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Tickers in this Article: OVTI, SNE, AAPL, STM, DELL, HPQ
Sometimes where there's smoke there's fire. Imaging chip developer OmniVision Technologies (Nasdaq:OVTI) has been an uncommonly controversial stock for most of its history, with recent worries focusing on whether the company was facing share loss to Sony (NYSE:SNE) and Toshiba at Apple (Nasdaq:AAPL). Now that the company has given very disappointing guidance for the next quarter, those worries have ratcheted up to a fever pitch. OmniVision shares are almost certain to be punished too far, but it will take a patient and aggressive investor to step up and fight the tide.

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A Few Blurry Spots in First Quarter Results
Although OmniVision met expectations for the first quarter (and earnings actually beat by a bit), it wasn't a uniformly clean quarter. Revenue did jump 43% from last year's level, with sequential growth coming in at 7%. Shipments climbed about 1% sequentially, with ASPs up about 5%. Given that laptop/notebook computer shipments haven't been all that strong, it seems fair to assume that OmniVision's growth is coming from other product categories like phones, tablets and gaming devices.

Profitability is where OmniVision's quarter gets more troublesome. The company did report what looks like strong gross margin momentum, as margin increased almost five points from last year and one point from the last quarter. Quality is the issue. Gross margin was boosted by increased sales on written-down merchandise and lower inventory allowances.

Why is This Problematic?
Some companies are known to take excessive writedowns during strong quarters (artificially lowering margins/earnings) and then reap the benefits when results weaken. I'm not accusing OmniVision of doing anything illegal or shady, but investors should realize that this is how some analysts and investors may interpret these results.

In terms of operating performance, OmniVision did better. Operating income more than doubled from last year and rose 13% sequentially. It was interesting to see the sequential decline in SG&A expenses (roughly 12%), though, and that certainly helped matters.

Guidance Becomes a Big Worry
OmniVision's guidance for fiscal Q2 chilled the Street. Management is now looking for $255 million to $275 million in revenue, well below the $303 million average estimate. EPS estimates are likewise heading much lower based on that guidance.

Management is claiming that the guidance revision is fueled by uncertainty in the notebook computer market, and that certainly syncs with what companies like Dell (Nasdaq:DELL) and Hewlett-Packard (NYSE:HPQ) are saying.

Momentum and Market Positioning Concerns
Unfortunately, investors also will interpret this as a referendum on the company's momentum and market positioning in smartphones and tablets. Even if the reality is that phone and tablet sales outside of Apple, Samsung and HTC are lagging, investors will interpret this as a sign that the company is losing momentum to Sony, Toshiba and perhaps STMicroelectronics (NYSE:STM), Sharp and Aptina as well.

Making matters worse, the development and roll-out timeline on OmniVision's new BSI-2 chip is stretching out, making it more likely that the company will not have the BSI-2 ready for the Apple iPhone 5 launch (and will have to make do with the BSI-1 at first). That likewise spooks investors - will Apple turn to Sony to fill the gap? Will Apple decide that OmniVision is not a reliable partner and design it out of future releases?

The Bottom Line
I don't expect OmniVision bulls to be happy with the rumors, innuendo and accusations that I included here. To be sure, I do not believe that OmniVision is a bad company or is run by dishonest management. I do believe, though, that there are some concerns that investors cannot afford to ignore. Too much is at stake with the Apple relationship (in investor perception if not actual profits) to be sanguine about the BSI-2 delays.

Still, the stock has been squashed to what looks like an extreme level. Consider this - if OmniVision does $1 billion in revenue this year (the company did $956 million last year) and converts 10% of that to free cash flow (the company's free cash flow margin was 13% last year) and then never grows again, the stock is still worth almost $20 when including the net cash on the balance sheet and discounting the cash flow at 12%.

Intriguing But Risky
The bears will still say that's too optimistic - the discount rate should be higher, and the assumption should be for declining revenue and falling margins. Thus far, though, there is no reason to believe that OmniVision is destined to wither away. If the company can continue to grow (even if not at the rates formerly predicted), the stock is an intriguing, albeit risky, proposition. (For additional reading, see A Primer On Investing In The Tech Industry.)

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