OmniVision Showing Much-Needed Signs Of Improvement

By Stephen D. Simpson, CFA | May 31, 2013 AAA

The “up again, down again” story at OmniVision Technologies (Nasdaq:OVTI) rolls on, with the latest installment showing a sharp upward turn as the company's revenue and margins continue to show meaningful improvement. While OmniVision remains one of the market share leaders in the CMOS image sensor industry, that leadership has never meant stability or predictability and it probably never will. That makes this a tricky stock to recommend at almost any level – although these shares too look cheap, and may well ride the momentum of this positive quarter for a while, it's hard to believe that the market will ever fully reward the potential of this company.

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Ending The Fiscal Year On A Stronger Note
Many of OmniVision's numbers have been gradually improving for a few quarters now, and that improvement continued in the company's fiscal fourth quarter.

Management reported that revenue rose 54% for the quarter, with the company seeing a good mix of volume and price growth. OmniVision saw unit shipments rise 28% from the year-ago period, while ASPs rose for the 5th straight quarter.

Margins are still tricky, but they're moving in the right direction. While the GAAP gross margin declined substantially on a year-over-year basis, the adjusted gross margin continues to improve sequentially – up 60 basis points from the third quarter. Reported operating income rose about 250% this quarter, and was up more than 70% even on an adjusted basis.

SEE: How To Decode A Company’s Earnings Reports

A Big Boost To Guidance, But Will It Last?
The biggest story coming out of OmniVision's quarter was management's substantial upward revision to guidance for the next quarter. Against a prior Street average estimate of $345 million in revenue, management guided to a range of between $355 million and $390 million. Likewise, management continues to expect ongoing margin improvements, as the forecast EPS range of $0.35 to $0.52 was well above the pre-report sell-side average of $0.29.

One of the issues for OmniVision has been the impact of product launch cycles on the company's revenue and margins. Winning, or losing, a slot with a major company like Apple (Nasdaq:AAPL) to a rival CMOS company like Sony (NYSE:SNE) has historically had a very large impact on results. More recently, though, the company has seen more design wins with mid-tier and lower-tier Chinese companies like HTC and Lenovo (Nasdaq:LNVGY). While this isn't necessarily great for selling the highest of the company's high-end products, it has improved volume and may help reduce some of the volume volatility.

Margins Still A Work In Progress
Although OmniVision has been reporting higher gross margins recently, they're still quite low on a relative historical basis. Improving these margins remains a priority for management.

Selling more chips (and more higher-end chips) would be a step in the right direction, but there's only so much management can do about that. To that end, the increasing ASPs are a positive sign, but this is a market (not unlike touch controllers for Atmel (Nasdaq:ATML) and Cypress (NYSE:CY)) where I expect ongoing price erosion/competition to be considerable.

OmniVision has also turned to its partners to address its COGS structure. The company negotiates with Taiwan Semiconductor (NYSE:TSM) on an ongoing basis for wafer and die prices, and with a lot of the start-up costs for BSI-2 taken care of, better pricing here should be possible. I'm also curious to see whether the company will play hardball – OmniVision has a second-source agreement with PowerChip, and though I don't believe the company wants to leave TSMC (they're a very good fab partner), they represent a fair bit of business to the fab and I don't believe TSMC wants to see that production capacity sitting idle.

SEE: The Industry Handbook: The Semiconductor Industry

The Bottom Line
While I've liked OmniVision for some time, this is a hard stock for me to like enough to buy with my own money. Clearly this stock can do well for periods of time, but the reality is that I'm not so deficient in alpha-generating ideas that I need the hassle and headache of owning a stock like OmniVision.

For all of the turbulence, OmniVision has grown its revenue at a trailing CAGR of about 18% over the past decade. A forward revenue growth forecast of between 4% and 5% doesn't seem too demanding then. Predicting the cash flow is considerably more challenging, though, as cash flow has been both volatile and weak for most of the past decade. As a result, I don't expect free cash flow (FCF) margins to move past the mid single digits. All of that works out to an implied fair value of $24 per share, which is well above even the pre-market indication for the stock (which seems ready to move up strongly after this report). As I've said earlier in this piece and many times before, OmniVision does look undervalued by the market, but that undervaluation comes at the cost of considerably unpredictability and volatility in the business itself.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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