Ambarella: Irrational GoPro Pairing Is Creating A Buying Opportunity

| About: Ambarella (AMBA)

Summary

It is clear that the market is struggling to decouple Ambarella and GoPro.

This pairing of Ambarella with GoPro, though, is short-sighted and neglects Ambarella's versatile product portfolio, which exposes the company to several high-growth opportunities non-related to GoPro.

Ambarella has significant versatility due to its proprietary and superior SoC technology, and we believe the company can maintain this advantage through continuing to lower power consumption.

We remain bullish on the body cam market in 2016, and think the dash cam market will follow suit in 2017.

We maintain a $66 fair value, and think the current $41 quote gives investors a significant margin of safety on the long side.

As Ambarella (NASDAQ:AMBA) shares continue to fall, we believe a compelling buying opportunity is presenting itself to investors. The market is clearly struggling to decouple AMBA and GoPro (NASDAQ:GPRO), but this pairing is short-sighted and neglects AMBA's versatile product portfolio. We would like to reiterate our claim from our previous article on AMBA, in which we stated the following:

"... AMBA's long-term growth is separate from the action sport market and GoPro. We see AMBA's more promising long-term growth prospects in the surveillance cam, dash cam, drone cam, and body cam markets."

In that article, we also expressed an expectation for further share price depreciation, as the prevailing sentiment was still very negative on AMBA. That share price depreciation has happened, and we now feel the stock price is too compelling (~$41) not to heavily add to our long position.

Weakness in the Action Cam Market

Admittedly, AMBA's outlook as it relates to the wearables space is bleak. GPRO faces increased competition from both smaller, low-cost players and bigger, high-quality players, neither set of which is inclined to use AMBA's SoCs.

The smaller, low-cost players will likely not use AMBA's SoCs because the cost is too high. These players will choose a lower-quality, lower-cost SoC to maintain margins. This creates the interesting scenario of compromising quality for cost, and we believe there are enough price-motivated consumers in this space to create GPRO product churn.

On the other end of the competitive spectrum, the larger, high-quality players will likely not use AMBA's SoCs because they don't need to. Due to smartphones needing a capable camera, companies like Samsung (OTC:SSNLF) and Apple (NASDAQ:AAPL) design their own SoCs. This axes out the necessity of AMBA as the SoC supplier.

This means that a significant portion of AMBA market share in the action cam space is at risk due to intensifying competition. Regardless of GPRO's brand relevancy and staying power, more competition, particularly more lower-cost competition, will force AMBA to lower ASPs on its lower-end SoCs, which will inevitably erode profit margins in that business.

We do think GPRO is a name that is here to stay given its brand relevancy. We also think the company has a chance to re-energize sales with its new drone, Karma. Therefore, despite its eroded profit margins, we do believe AMBA will continue to generate a healthy amount of profit from GPRO in the long term.

Multiple Market Exposure - Action Cameras Were Just the First

The pairing of AMBA with GPRO, though, is short-sighted, as the action camera market will shrink as a mix of AMBA's net profits over time. This is because AMBA has multiple market exposure to several seed-stage, high-growth potential markets.

We firmly believe that action cameras were just the first market to explode in the new-gen HD video capture space. We think other markets, like the body, dash, and drone cam markets will follow suit, and AMBA's revenue sources will become increasingly diversified. This diversification makes it an attractive long-term investment.

We believe this is what many investors are missing. AMBA has significant versatility due to its proprietary and superior SoC technology. This technology advantage allowed the company to benefit from a surging action camera market in 2014-15, and will similarly allow it to benefit from a surging body cam market in 2016-17, a surging dash cam market thereafter, and a surging surveillance cam market after that. AMBA's high-growth prospects have a long runway, because the company has a top-notch technology that lends itself to multiple high-growth markets.

As 2015 was the year of the wearable action camera, we see 2016 as the year of the body cam. A more in-depth explanation of why this is so can be found in our previous article. In short, a significant amount of law enforcement-related shootings in 2015, coupled with a highly socially aware Millennial generation that uses social media to shed light on civil issues has brought law enforcement integrity into question and put law enforcement agencies under the microscope. In this sense, the body cam market, which provides the most obvious solution to this issue, is driven by politically and socially charged undercurrents, and will benefit from growth synergies with an election year in 2016.

AMBA will benefit as it currently has superior SoC technology. Intensifying social and political pressures on law enforcement agencies to become more transparent will force swift action. Swift action means ordering thousands upon thousands of body cams quickly, which police departments across the United States and United Kingdom are already doing. The volume of these orders means these are not light investments, so the law enforcement agencies will likely be inclined to order the best product on the market. AMBA is leveraged here, because it creates the highest-quality SoC. For example, when TASER (NASDAQ:TASR) wanted to create a next-generation body cam, they built it on an AMBA SoC. That camera, the Axon Body 2, will have a big 2016. London has already ordered 22,000 of them.

We believe the argument extends to the dash cam market (which we see as taking off in the near future as visual automotive solutions grow in popularity), the surveillance cam market, the drone cam market, and any other HD video capture market. In essence, AMBA will continue strong growth as long as it makes an argument for possessing the best SoC technology on the market.

We might be nearing the high end of the HD video capture technology spectrum, but we believe AMBA can continue to separate itself technologically by lowering power consumption. The company's recent announcement of its low-power 4K UHD SoCs for sports and flying cameras is an example of this.

The Investment Takeaway

From an investment standpoint, weak wearables sales is a temporary headwind that has devalued shares to a 15.5x earnings multiple, markedly cheaper than the market's 20x P/E multiple, despite AMBA's significant sales and earnings growth.

The stock is currently trading at around 12x EBITDA, 4.5x sales, and 4.3x book, with $267.7 million in cash on the balance sheet and no debt. The capex-lite business has generated LTM free cash flow of $108.2 million on LTM operating cash flow of $109.7 million. This means the stock is now trading around a conservative 12x cash EPS multiple and sports an attractive ~8% FCF yield. We maintain that revenues should grow consistently into 2026, with LT revenue growth stabilizing around 5% per annum as the markets saturate. Even factoring in significant margin compression to a perpetuity operating margin of 22% as a result of lower ASPs, we still think this means shares are worth $66 today (the full model can be seen in previous article).

By our numbers, the current share price of $41 provides investors with a significant margin of safety. We are adding to our long position here, and believe the shares have nice upside as the politically and socially charged body cam market explodes in 2016. We expect the company to continue to benefit from its multiple market exposure over the next 5-10 years.

Disclosure: I am/we are long AMBA, GPRO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.