Is Ambarella A Buy After Earnings?

Summary:

• Ambarella operates in buzzword areas, but its growth has slowed.
• The company is generating losses and shows pro forma income only after adding back stock compensation.
• The stock is likely to go down as employees keep selling shares.

Introduction

For the last few years, success in the stock market has followed a simple formula for companies. Add a few buzzwords (e.g., AI, cloud, cyber, autonomous, IoT) to what you do. Pay your people handsomely in stock rather than cash. Pretend these stock payments are not an expense. Report growing non-GAAP income. Gather an increasing number of investors who are willing to believe your fictional profits, and to whom your employees can sell their stock.

It doesn’t take much to realize that the above game has to end at some point. And this is the year it is ending, as the Federal Reserve raises interest rates and the government is wary of pumping any more stimulus into the economy with inflation raging. Stock prices, always a function of supply and demand, now face increasing supply and lackluster demand.

Company Background

Ambarella (NASDAQ:AMBA) is a fabless semiconductor company that develops solutions for video compression and image processing. Its products are used in cameras – in cars, for security, in industrial applications, in drones, and in virtual reality products. Not a bad space to be in.

The company was incorporated in 2004 and is based in Santa Clara, CA. 88% of sales last year were to customers in Asia. A distributor named Wintech accounted for 62% of revenue and Chicony, an electronics manufacturer, accounted for 13%. Most of the company’s products are made by Samsung and a small portion by GlobalFoundries.

The company’s competitors include Huawei, Nvidia (NVDA), Qualcomm (QCOM), Omnivision, Intel (INTC), NXP (NXPI), Texas Instruments (TXN) and a bunch of smaller players.

External Ratings

The company’s SA quant rating is 2.6, between a sell and a hold. Looking at its factor grades, it garners a D+ for valuation, A- for growth, C+ for profitability, C for momentum and D+ for earnings revisions. Not a pretty picture, but apparently not the same one Wall Street analysts are looking at. They have a composite rating of 4.3 on it, between a buy and a strong buy. I would not pay much heed to their opinion as they have been uniformly positive on the stock even as it has lost half its value this year. They also seem to ignore the company’s substantial stock compensation in their analysis.

Financial Overview

For the year ended January 31, 2022, the company generated $332 million in revenue and an operating loss of $30 million. Revenue was up a good 20% compounded over the prior two years.

The company currently has 38 million shares and a market capitalization of $3.2 billion, with no debt and $200 million of cash. It thus has an enterprise value of $3.0 billion.

The balance sheet is clean, and the cash flow statement shows nothing amiss. The company reports non-GAAP net income by excluding a large amount of stock compensation ($88 million last year, heading to more than $100 million this year).

For this year, expectations are for modest revenue growth of 6%, with a decrease in profitability as the company continues to increase spending. Note that the analyst estimates are for non-GAAP EPS, ignoring more than $2 per share of annual stock compensation. I would regard the revenue growth expectation of 24% for next year to be quite aggressive and expect this to come down over time.

The company’s recent results for the first quarter were in line with expectations, but its guidance for the next quarter was weak, with the company blaming lockdowns in China.

AMBA Valuation: Fair Value Of $45 Per Share

I will assume that the company can do $400 million of revenue next year. Although I expect the company to be at best at a break-even level, I will assume a normalized operating margin of 10% (up from the current -10%). That would generate $40 million of operating income, or $1 per share if no tax is assumed (as the company has a lot of net operating losses for tax purposes). I will put a generous multiple of 40x on these earnings and add back $5 of excess cash for a fair value of $45 for the shares.

I believe there is substantial downside from the current $83 share price and recommend that investors not buy the stock. Intrepid ones with a balanced portfolio can consider shorting the stock. A lower risk alternative is to buy the $80 strike puts a few months out.

In terms of comps, Qualcomm (QCOM) and Intel (INTC) trade at 15x next year’s GAAP earnings, while Nvidia (NVDA) is at 35x.

Share Price History

The stock was steady at about the $60 level for many years until it started going up towards the end of 2020 as the company showed good revenue growth. Then it took off in 2021 amidst the retail trading frenzy, more than doubling during the course of the year, reaching a peak of a little above $200. This year, it is down more than 60% as the company’s growth is projected to decline and investors punish poor earnings quality.

Risks Are High, But Manageable

The biggest risk to a short position here is the company being acquired by a competitor. Many are substantially larger and may not mind the hit of buying a profitless company for a couple of billion dollars. This is a risk that needs to be diversified by holding a large number of short positions.

The short interest is low (~4% of outstanding shares and float), but the chances of a short squeeze are not minimal. The company has the cash to buy back 6% of its shares at the current price.

The company may surprise us by increasing its revenues and margins much more than projected.

Investors may decide to pay higher multiples for growth stocks, and continue to ignore expenses like stock compensation.

Pre-emptive Disclosure

Writing a short thesis on a stock on a public forum is an invitation for blowback from holders of the stock. I welcome respectful comments from eponymous readers. Please desist from hurling insults from behind a veil of anonymity.

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Disclosure: I/we have a beneficial short position in the shares of AMBA either through stock ownership, options, or other derivatives. 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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