Update on Omnivision

This stock is always interesting. Margin buyers beware.

Ok, you might recall that I predicted last week that Omnivision Technologies (OVTI) would slightly exceed estimates for the quarter just past and would increase guidance significantly for the current quarter. I'm happy to report that this is, more or less, what happened during their earnings call this past Friday (June 16).

(For last quarter, revenues beat Street estimates by 5.5%, and earnings exceeded Street estimates by about 2.5%. For the current quarter, OVTI estimated that it would beat Street estimates of revenues by 4-11%, and beat Street estimates of earnings by 4-13%. [And if, as it has the last few quarters, OVTI performs better than it says it will in its estimates, the upside will be even higher]).

Moreover, the normally cautious CEO forecast "a return to solid sequential growth in the July quarter, throughout the second half of calendar 2006 and beyond."

Sounds great, right? Think again. I am unhappy to report that the stock has lost a whopping18.6% of its value since the earnings call (Update: but recovered a small bit on Wednesday).

So what's going on? Well, I'll try to make this factual, though it will be quite obvious where I stand on this matter.

The morning after earnings, two analysts - one from Neeedham, one from Baird - published concerns about margin erosion/falling prices, a supposed glut of handsets in Taiwan, and over-concentration of business in China - all of which, in their view, augured poorly for the company and its stock. These same two analysts, interestingly enough, did not downgrade their rating on the company and in fact raised their guidance based on the upbeat forecast given during the earnings call. Making matters even stranger is the fact that the first 2 of these 3 issues were specifically dealt with in great detail during the earnings, and management explained exactly why they should not be cause for concern. The third issue was brought up as an analyst (seemingly) innocuously asked how much of the company's business for the quarter had been in China. It was not at all clear where he was going with the question and what he thought of the answer - did the 28% (as compared to 20% the previous quarter) in China concern him or please him? Well, he didn't ask a follow-up question, so - conveniently enough - management was not given an opportunity to respond to the matter.

Now, that same Friday morning, Morgan Keegan and Merriman came out positively. In their view, the earnings call went very well and, to put is simply, the future looks bright. (Indeed, anyone who listened to the conference call cannot help but note that virtually every questioner congratulated management on a succesfull quarter and, often, on the promising guidance as well). Over the weekend, JPMorgan reiterated its positive rating on the company and, given the precipitous dop in price, named it one its top 3 recommendations in the sector. JPM also wrote about a response from OVTI management saying, essentially, that the theories leading to the negative evaluations were based on false assumptions. Earlier today, AMTech research put out a note consistent with JPM's. Here are excerpts from the JPM and AMT notes.

JPM

We conducted a one-on-one post earnings conference call with theOVTI CFO, post
earnings.
• Unsurprisingly, the company is disappointed by the market reaction to its F4Q results and guidance. OVTI believes it is winning market share in all handset segments, though particularly strong in budget (VGA) and high-end (2MPx). Handset inventory issues in Asia, if they are happening, are not related to the cameraphone subset of the market, in their view. On the contrary, OVTI believes the camera-phone products may be causing slower sell through of standard (non-camera) handsets. In other words, ovti believes the market is misreading their situation, confusing it withother handset component suppliers in Asia.
• OVTI stated on the conference call that 28% of sales are into China. However the company cannot determine which handsetsthe product is incorporated into, nor where the product finally gets shipped. Hence, it is not appropriate to conclude that its business is increasingly focused on emerging markets (market sees related risks to gross margins).

AMTech

OVTI: OmniVision: Concerns of China exposure overblown and misunderstood -

Amtech
(21.85)Amtech says discussions with various clients have led them to believe that investors perceive that OVTI has too much China exposure. The firm does not believe this to be the case. They note OVTI ships its die into module makers who in turn ship to their end customer, a cell phone OEM/ODM. They also sayOVTI counts the module maker as its customer. If the module makers happen to be in China, it counts the revenue from China. However, they say this module maker could be shipping the finished module to some other country for final cell phone assembly. They note that in the April 2006 quarter business from Hong Kong has ramped down as Taiwan and China have picked up. They do not view the low-cost handset issues in emerging countries as having any bearing on OVTI since most of the low-cost GSM handsets do not have cameras in them.

So, according to management, all of the issues raised are actually non-issues. If the analyst had simply asked the company what the implications were of OVTI's increasing business in China, the company would have given its perfectly plausible answer. In plain English - just because OVTI is physically shipping components to China (so that OVTI's customers, technically, are Chinese) does not mean that the phones being built are being sold in the Chinese market (whose consumers tend toward cheaper, lower margin phones). So Nokia, for example, might pay a Chinese manufacturer to assemble even its most expensive phones, in China, before they are sold anywhere in the world - in the US, Europe, etc. In such a case, OVTI's customer is the Chinese manufacturer, even though the phone will not be sold in China. And, as OVTI stated, according to their data, it is precisely because of the success of camera phones that there is an inventory glut in parts of Asia. The glut is of low-end, non-camera phones, which nobody wants to buy. And insofar as falling prices and margins, the company acknowledged that margins had fallen slightly during the quarter due to their growing share of the low-end market, but they assured the market that they will remain between 35-40% for the next couple of quarters and will tend to increase as handset makers shift towards OVTI's next generation of (more advanced, more expensive) chips.

Aright, I'm sick of writing. Maybe I'll add a bit more soon. Bottom line: I stand by my earlier evaluation and prediction. I would strongly recommend buying more here (with a stop no greater than 10%).