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Ignore Ambarella, Inc -- Here are 2 Better Chipmaking Stocks

By Leo Sun - Apr 11, 2016 at 9:18AM

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Qualcomm and Nvidia might be more compelling buys than the GoPro supplier.

Shares of Ambarella (AMBA -3.31%) recently rebounded slightly after Morgan Stanley analysts upgraded the stock from "equal weight" to "overweight" at the end of March. The firm claimed that sales of its image application processors for connected cars, security cameras, drones, and wearables could continue to drive its future growth.

However, the stock remains down 40% over the past 12 months due to concerns about its dependence on GoPro (GPRO 0.54%), imminent competition from Qualcomm (QCOM -3.30%), and the rise of lower-priced competitors in China. Those pressures are expected to cause Ambarella's sales to fall 1% this year, compared to 38.5% growth in 2015. Analysts still expect Ambarella to grow its earnings 15% annually over the next five years, but its 5-year PEG ratio of 1.2 indicates that the stock still isn't undervalued.

Source: Ambarella.

During last quarter's conference call (as transcribed by Thomson Reuters), Ambarella CFO George LaPlante claimed that GoPro's orders would only account for a "low single-digit" percentage of its first quarter revenue. However, that percentage will likely rise later this year as GoPro launches new devices. When that happens, Pacific Crest estimates that GoPro's orders could account for a quarter of Ambarella's 2016 sales -- an uncomfortable percentage considering that GoPro's sales are expected to fall 15% this year. Therefore, I believe that investors should ignore Ambarella and focus on two more promising chipmakers -- Qualcomm and Nvidia (NVDA -4.20%).

Qualcomm
Qualcomm, the largest mobile chipmaker in the world, has faced plenty of problems over the past two years. Its chipmaking business, which generates the majority of its revenue, has lost market share to lower-priced rivals like Taiwanese chipmaker MediaTek. Meanwhile, its higher-margin patent licensing business, which generates most of its profits, has been targeted by government regulators and margin-starved handset makers demanding lower fees.

Last quarter, Qualcomm's chipmaking revenue fell 22% annually to $4.1 billion as operating profit plummeted 49% to $590 million. Licensing revenue also declined 12% to $1.6 billion as operating profit fell 15% to $1.3 billion. Qualcomm's total sales fell 19%, net income fell 24%, and adjusted earnings per share (supported by buybacks) declined 15%. Those bleak numbers indicate that Qualcomm stock probably won't recover from its 26% decline over the past 12 months anytime soon, but its forward dividend yield of 4.2% might put a floor under the stock.

Qualcomm is also aggressively diversifying away from mobile chips into connected cars, cameras, drones, and other Internet of Things devices. These efforts, which leverage its mobile expertise to connect devices to 4G networks, could marginalize smaller players like Ambarella and boost its chipmaking sales. Analysts currently expect Qualcomm's revenue to fall 11% this year before bouncing back 6% next year. Earnings are expected to grow 11% annually over the next five years, giving Qualcomm a 5-year PEG ratio of 1.1. While that ratio hasn't fallen below the threshold of 1 for "undervalued" stocks, it indicates that Qualcomm stock remains slightly "cheaper" than Ambarella's based on its potential earnings growth.

Source: Qualcomm.

Nvidia
Compared to Ambarella and Qualcomm, investors have been much more bullish on Nvidia, which has rallied 70% over the past 12 months for three main reasons. First, the chipmaker sidestepped the sluggish PC market by selling premium graphics add-in boards to hardcore gamers. Research firm JPR estimates that between the fourth quarters of 2014 and 2015, Nvidia's share of the add-in graphics board market rose from 75.9% to 78.8%.

Second, Nvidia pivoted and sold its Tegra mobile chips, which previously failed to make a splash in mobile devices, to connected automakers instead. Lastly, it sold more of its Tesla chips for cloud servers and Quadro chips for workstations. Last quarter, Nvidia's total GPU sales rose 10% annually to $1.18 billion, with gaming GPU sales climbing 21%. Tegra sales jumped 40% to $157 million, thanks to a 68% jump in automotive revenue. Quadro sales climbed 7% to $203 million, while Tesla/GRID sales grew 10% to $97 million.

Nvidia's total sales rose 12% to $1.4 billion, non-GAAP net income improved 23%, and diluted earnings per share rose 21%. While those numbers look solid, investors should note that Nvidia's year-long rally has inflated the stock's valuations. Analysts currently expect Nvidia to grow its annual earnings by just 6% over the next five years, giving it a very high PEG ratio of 4.3. Therefore, Nvidia doesn't belong to the same "value" category as Ambarella or Qualcomm, but its promising growth in multiple markets might cause forward estimates to be raised and valuations to cool off.

The key takeaways
Qualcomm and Nvidia might seem like better chipmakers than Ambarella, but both stocks have their weaknesses. Qualcomm might keep losing market share to its cheaper rivals, while regulators and OEMs force it to reduce its license fees. Nvidia has had a great run, but the stock's momentum might run out as fundamental gravity kicks in. Simply put, investors shouldn't jump into any of these stocks until they do their homework and fully understand their strengths and weaknesses.

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Stocks Mentioned

QUALCOMM Incorporated Stock Quote
QUALCOMM Incorporated
QCOM
$123.53 (-3.30%) $-4.21
NVIDIA Corporation Stock Quote
NVIDIA Corporation
NVDA
$145.23 (-4.20%) $-6.36
Ambarella, Inc. Stock Quote
Ambarella, Inc.
AMBA
$63.29 (-3.31%) $-2.17
GoPro, Inc. Stock Quote
GoPro, Inc.
GPRO
$5.56 (0.54%) $0.03

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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