Smoke Starting To Billow From The OmniVision Story

By Stephen D. Simpson, CFA | November 09, 2011 AAA

For some time now, I have thought that the bears had it wrong on OmniVision (NASDAQ:OVTI) and that even if the company was losing some of its technological lead over Sony (NYSE:SNE), Aptina and STMicroelectronics (NYSE:STM), the stock was still too cheap relative to its prospects and cash on the balance sheet. As it turns out, though, those wisps on the horizon weren't just clouds, but actual smoke, and it seems like OmniVision may have a very real problem on its hands.

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The News Is Getting Worse
OmniVision didn't exactly have investors excited with its last earnings report in August. At that point, the company talked about some product delays and revised revenue guidance lower - due supposedly to problems with tablet customers.

As it turns out, the company did not go nearly far enough. OmniVision announced on November 7, 2011 that it was once again revising guidance lower, taking the numbers for the next quarter down another 20% or so to a range of $212 million to $217 million, a steep fall indeed from the $300-million-plus level of not so long ago. Making matters worse, the company was fairly cryptic about the reason - simply referring to "unexpected cutback in orders for certain key projects."

Is Apple the Core of the Problem?
There was already a fire burning out there in the bear camp that OmniVision was in the process of losing its valuable Apple (Nasdaq:AAPL) iPhone slots to Sony. In fact, a teardown by Chipworks indicated that Sony did get the image sensor slot, before follow-up information seemed to suggest that it might be a dual-source situation where any particular phone could have either Sony or OmniVision. Given that OmniVision had once had that slot all to itself, even dual sourcing is a loss. (For additional reading, check out How Should Apple Spend Its Money?)

Now the company has thrown gasoline on that fire. With that big decline in orders, it looks like OmniVision is definitely seeing less Apple business. That may not be the whole of the story, though, as the generally poor sales of Research In Motion (Nasdaq:RIMM) Blackberry products isn't helping sales right now either.

Is This Just the Beginning?
The optimist has a few handholds left. For starters, OmniVision's technology is pretty good and end-user customer expectations are getting higher and higher. It is also worth pointing out that chip slots can be fluid; if OmniVision can resolve some delays in next-gen products, the balance of Apple's business could come back. What's more, this revenue revision may not be wholly due to "slot loss" with Apple - word started leaking out Wednesday that Apple may have started reducing orders to component suppliers after iPhone 4S sales slowed meaningfully from the launch period. If that's true, it's certainly not a positive for OmniVision, but it doesn't damage the bull thesis on these shares quite so much.

On the other hand, competitors are always waiting for an incumbent to stumble and Sony will likely fight like a cornered weasel to keep this slot. What's more, there's a bigger issue for OmniVision - namely, that outside the iPhone, it has not been able to get itself into very many top-tier popular phones. That simply has to change; OmniVision cannot afford to be so dependent on Apple and needs to find a way into Google (Nasdaq:GOOG) Android phones from Samsung, Motorola Mobility (NYSE:MMI) and HTC, to say nothing of future phones from the likes of Nokia (NYSE: NOK).

A Warning For Others
I can't help but think of Atmel (NASDAQ:ATML) when I read this OmniVision news. One of the bull-bear debates on Atmel is whether this company is losing (or about to lose) touch controller slots to rivals like Cypress Semiconductor (NASDAQ:CY) and Texas Instruments (NYSE:TXN). As the OmniVision story shows, the consequences can be severe and it should be noted that both Atmel and OmniVision have been touted as technology leaders in their respective niches. Clearly, trouble at OmniVision proves nothing about Atmel, but investors need to appreciate the risks. (To know more about bull and bear market, read: Where did the bull and bear market get their names?)

The Bottom Line
I still don't believe that OmniVision is doomed and/or that this is the beginning of a slide into irrelevance. Then again, I saw the Genesis Microchip story play out (eventually it was acquired by STMicroelectronics), so I cannot rule that out entirely. As it stands now, though, OmniVision has a lot of cash, good technology and still some foothold with Apple.

There is no question that there is a lot of risk in this story. If sales snap back promptly, the stock will rebound sharply and some of these concerns may ease. Even with modest growth expectations, the stock looks too cheap, but bears will certainly argue that "modest growth" may be excessively optimistic. I wish I had a more definitive buy/hold/sell call to make, but all I can say is that while this is an intriguing valuation for good technology, running into a burning building seems too risky for me.

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

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