Why Ambarella Inc. Stock Growth Is No Sure Thing

Investors have good reasons to be optimistic about Ambarella's (NASDAQ: AMBA) business. After all, the camera tech specialist owns valuable semiconductor design properties that could earn it an early leadership position in attractive markets including automotive, computer vision, drones, and wearable devices.

That vast addressable market supports the company's premium valuation. Even after a double-digit decline so far in 2017, Ambarella is priced at 30 times earnings, compared to a P/E of 24 for the broader market.

It's far from a sure thing that the company will grow into that valuation, though. Here are few reasons why the stock could continue underperforming from here.

Questionable growth

Ambarella has a diversity problem that it can't seem to shake. Its business has been highly reliant on the consumer market for sports cameras, with one company, GoPro, accounting for a huge proportion of the business.

This weakness isn't simply a matter of giving the management team time to bulk up its product lines. Instead, it's a more fundamental question centered around whether Ambarella can extend its leadership position into new fields. The early results aren't bullish on that score. The company failed to earn a place in DJI's hit Spark drone even though the device targeted exactly the type of high-definition, low-power properties that Ambarella's camera platform promises.

Unless it can become a compelling standard in these niches, the company can't hope to benefit much from their growth. In fact, Ambarella recently lowered its growth outlook, in part because of weakness in the drone segment.

Declining margins

The company understands that its design properties and engineering abilities form the basis for its competitive edge. That's why Ambarella devotes a whopping 33% of sales toward research and development. As management explains in its 10-K, "our continued success depends on our ability to both introduce improved versions of our existing solutions and to develop new solutions for the markets that we serve."

Consistent wins in these areas are needed to fend off the competition and offset the industrywide trend of falling prices for semiconductors. Otherwise, management warns, "our gross margins and financial results will suffer."

While its business is still young and volatile, Ambarella's recent financial results suggest that it is struggling to churn out technology that's in high demand among device manufacturers. Gross profit margin dropped to 63% of sales last quarter from 67%. and operating income dove by 40% to below $6 million.

Earning that premium valuation

The good news for investors is that many of Ambarella's customers, particularly in the home and commercial security niches, are still snapping up its camera platform. Its formidable assets also include a highly skilled team of engineers that's been responsible for major advances around image capturing, encoding, and delivery.

These employees have been working for years at potentially game-changing advances on both the hardware and software sides of the industry. Ambarella is unveiling one promising result of its continued efforts, its new computer vision chip, at the CES show in January.

Executives believe this chip will be just the first in a long line of generational releases that serve what should be a large, growing market. Investors won't know whether that prediction is right until they see sales of the release contribute to a return to revenue gains and expanding profitability as early as fiscal 2018.

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