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There is much to be excited for Apple (AAPL), as shares trade at all-time highs, supported by anticipated strong sales stemming from pent-up demand for the next iPhone. Its launch will most certainly renew profit growth, in contrast to its 26% sales drop in Q2 over Q1. In Q2, Apple sold 35 million iPhones.

The expected success for the next iPhone will not necessarily imply a higher share price for suppliers, and notably OmniVision Technologies (OVTI). When OmniVision reported earnings, the company sacrificed profit margins for the purpose of securing a contract with Apple. Higher inventory, inventory write-down, lower margins, and higher research and development costs are reasons investors should avoid OmniVision shares at this time.

Quarterly Earnings Summary

OmniVision reported in its Q1 fiscal 2013 results:

  • Revenue of $258 million
  • Shipment of 166 million units, up from 147 million (or 12.9%) from the previous quarter
  • Average selling price of $1.55, up from $1.48 (or 4.7%) from the previous quarter
  • Gross margin of 19.5%
  • Cash balance of $237 million, down by $94 million
  • GAAP net income of $2.3 million or $0.04 on a per diluted share, compared to $2.7 million or $0.05 per diluted share in Q4 of fiscal 2012
  • Inventory increase of $111.9 million to $403.2 million
  • Accounts receivable of $142.7 million, up 32.4%

OmniVision's headline GAAP earnings excluded expenses related to stock-based compensation. The company had an operating loss of $682,000, compared to an operating income of $3.4 million in the previous quarter.

Quarterly Forecast

OmniVision provided the following forecast for its next quarter:

  • Revenue of between $335 million to $390 million
  • Expected GAAP EPS in the range of $0.06 to $0.22 per diluted share
  • Non-GAAP earnings in the range of $0.21 to a $0.37 per diluted share

Analysis of Results

OmniVision increased its inventory to a level that is nearly half its market capitalization. The company believes demand will be strong, particularly in the mobile phone market. Unit shipments and prices increased in the quarter due to the product mix shifting from 5 megapixels to 8 megapixels. 37% of total shipments were still 2 megapixels, and 31% were for 1.3 megapixels. OmniVision benefited from low-cost smartphone sales in the Far East for the 2- and 3- megapixel sensors.

During the quarter, a new BSI-2 base HD sensor was released, adding to the line-up of OV ADA 25, OV9724 and OV2722 sensors released over the last several quarters. In the future, the company will have an OV12830 12 megapixel one-third inch sensor.

Despite advances that would broaden its product line, OmniVision expects gross margins to decline next quarter due predominantly to production costs for the BSI-2 sensors. Another concern for investors is that day sales were 178 due to a mismatch between capacity ramp up and customer demand. Day sales outstanding increased to 51 days, up from 44 days in the previous quarter.

OmniVision is sacrificing improving margins for higher sales volume for BSI-2 sensors. By purchasing more material to build inventory, risk is increased for shareholders if customer demand weakens. Another inventory write-down is possible.

Sensor sales are still a small part of the PC market, but the weak Ultrabook market adds to another reason to avoid OmniVision at current levels. For example, Intel (INTC) confirmed that the PC market was weakening, when it lowered revenue guidance. In its news release, Intel said that revenue will be $13.2 billion, down from a previous guidance of $13.8 billion to $14.8 billion. Intel customers were reducing inventory in their supply chain.

Conclusion

Revenue is expected to improve on demand for BSI-2 based sensor, helped by a new Apple iPhone release. OmniVision is taking much of the risk in Apple's smartphone product refresh, and is doing so due to a goal of higher record revenue at the cost of record low margins. The company has experience in managing inventory risks, but OmniVision still needs to reduce its high-cost structure before earnings improve. The cost reduction effort will likely take more than one quarter. Its share price reflects otherwise. Shares are already up 65% from its 52-week low, though it is 20% below its 52-week high. Further upside will only be justified if OmniVision is able to negotiate better terms of margin. Until then, shareholders are holding all of the risk.

Source: New iPhone Release: Avoid This Supplier