Better Bad News Buy: GoPro Inc or Ambarella Inc?

Shares of action camera maker GoPro and its image processing chip supplier Ambarella have each declined about 40% over the past three months on concerns about slowing demand for wearable cameras. The market downturn exacerbated that pain, as their high valuations further spooked investors.

Source: GoPro

Granted, GoPro stock was looking bubbly when it soared over $90 per share last October with a forward price-to-earnings of nearly 200 times. The same can be said about Ambarella in June, when it traded at around $120 with a forward price-to-earnings of nearly 60 times. But now that both stocks have fallen out of favor, is it time for investors to swoop in at more reasonable valuations?

GoPro: Growth beyond action camsGoPro has the first-mover's advantage in the action camera market, which Research and Markets forecasts will grow at a compound annual growth rate of 22.2% between 2014 and 2019. The company's early entry enables it to control over half of the global action cam market, according to IDC, while its rivals fight over single-digit market shares.

Despite fears that better smartphone cameras and cheaper devices would hurt GoPro's growth, the company's revenue soared 72% annually last quarter -- up from 54% growth in the first quarter and 38% growth in the prior year quarter. That growth was fueled by the launch of two new devices -- the HERO+ LCD and HERO4 Session. GoPro isn't expected to launch a new device during the third quarter, yet it still expects revenues to rise 56% annually.

Looking ahead, GoPro will likely launch a new flagship camera and consumer drones next year, which should respectively boost and diversify its top line growth. New investments in virtual reality software and a cloud platform should increase the amount of content shared to the GoPro Network, the crux of its media expansion efforts. The GoPro Network not only serves as a content sharing site but also as free advertisement for its products.

Ambarella: Big threats aheadAmbarella SoCs process high-definition video for a wide variety of devices, including security cameras, in-dash cams, action cameras, and drones. Orders from GoPro account for about a third of its top line. Robust demand for GoPro devices and other products boosted Ambarella revenue 79% annually last quarter -- up from 73.5% growth in the first quarter and 25% growth in the year-ago period.

Those numbers look solid, but investors are concerned that Ambarella customers could start buying mobile SoCs based on smartphone chipsets instead of its dedicated image processing SoCs. Evidence of this shift can be seen in Ambarella's loss of a bid to Qualcomm, the largest mobile chipmaker in the world, to supply SoCs for action cam maker 4GEE. Qualcomm's development of SoCs and cameras for consumer drones has also cast a long shadow over Ambarella's future in that growing market.

Qualcomm's Snapdragon Cargo drone. Source: Qualcomm

Morgan Stanley analysts believe that on their own, mobile SoCs remain less cost-effective than Ambarella's SoCs. But if mobile SoCs are integrated with cellular capabilities, they actually become cost-effective for devices like the 4GEE camera, touted as the world's first 4G action cam. This means that if action cam and drone makers like GoPro make cellular connections standard for their devices, Ambarella could be crushed by the competition.

Earnings growth and valuationsBoth GoPro and Ambarella have stellar bottom-line growth. Last quarter, GoPro's net income rose 277% annually as Ambarella's surged 148%. But to decide which stock is actually "cheaper," we should compare their valuations.

GoPro currently trades at 20 times trailing earnings, which is slightly lower than Ambarella at 23 times. Looking ahead, GoPro trades at just 16 times forward earnings, which is again lower than Ambarella at 19 times. The S&P 500, by comparison, currently trades at 16.5 times forward earnings.

The 5-year PEG ratio tells us how "cheap" a stock is based on long-term analyst estimates. A ratio under 1.0 means the stock is currently undervalued. GoPro easily passes that test with a 5-year PEG ratio of 0.65, based on Thomson Reuters estimates, while Ambarella fails with a ratio of 1.16.

The winner: GoProIn my opinion, GoPro is a better investment than Ambarella thanks to its dominant brand, growth potential, and cheaper valuation. It faces lots of hungry competitors, but none of those rivals have taken a meaningful bite out of its business yet.

Ambarella, on the other hand, faces the disruptive threat of Qualcomm, MediaTek, and other massive mobile chipmakers searching for growth in action cams, drones, and other rising niche markets. If GoPro gets lured away by those competitors, Ambarella could be in serious trouble.

The article Better Bad News Buy: GoPro Inc or Ambarella Inc? originally appeared on Fool.com.

Leo Sun owns shares of GoPro. The Motley Fool owns and recommends Ambarella, GoPro, and Qualcomm. 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.