Ambarella's Price Target Hiked 41.5%: What You Need to Know

In just twoshort days, Ambarella(NASDAQ: AMBA) will report its fiscal Q2 2017 earnings. What should you expect when it does?

My fellow Fool Steve Symington has a few thoughts on that score, and early this morning, the analysts at Portland, Oregon-based Pacific Crest Securities offered investors a few more. Reiterating their recommendation to overweight (i.e., buy) Ambarella stock, Pacific Crest announced this morning that they are hiking their target price on Ambarella shares -- all the way from $53 a share to $75.

Now, Ambarella stock is down 26% over the past 52 weeks, and owners of the stock today are hurting. But if Pacific Crest is right about its prediction, this implies that new investors could enjoy as much as a 41.5% profit from buying the stock today.

Is Pacific Crest right, though? Here are three things you need to know.

The drones are coming -- and they're bringing profits to Ambarella. Image source: Getty Images.

1. 50% more opportunity, 41.5% more profit

The first thing you need to know about Pacific Crest's excitement over Ambarella is that it's not just Ambarella they're excited about. Ambarella, you see, makes semiconductor chips that enable high-definition video capture, sharing, and display, and these chips can be used in a wide array of devices. The ones that are particularly attracting Pacific Crest's notice this morning, though, are chips used in drones, and in action camerasmade by companies like Ambarella customer GoPro (NASDAQ: GPRO).

As explained in a write-up on this morning, Pacific Crest sees GoPro offering no fewer than three new types of action cameras to holiday shoppers this year, up from a previous expectation of just two -- a 50% increase. And with Ambarella's chips sitting inside those cameras, Pacific Crest sees this adding up to (nearly) 50% better profit potential for Ambarella stock.

2. The drones are coming

"Huge holiday builds" of specialty drones with video cameras "are coming," says Pacific Crest, adding, "we expect a rush of new products for the holiday, many of which at lower price points and from new entrants to the space." This should build on Q2 sales for Ambarella that have already been "in line with expectations," and give "tailwinds to Ambarella's October quarter" as well.

At least, it should if consumers can be enticed to buy all of these new drones that are getting built.

3. There's no reason for Ambarella stock to be down this much

That's really the upshot of Pacific Crest's endorsement today. According to the analyst, "Ambarella has consistently outexecuted expectations since going public, and we expect the same this quarter. Ambarella has exceeded revenue andearningsexpectations by an average of 4.8% and 29.2%, respectively, over the past 13 quarters." And given this strong outperformance, and the bright prospects for drone sales -- and camera sales, and Ambarella chip sales -- the analyst doesn't see any good reason for Ambarella stock to be selling for 26% cheaper today than what it cost a year ago.

To the contrary, Pacific Crest thinks the stock should go up.

The most important thing: Valuation

But is the picture really as bright as Pacific Crest paints it? True, Ambarella may be outperforming expectations, but that doesn't change the fact that sales at the chipmaker were down 20% year over year in Q1. And even if the analyst is right about Ambarella's sales being "in line with expectations" in Q2, those analyst expectations, at last report, called for a another declining sales quarter -- this time, down 24% (according to Yahoo! Finance data).

Meanwhile, while Ambarella stock is selling well off its highs today, the stock still doesn't look particularly cheap. Valued at $2.4 billion in market capitalization, the stock sells for 40 times earnings today. Granted, Ambarella has a lot of cash on its balance sheet, generates strong free cash flow, and has no debt to speak of, so a more charitable view of the stock's valuation might be to say that it sells for an enterprise-value-to-free-cash-flow ratio of less than 18.

But even looked at thusly, according to the most recent reports from S&P Global Market Intelligence, most analysts who follow Ambarella stock predict no more than 14% annualized profits growth for the company over the next five years. That's a respectable rate to be sure, but perhaps not enough to justify an 18 times EV/FCF valuation. And that is certainly not cheap if Pacific Crest turns out to be wrong, and Ambarella's sales and profits continue to decline, instead of increase.

I agree with the analyst's major thesis that the drones are coming. I just don't think they're coming soon enough, or carrying enough profits, to make Ambarella stock a buy.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he currently ranks No. 295 out of more than 75,000 rated members.

The Motley Fool owns shares of and recommends Ambarella and GoPro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.