to develop new computer vision (CV) chips for processing AI tasks, including facial identification features for security cameras and driverless features for connected cars.

But Ambarella's turnaround plan faces two significant headwinds. First, it faces tough competition from Intel (NASDAQ:INTC), which acquired computer vision chipmakers like Movidius and Mobileye over the past four years.

Second, the U.S. Commerce Department blacklisted several of Ambarella's top Chinese customers -- including the top security camera makers Hikvision and Dahua -- amid escalating trade tensions last year. Huawei's internal chipmaker, HiSilicon, likely picked up some of those orders.

To counter these challenges, Ambarella is trying to diversify its business (especially in China, where it's pursuing smaller companies), reduce its customer concentration, and grow its CV business.

Ambarella's plans seemingly paid off in the second half of 2020 and the first quarter of 2021, as its revenue grew by the double digits again and the expansion of its professional camera security business beyond China's low-margin market boosted its gross margins:

Metric

Q2 2020

Q3 2020

Q4 2020

Q1 2021

Q2 2021

Revenue (Millions)

$56.4

$67.9

$57.2

$54.6

$50.1

Growth (YOY)

(10%)

19%

12%

16%

(11%)

Gross Margin*

58.1%

58.1%

58.7%

59.1%

62.4%

YOY = Year-over-year. Source: Ambarella. *Non-GAAP.

However, the COVID-19 crisis disrupted that recovery in the second quarter, which saw declining sales to the auto and security markets. Ambarella expects its revenue to decline another 18%-23% year-over-year in the third quarter, and for its gross margin to slip sequentially to 60%-62%. Analysts expect its revenue to decline 8% for the full year, and for its adjusted earnings to tumble 80%.

Will AI chips save the day?

During the conference call, CEO Fermi Wang declared Ambarella was "embedding AI in all of our new products," and its "AI business continued to show growing signs of acceptance."

A close-up shot of a camera lens.

Image source: Getty Images.

Wang noted its CV business generated a "mid- to high-single-digit" percentage of its total second-quarter revenue, and that that percentage would hit 10% for the full year. That percentage might seem low, but it's a step in the right direction because Ambarella's average selling price (ASP) for a CV chip is more than double the ASP for its non-CV chips.

Ambarella believes the growing need for more sophisticated security cameras, like the body temperature scanning cameras in demand throughout the pandemic, as well as new advanced driver-assistance systems for semi-autonomous and autonomous vehicles, can support its long-term growth.

Unfortunately, Wang also admits Ambarella faces a growing number of competitors, including HiSilicon in the mid- and high-end markets and a "huge amount" of Chinese and Taiwanese competitors in the low-end market. Wang also listed Intel, NVIDIA, NXP, Texas Instruments, and programmable chipmaker Xilinx as its "key competitors" in the automotive market.

Ambarella is much smaller than all of those companies, and it could struggle to match their scale and operating margins as the security and auto markets recover.

Stick with the AI market leaders

Ambarella's stock isn't cheap at over 130 times next year's earnings, and it's tough to justify that premium valuation as its growth stalls out amid escalating competition. New AI chips might help Ambarella retain its existing customers and gain a foothold in the automotive market, but it could be difficult to grow its market share against its larger rivals.

In short, investors who are interested in the AI market should simply stick with market leaders like NVIDIA. Ambarella is worth keeping an eye on, but it still can't be considered an underappreciated investment in the broader AI market, which Grand View Research estimates could expand at a whopping compound annual growth rate of 46.2% between 2019 and 2025.