Medium

The DJI Phantom 3, which starts at $1,259, helped drive Ambarella's drone business last quarter. Image source: DJI.

Amid a broad market sell-off last week, shares of Ambarella (NASDAQ:AMBA) got completely crushed. The maker of HD video processors fell on competitive fears following reports that mobile chip giant Qualcomm (NASDAQ:QCOM) could be preparing to jump into its ring. Re/code reported that Qualcomm was considering getting into the consumer drone market, specifically the segment targeting photography. That's precisely where Ambarella and several of its key customers are betting future growth will come from. Can Qualcomm take a bite out of the smaller chipmaker that's priced for growth?

Why Qualcomm is looking to expand
With as large as the global smartphone market has become, growth is naturally decelerating. This is impacting Qualcomm's core business in several ways. Smartphones are broadly becoming quite commoditized, particularly within the Android camp. This is leading to continued price erosion, which puts pressure on Qualcomm's royalty revenue since the company's take is based on the final selling price. Qualcomm estimated that smartphone average selling prices fell 10% last quarter, while royalty-bearing units were flat.

Qualcomm's chip business has also been under pressure because of "lower demand for our premium-tier chipsets from a vertical customer," referring to Samsung. The chip segment's revenues were down 22% last quarter. Meanwhile, there's some ongoing debate about whether or not Intel (NASDAQ:INTC)has been able to win some of the iPhone's modem business. Even though investors won't know for sure until the new models are released, you can be sure that Intel is definitely trying and that competition won't do Qualcomm's business any favors.

With all of this in mind, it makes sense that Qualcomm is evaluating tangential verticals where it can sell some chips. With all the buzz around consumer drones lately, it's a natural fit. The company's Snapdragon 800 chip can handle all of a drone's processing needs, from image capturing to navigation to communications. Qualcomm's value proposition to drone manufacturers will be that its single chip can accomplish all of these tasks, whereas currently multiple chips are needed. That could help drive down costs, which could in turn spur unit sales and adoption. Right now, drones start at $500, but can easily cost upwards of $2,000.

Even though Qualcomm is in the midst of of a restructuring that will reduce annual costs by $1.4 billion, expanding into the consumer drone market wouldn't require significant investments. This is simply selling an existing product into a new addressable market -- not developing new technology from scratch.

How it could hurt Ambarella
Ambarella has already begun pushing into the consumer drone market, and investors already have high hopes for the smaller chip maker. Drones are already contributing to Ambarella's growth in a meaningful way. Following the recent launch of the DJI Phantom 3, which is powered by Ambarella, drone-related revenues comprised over 10% of sales for the first time last quarter.

Ambarella enjoys robust margins in the drone market as well, which is bound to attract competitors. The company is acutely aware of this threat, with CEO Fermi Wang noting on the last conference call:

Well, in fact that, when you talk about drone market, if you're able to see as you see, a lot of app processor guys start talking about how they want to participate in the strong market because the drones need a high-end solution in the last group of performance. You can say that, if you talk to an Intel core company, they all say they're going to come into the drones.

Earlier this year at CES, Intel showed off a drone using its RealSense technology that can power self-navigating drones. Even if Ambarella is able to play defense as it grows, there's still a good chance that Qualcomm and Intel can put some heavy pricing pressure on the smaller rival. This could be painful.

Evan Niu, CFA has no position in any stocks mentioned. The Motley Fool owns and recommends Ambarella, Intel, 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.