The Trade War Could Derail Ambarella's Turnaround Plans

Ambarella (NASDAQ: AMBA), which makes image-processing systems on a chip for a wide range of devices, lost nearly a quarter of its value over the past 12 months due to concerns about its tumbling sales, contracting margins, and competition from bigger chipmakers. The Trump administration's decision to ban the use of security cameras from Hikvision and Dahua, two of Ambarella's top customers, exacerbated the pain last year.

That pain isn't over yet. The New York Times claims that the U.S. government could put Hikvision on its "entity list" of companies, which means that U.S. companies like Ambarella would need to seek government approval before supplying the company with components.

Ambarella doesn't break down its revenues by customer, but Morgan Stanley analyst Joseph Moore recently warned that the chipmaker likely has "high-teens exposure" to Hikvision. That warning caused Ambarella's stock to tumble more than 11% on May 22.

Why security cameras matter to Ambarella

Ambarella once generated most of its revenues from GoPro (NASDAQ: GPRO). However, GoPro's sales have plunged over the past few years and forced Ambarella to diversify beyond action cameras with SoCs for drones, cars, and security cameras.

GoPro's weight on Ambarella's top line dropped to "immaterial" levels last year and cleared the way for other customers to fill the void. Unfortunately, that transition didn't go smoothly, as waning demand for SoCs for consumer electronics (like wearable cameras and drones) offset rising demand for SoCs for cars and security cameras. Here's how Ambarella fared over the past year:

Ambarella's revenue declines look horrendous, but it expects its revenue to decline 17% annually (at the midpoint) during the first quarter -- which indicates that its declines could be bottoming out.

Ambarella now expects two pillars to support its sales: the growth of its automotive business (which includes SoCs for dash cams and its new CV-series computer vision chips for semiautonomous and autonomous driving) and higher sales of SoCs for security cameras to Chinese original equipment manufacturers.

However, Ambarella's Chinese security camera business generates lower gross margins than its other businesses. The company's increasing dependence on that business for sales growth has already caused its gross margins to contract over the past year:

Ambarella expects that decline to continue with a non-GAAP gross margin of 59%-60% in the first quarter of 2020. If the Trump administration puts Hikvision on its entity list, Ambarella's revenue declines could worsen. Its gross margin might improve if it stops selling SoCs to Hikvision and Dahua, but the loss of revenue would likely offset those improvements.

Why Hikvision matters

The U.S. government is currently scrutinizing Chinese tech companies backed by the Chinese government. A Chinese state-owned company currently owns over 40% of Hikvision, which raises red flags regarding national and corporate security.

Despite those concerns, Hikvision still controls about a fifth of the world's security camera market. Transparency Market Research expects that market to grow at a compound annual growth rate of 12.7% between 2017 and 2025, which bodes well for Hikvision and its suppliers.

If the Trump administration bans Hikvision, it could lock Ambarella out of that growing market. It could also pave the way for additional bans on Ambarella's other Chinese customers, like Dahua and DJI Innovations, the world's biggest drone maker.

Another reason to avoid Ambarella

I've repeatedly warned investors to stay away from Ambarella. Its stock is ridiculously expensive at 65 times forward earnings, its revenue growth is negative, its margins are crumbling, and it faces tough competition from Intel across multiple markets.

The potential ban on Hikvision's products highlights two other big risks -- Ambarella's dependence on big customers and its exposure to the Chinese market. Investors should stay away from this stock until trade relations improve between the U.S. and China again.

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Leo Sun has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Ambarella. The Motley Fool has a disclosure policy.