Ambarella (AMBA) has been a white-hot IPO since coming out in 2012 it’s up over 1400%! The company is the current king of video-processing chips. More elaborately stated in their company description: “The company’s system-on-a-chip designs integrated HD video processing, image processing, audio processing, and system functions onto a single chip for delivering video and image quality, differentiated functionality, and low power consumption. Its solutions enable the creation of video content for wearable sports cameras, automotive aftermarket cameras, professional and consumer Internet Protocol (IP) security cameras, telepresence cameras, and unmanned aerial vehicles in the camera market; and manage IP video traffic, broadcast encoding and transcoding, and IP video delivery applications in the infrastructure market.” It’s a great company and one that’s not a newcomer – they started out in 2004. They are also the “Intel-inside” the GoPro cameras which has helped win them an avid retail investor following. For anyone wanting to see the original story here are the AMBA IPO roadshow slides from 2012.
[Before we get started let’s be clear – this is *not* a call on the quarterly report coming today after the close. In fact we expect the company to easily beat Wall Street consensus of $80M in revenue and 81c of earnings per share. Maybe they will even beat the “whisper numbers” of $85M and 85c.]
The explosive gains the share price have been driven by strong and improving fundamentals. Most importantly the company has expanded operating margins from 10% in 2012 to almost 26% for the LTM ended April 30, 2015. Combined with accelerating revenue growth it’s the magic nirvana for growth investors – valuation be damned.
What we consider here isn’t the current merits of the investment case but the potential for a change of amplitude if not direction as strong industry factors, similar to gravity, begin to impact the company. The two charts below are amazingly similar and they set up the discussion. OmniVision (OVTI) was a rocket ship in the image processing space with their “camera on a chip” in much the same way Ambarella is with their “video system on a chip.” And it does great things for your stock as the product cycle drives revenue growth and margins. OVTI was up 1500% over the three year boom period for them. But watch what happens next…
Competition enters the market. The revenues and margins AMBA is generating are a siren call for other players like Qualcomm (QCOM), NVIDIA (NVDA), Samsung, Broadcom (BCOM) and Sony (SNE) among others begin investing heavily on competing products. I’m not suggesting anyone will field a superior product or that AMBA is going to lose share. But in the face of much more and very credible competition revenue growth decelerates and improvements in margin come to end. Said another way “trees don’t grow to the sky.”
It’s more than competition though. After a “home run” in a core market the demands for expansion and scale dictate moving into adjacent markets. It makes good sense *but* often the dynamics, and margins in these markets differ from the core market – generally they are less attractive (that’s why the didn’t come first.) Again it’s a reason that dramatic improvements in margins and the business will come to an end.
Now or later?
What about timing? Being wrong about the “when” can be just as damaging as being wrong about the “what” to invest in. When might the end of heady stock performance come for AMBA?
Again if we look back to OVTI their stock started to move sideways in 2004. Interestingly that was their last year of great revenue growth. Digging a little deeper in 2004 what happened was that *sequential* quarterly revenue growth stopped (even though there was great YoY performance.) After three quarters of flat revenues they started to decline and that the beginning of a long term trading range for OVTI.
As you can see from the chart there was another big run from 2005 and into 2006, then again from 2009 to 2011 and finally in 2014. But these were all confined to the $10 to $30 trading range – no more 1500% rides.
Turning back to Ambarella and looking at quarterly earnings we’ve had some flat QoQ performances but AMBA revenues are more seasonal than OVTI so it hasn’t phased anyone. Right now Ambarella is basically doubling net income every year and is forecast to do that for this year and next. It’s hard to fight against those numbers. That being said let’s turn to valuation.
In high growth industries price/sales is a moving target. But it’s still worth knowing some of the anchor points. Established companies like QCOM, NVDA, BCOM trade at 3x sales plus or minus about 1/2 point. AMBA is trading at well over 10x estimated 2015 sales and 6x estimated 2018 sales (!).
What’s our conclusion?
At $3B the shares of AMBA are absolutely fully valued. It’s a great company, good story and solid stock. But where is your upside? They are a leader in the market but do you think it’s plausible that a company like Qualcomm could come up with something compelling to an important customer in this market? I do.
Yes we are short some AMBA. Not as a bet against the company but more as a hedge against our other long positions. We’re not on anybody’s “side” but rather using our experience to try to optimize our overall portfolio positions.
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