No Blind Spots: Citron Is Wrong About Mobileye On Several Levels

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About: Mobileye (MBLY), Includes: GRMN, TMOAF
by: Krishna Sharma
Summary

Mobileye has seen a correction of 20% over the last month but the last couple of days have been excruciating after Citron Research set a $25 target.

The correction is excessive for Mobileye which beat street estimates on revenues and profits in its second quarter results and raised guidance for the full year.

Citron Research’s argument that Mobileye’s valuation is driven by self-driving cars doesn’t hold water but the bearish stance has worked well to make the stock more attractive.

ADAS presents a near-term opportunity and there is no scope for confusion that Mobileye has a competitive advantage when it comes to forward-facing camera technology.

Shares of active driving assistance systems (ADAS) specialist Mobileye (NYSE: MBLY) have corrected over 20% over the last month with major weakness in the last two days. Like the rest of the market, Mobileye was caught in the wider scheme of things, primarily involving negative new flow from China, but the last couple of days have been extraordinarily excruciating for the stock after Citron Research set a $25 target, indicating 50% downside from erstwhile levels.

Continuing with its tradition, Citron Research's assessment of Mobileye's valuation is a treat to read but has some gaps. Most important among these is the assumption that the stock is "riding the hype cycle of the self-driving car story". There is little doubt that some amount of autonomous driving premium was factored in the stock price before the crash, but that has vanished now and the stock price now largely reflects the prospects in the core ADAS business. More on this to come later after a brief snapshot of latest financial performance.

Prior to the recent correction, Mobileye had a decent run up on the bourses and as such, the price fall is in line with the adage of "what goes up must come down". However, the correction is excessive for Mobileye which not only beat street estimates on revenues and profits in its second quarter results but also raised revenue guidance for the full year. In short, Mobileye delivered a 57% jump in second quarter revenues. Sample this too, net income more than doubled to $23.7 million on non-GAAP basis which excludes share-based compensation expense. As one can guess, performance was solid on other important financial metrics such as operating margin.

While this financial performance is remarkable, it is only the beginning. This is amply clear through the upward revision of revenue guidance for the full year. From the earlier estimate of full year revenues being in the range of $217 million and $218 million, the company now projects top line will remain between $235 million and $239 million. This not only marks a jump of nearly 65% from 2014 levels, but also highlights that the uptick in demand of ADAS products is coming sooner than expected. Similarly, the company increased its non-GAAP net income guidance to a range of $105 million to $107 million, from the earlier estimate of $92.6 million to $93 million.

Regulations to drive growth

During the quarter, Mobileye confirmed that it was selected as a strategic partner to the VW Group's Future Automotive Supply Track (NASDAQ:FAST) program. While this selection does not add anything to Mobileye's order book, it is a testimony of the company's growing capabilities. Coming after the successful roll out of Mobileye's EyeQ3 systems on the Audi Q7, the supplier's selection to a group-wide program may herald bigger wins in future although the management is keeping a measured silence on this front as of now.

Without doubt, autonomous driving is another of Mobileye's area of interest which is already regarded as a mega trend by analysts. Autonomous driving and collision avoidance aren't vastly different functions and the former relies heavily on technologies like the latter. In varying degrees, these technologies are already here. For example, Ford's latest update of Mondeo sedan has semi autonomous features such as Pre-Collision Assist Technology with pedestrian detection. This Advanced Driver Assistance Systems would be available on a vehicle in the United States next year, the automaker has promised. As such, autonomous driving is the next frontier for Mobileye. However, the road for autonomous driving is a rocky one while ADAS presents a near term opportunity and there is no scope for confusion that Mobileye has a competitive advantage when it comes to forward-facing camera technology.

Without doubt, consumers want safer cars but prohibitively high cost of such technologies often put the ball in regulators' court to mandate a market-wide implementation at reasonable prices. The situation with ADAS technology is no different. More than anything else, regulations will be driving the uptick of autonomous driving over the next decade or so. For example, the Euro NCAP has made it clear that starting 2016, five-star rating will be reserved for vehicles equipped with cutting edge technologies such as Autonomous Emergency Braking (NYSE:AEB), pedestrian detection, and lane-departure warning. Back home, NTSB's recommendation to the safety watchdog NHTSA for making Collision Avoidance Systems as standard equipment on vehicles is a precursor to an eventual market-wide phenomenon.

It helps to have a regulatory support as adoption of advanced technologies can easily taper off if left entirely on consumer demand or the desire of automakers. Electrification of vehicle powertrains is a perfect example of this vulnerability.

Scalable business but margins

Unlike the regular manufacturing operations in the auto industry which pretty much have a linear relationship between revenues and costs, Mobileye is in a sweet spot. In this sense, Mobileye's business is highly scalable while allowing high profit margins. While margins in this business are cost-proof, they are subject to competitive pressures. It is not going to be a smooth ride for Mobileye in the sector. As with everything else highly profitable, competition will catch up eventually. As such, it is highly unlikely that Mobileye's famed 60% EBIT margins will remain unchallenged. However, it takes time and investment to develop competing products and bring them to even testing stage. Mobileye's competition including Bosch and Continental is currently busy developing their suit of products but there is no evidence to suggest any of these players making inroads in the space in the next 2-3 years. That's where Mobileye's first mover advantage comes in.

This is another point where Citron Research slips by describing Mobileye as a small fabless chip manufacturer which "just got there first". It is true that there are no barriers to entry for competitors (and the automotive industry has several deep pocket players), a lead time of three years is simply a bad choice for trivialization.

For investors, it is good that Mobileye management acknowledges this eventuality and is keeping an eye on competition. Investors still need to exercise caution as optimism and euphoria have a history of propelling stocks ahead of fundamentals. Here is an example of navigation device manufacturers Garmin (NASDAQ: GRMN) and TomTom (OTCMKTS: OTCPK:TMOAF) which spiked in late 2007 when the hype around portable navigation devices (PNDs):

Conclusion

Being the frontrunner in a rapidly growing space, Mobileye has tremendous potential and the recent analysis by Citron Research has done great work in killing the hype around self-driving. From the perspective of potential investors, it is difficult to see the recent price correction any other way than positive. There are few plays out there is the market which allow investors to participate in creation of new industry altogether. ADAS and self driving technologies are currently at a nascent stage but there is little room for confusion that just like lightweighing and better fuel efficiency, advanced safety is likely to attract lot of regulatory tailwinds going forward.

Equity markets tend to behave like voting machine in the short term so more correction in the stock is possible. However, Mobileye second quarter financial performance is solid evidence that the business is ramping up fast. With a wide target price range starting from $25 and going up to three digits in some cases, investors are spoilt for a choice and $45 doesn't look like a bad choice to start nibbling in.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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