For those investors who bought into the worst of the OmniVision (Nasdaq:OVTI) news in late November, I salute your bravery. I was definitely tempted to take a flier on this stock, but chose not to and missed out on the subsequent 80% jump in the shares. As this most recent quarter demonstrates, though, conditions remain volatile and murky for this imaging sensor company.

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A Surprising (Partial) Rebound
OmniVision warned investors a little while ago that financial performance was going to be down as the company worked through lower demand and higher inventory. That said, the company managed to deliver better performance than it had expected.

Revenue fell 15% sequentially and 30% from last year, fueled by a 7% sequential drop in shipments and a 9% drop in average selling prices. Although the company did see better demand than it expected (apparently in tablets and entertainment devices), the demand was mostly in lower resolution products.

OmniVision paid for that higher percentage of lower resolution products in the margins. Gross margin fell about five and a half points on those lower margin sales and the burn-off of higher cost inventory. Operating income declined to just barely above breakeven.

Is the Recovery Underway?
OmniVision management seemed cautiously optimistic that business had turned. Although inventory overhangs are going to take their toll for at least one more quarter (and inventory stands at a very high $247 million), order growth did seem to re-ignite.

The question, though, is how much of those orders are, or will be, coming in the higher-end BSI-2 products (5 and 8 megapixel). OmniVision should now at least be in position to drive this product cycle and that should be good for revenue and margins.

That said, it's not exactly a brand new day. Sony (NYSE:SNE) secured a major design win with Apple (Nasdaq:AAPL) and that's just the reality of the situation. While OmniVision can certainly pick up business with other customers, to say nothing of win a slot in the next Apple iPhone (the "5"), competition is on the increase.

A Two-Horse Race or a Free-For-All?
What is the nature of competition going to look like going forward? Sony, Samsung, Aptina, Toshiba and STMicroelectronics (NYSE:STM) all want to get bigger in this space, and many are looking to compete on price now that they've closed the gap in terms of performance. That suggests that while BSI-2 can still be a significant product cycle for OmniVision, it may not be as big of a winner as past cycles.

If OmniVision is lucky, this will evolve into a situation with Sony akin to Altera (Nasdaq:ALTR) and Xilinx (Nasdaq:XLNX), where the companies trade off leadership between technology cycles and both make solid returns. The downside risk is that it becomes a more price-sensitive commodity-like market.

The Bottom Line
Even though I follow OmniVision fairly closely now, I still don't have a great sense of how to value this company on a cash flow basis. I do believe that revenue growth can recover in the years to come, but I still don't have a lot of confidence in what the long-term free cash flow conversion rate will look like. If this market becomes more of a duopoly, it's pretty likely that OmniVision can enjoy sustainable strong free cash flow. If it's more of a melee or maelstrom, then performance is likely to be much more volatile and lower overall on an averaged basis.

SEE: Free Cash Flow: Free, But Not Always Easy

Even with the major rebound in these shares, I don't think the stock is all that expense. At less than 1x fiscal 2013 revenue, free cash flow positive, and buying back shares aggressively, I think there's definitely value in the shares. As the past year has shown, though, there's also a lot of risk and unpredictability and that makes these shares unsuitable for a lot of investors.

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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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