OmniVision (NASDAQ:OVTI) is at it again. It recently announced an "informal" SEC investigation into some of its past revenue recognition policies. Unfortunately, the "informal" modifier didn't pacify the analysts the way OmniVision hoped it would. The stock has dropped 15% in the past week.
The SEC investigation will cost the company money and divert resources from developing and marketing its new products -- both damaging disadvantages to a small company. But OmniVision is in a relatively good position to handle the charges -- it has good revenue flow and new products in the pipeline. And the revenue recognition issue that triggered the investigation is no surprise to it, although its own internal investigation in June uncovered no improprieties (see Rich Duprey's recent comments for more information).
More importantly -- and more troubling to me -- is OmniVision's pattern of underreporting events that could be alarming to its investors.
In its recent quarterly report (filed Dec. 10), the company quietly mentioned the investigation, but it failed to address it at all in its analyst conference call on Nov. 30. Perhaps the company thought it wasn't that important. Or more likely it didn't want to detract from the generally positive tone of its earnings results.
OmniVision hasn't always been forthcoming about disclosing information on some questionable events. After I initially recommended the stock in September, OmniVision announced a new CFO, its third in a little more than a year. Such turnover is alarming and at least a little retrospectively disconcerting to shareholders of a company under investigation for accounting issues. Yet OmniVision failed to provide any explanation for the change in the accompanying press release. Although I looked into the issue and satisfied myself that the CFO shuffle wasn't cause for undue concern, I was disappointed OmniVision didn't feel the issue important enough to provide a basic explanation.
Also, there are some unsettling aspects to its recent earnings announcement. Although the company exceeded earnings expectations, its revenue came in below forecasts. This indicates gains came from factors such as one-time cost cuts rather than from sustainable growth streams. In fact, during OmniVision's conference call, CFO Peter Leigh noted that the increase in gross profit margin (from 40% to 45%) could be entirely accounted for through one-time gains -- gains the company was not willing to discuss in detail.
The one-time gain that was mentioned in the quarterly report was a $1.4 million payment by a customer to settle a contract dispute. This represents 8% of its reported earnings. Finally, current liabilities rose by $17 million -- a 37% gain. This is money the company owes but hasn't paid out, so it could be argued that its improved cash position probably isn't as shiny as it seems.
What does all this mean? Not a lot in terms of the company's valuation (see below). But it illustrates why full disclosure is so important. When a company isn't forthright with its explanations and its numbers, we investors are left in the dark, forced to draw our own conclusions about what is going on behind the scenes. In addition, there is a loss of trust when investors have to discover issues for themselves rather than hear the company explain and discuss them proactively.
Is OmniVision still a value?
Since I recommended OmniVision in September, the stock has gone from around $12 to $19 (before its recent decline). During that time, I have received several emails asking whether the stock is still attractive. Here are my thoughts.
I am pessimistic about the general market. I think the budget deficit is potentially crippling. Employment gains haven't been what they should be for a strong recovery. And I don't see much progress toward addressing these issues.
Having said that, I favor stock-specific factors to macroeconomic indicators. Back in August, OmniVision had a P/E ratio around 10 and an enterprise value-to-free cash flow-to-growth (EV/FCF/G) ratio around 0.65, both significantly below the industry averages. And all this for a company that is also the leader in its market. Those numbers made the value obvious.
Since then, the stock has risen 50%. Although I still think it is undervalued, it certainly isn't the no-brainer I saw a few months back. If I were looking to invest now, I would spend more time mulling OmniVision's forward-looking statements -- its expected earnings, its expectations for its new products, and its explanations supporting its predictions. Unfortunately, OmniVision's historical secrecy obscures the accuracy of this information.
I would also pay more attention to the competitive landscape. With 40% gross margins, we should expect OmniVision to attract lots of attention. And it does. Micron (NYSE:MU), Agilent (NYSE:A), and ST Micro (NYSE:STM) all have digital imaging sensor products. As supply increases, prices will decrease, and margins will shrink. OmniVision's small size is its main advantage because it can move more quickly than the mammoth competitors. It is also the company's main disadvantage because it doesn't have the well of resources to endure a down market, price cuts, and extended litigation. The most attractive option might be an acquisition by a Sony (NYSE:SNE) or Toshiba trying to play catch-up by buying their way into the market.
I continue to hold all of my shares of OmniVision. I believe it will weather the current storm relatively unscathed. But there are a few barometers I will follow closely in the next 10-Q to help determine whether the company and stock are reaching a peak or just starting a climb. First, if the SEC investigation drags on, it may indicate more entrenched issues than OmniVision admits. Second, I want to see whether the revenue decline was a one-time event; the company indicated it would be, related to ramping up production of its next-generation products. If the company's higher resolution chips can gain the market share OmniVision hopes for, its stock may just be getting started. Finally, I want to see OmniVision provide full and accurate information on its business to the marketplace.
Please do not send Jim any self-help relationship books for Christmas -- his dad has that covered. He would, however, love to receive holiday emails -- even if it is just to correct his misinformed opinions. Jim owns shares of OmniVision Technologies. The Motley Fool has a disclosure policy.
