Description

OVTI ($16.11 as of 6/13/05) OmniVision Technologies, Inc. (common stock)
(All references to quarterly results reflect calendar quarters)

I believe OVTI represents an attractive investment opportunity as it offers an attractive valuation, a leading position in a growing market, and a solid balance sheet.

OVTI is the leading independent supplier of CMOS (complementary metal oxide semiconductor) image sensors to a variety of growing markets including camera-cell phones, digital cameras, digital video recorders, and automotive and security applications. CMOS are the most cost and power efficient digital image-capturing device for these applications. A CMOS solution, as sold by OVTI, is the chip inside the camera responsible for capturing and processing an image to make it ready for viewing and storing in digital form.

OVTI offers a very attractive valuation. OVTI has a $1022 million market cap with no debt and $315 million in cash, which adds to a TEV of $708 million. Over the last twelve months, it had net revenues of $385 million, Ebitda of $113 million, Capex of $3 million, and generated $1.72 dollars per diluted share of cash flow before financing (cash from operations less cash used in investing – other than buying or selling marketable securities). The following metrics support my view of an attractive absolute valuation: a) TEV/(Ebitda-Capex)=6.5x, b) TEV/Ebit=6.5x, c)TEV/Net income=8.9, and d) TEV/Cash flow before financing=9.5x.

Presumably, one would be surprised that the market is assigning such a low valuation to OVTI, a (widely followed by Wall St) leader in a rapidly growing market. The consensus then must have concluded that OVTI will not be able to attain at least similar results in the future. Allow me first to briefly assess what could the current price reflect. This discussion would then lead me to analyze in detail the company and its market to conclude that OVTI is worth much more than its current price.

While there are many assumptions about future performance that one can make to justify the current price of OVTI, let me provide a simplistic view. A TEV of $708 million could be seen as a zero-growth perpetuity of $35 to $71 million of annual free cash flow. This assumes a cost of capital of 5% to 10% (which combined with zero-growth is very generous relative to what the market generally uses). Thus, the real discussion centers on the capability of OVTI to generate more than $71 million per year.

Let me now provide you with the reasons (and risks) that support the view that OVTI is capable of generating much more than $71 million. First history, during the last twelve months OVTI generated $107 (and its run-rate is $120) of cash flow before financing (as defined above). Now let’s briefly talk about the target market.

The market for digital image sensors is quite large: a) camera-cell phones (250 million units), b) digital still cameras (50 million units), c) automotive (60 million vehicles sold worldwide), d) security and surveillance, and e) other consumer applications like video recorders, toys, computer cameras, etc. In the last twelve months OVTI shipped 88 million units, the large majority of which went to the cell-phone market (where the ASP is lower). However, management is confident it will achieve meaningful penetration of the sweet-spot of the digital still camera market with its 5 mp product (with much higher ASP). In addition, it has a nice base of security and surveillance product sales, and is developing its automotive market (with new products specifically designed for it). In my view, the automotive market could develop into a very large opportunity as each vehicle could be equipped with a number of image sensors (at a modest cost) making it safer, more comfortable and luxurious. Security and surveillance is another very large and interesting opportunity. As the cost of image sensors and bandwidth continue to decrease on the one hand, and security and surveillance awareness increases on the other, the proliferation of government, enterprise, and home surveillance cameras is growing rapidly. For example, Telus (one of the two Canadian telecom incumbents) is offering the mass market a home monitoring service based on digital video cameras.

CMOS provide manufacturers of digital imaging devices (e.g. digital cameras) a much cheaper alternative to CCD image sensors (the incumbent competing technology). The cost of a CMOS is one order of magnitude less than the cost of a CCD device (around $4 vs $12). In addition, CMOS power consumption is a fraction of that of a CCD sensor. As you can imagine, power consumption is a very important feature of a portable device like a cell-phone, digital camera or video recorder. Finally, after years of development, now the technical performance of a CMOS is equivalent to that of a CCD especially for mass-market applications.

The digital still camera market is a good example of a market that CMOS (in general and OVTI in particular) is conquering, as it was previously dominated by CCD technology. It took CMOS technology a number of years to match (moving target) the resolution and other features offered by CCD. Only now that OVTI has developed its 5 megapixel (mp) product for this application, there is for the first time a CMOS product that competes in the sweet-spot of the digital still camera (and video recorder) market.

Probably Wall St believes that competitors are about to bring a substantially better (family of) product than OVTI’s current offer. One has to admit that in the technology field this always possible. However, in this widely contested field populated by several of the world’s technology powerhouses, OVTI continues to be a leader. OVTI is currently shipping in volume leading-edge CMOS. As you may know, simplistically the resolution (# of mp) of a device is what defines the product category in digital imaging. OVTI is and has been one (and now probably two) steps ahead of the pack. For example, while most competitors are shipping 1.3mp and below to the camera-cell phone market, OVTI derives most of its revenues from 1.3mp and above. Furthermore, in the digital still camera market (i.e. regular digital cameras) OVTI has a 5mp CMOS product; definitely ahead of most competitors.

OVTI is completing the transition to a new product line called OmniPixel architecture. This new line includes products I have mentioned (5mp for digital cameras, 1.3+mp for camera-cell phones, and new products for the automotive industry). This transition became meaningful in 2Q04 and beyond.

My guess is Wall St became disappointed with OVTI as it transitioned to its new product line. After at least 8 consecutive quarters of significant sequential revenue growth, OVTI posted sequential declines (despite being up year-over-year) in 2Q04 and 3Q04 then had an excellent (record) 4Q04 but guided flat for 1Q05 (ending on April 30th, and to be reported on June 23rd). Note that even during 2Q04 and 3Q04 it generated record cash flow (cash from operations less cash used in investing) of more than $30 million each quarter. Analysts are apparently disappointed with the relatively high level of inventory at the end of 4Q04. Before explaining why I am not that concerned with the last reported inventory level, let me mention that analysts were also concerned with this same topic back during the first three quarters of 2004. Logically people worried about inventory obsolescence as OVTI transitioned to a new product line. Management later reported that not only it did not have obsolete inventory problems but also had to reverse some inventory reserves as a result of better than expected sales of its previous product line. In terms of the current inventory level, one can be comfortable because demand for the new product line is just picking up as evidenced by recently announced design wins for high volume camera-cell phones and penetration into the 5mp digital still camera mkt.

Probably the controversy arises out of flat revenue guidance and high inventory level. Consider that production lead time is 13-14 weeks (or one full quarter). On the other hand, customers order basically on a just-in-time basis (1-2 weeks). My rationale to this short term controversy is that management is being conservative on its revenue guidance and on its inventory position. In other words, management probably guided revenues in accordance to “firm” orders but expects actual demand to be much higher over the coming two quarters and wants to avoid not being able to supply adequately. Of a total inventory of $67 million, $46 million is work in progress and $21 million finished goods, which is roughly equivalent to 30 days of cost (or 30 days of sales depending on product mix). This is a very reasonable level of finished goods inventory for this company.

Another possibility for the apparently low price of OVTI is that the current “high inventory and flat revenue guidance” controversy could not be a short term issue. In this case, then the consensus believes that the new product line is not selling well and management is making the wrong calls (i.e. overproducing). In light of the recent design win announcement with a leading cell phone manufacturer and the fact that the company now sells to all major handset manufacturers, I have a hard time believing the new product line is not selling well. Therefore, production (of a new product with little obsolescence risk) being a little ahead of demand becomes irrelevant for valuing OVTI. It could only affect the short-term movements of the stock (i.e. when to buy). Furthermore, I would rather have more inventory than not being able to supply adequately.

Since I just referred to management, let me provide you with my impression of the management team. It strikes me as a technologically aggressive but administratively conservative team focused on the long term. First let me mention that the current CEO and Exec VP founded OVTI and own 2.5 million shares. Understandably but still disappointing, they together with other senior managers have sold a few hundred thousand shares over the past two years. Nevertheless, they presumably have the great majority of their net worth tied to OVTI. They obviously understand that to keep OVTI as a valuable entity, it has to be a technology leader. In addition, to minimize operating risk, they use an asset-light strategy (basically a fab-less model) with its testing operations in low-cost China, they partnered with leading foundries despite having to put some of the capital for certain equipment, and they chose to use prominent distributors and VARs in addition to their sales force. OVTI keeps a very large (and consistently increasing) cash balance and no debt.

As it is probably apparent by now, OVTI depends to a large extent on sustaining its technological edge. The biggest risk is that someone else comes up with a better technology alternative to CMOS. Then like CMOS is doing with CCD, this new technology displaces it. This is certainly possible. However, for OVTI to be a bad investment, this new technology would have to come into existence within the next two or three years and quickly develop into a commercially accepted low-cost and high-volume product. In addition, OVTI would have to be unable to adapt in spite of its substantial knowledge of the multiple aspects of technology surrounding digital image sensors and its processing, the design and production of integrated sensor solutions, and its miniaturization and testing. I find it unlikely that OVTI would be unable to adapt after more than 10 years of technological leadership in several areas of the space. Furthermore, CCD manufacturers being able to adapt is an indication of the value of technological knowledge in the space. Despite being very late to the game, leading CCD manufacturers (mostly Japanese firms like Sony and Toshiba) have now successfully adopted CMOS technology.

Disruptive technologies like CMOS or NAND flash memory become mainstream in the existence of a new large market opportunity then served by technology not suitable for it. NAND flash memory, for example, became a successful mass-market product because of the need of digital cameras for a reliable, shock-resistant, low powered, compact memory storage device with fast recording capabilities. Prior to that, NAND flash was probably a cool technology with no large cost-effective application. In the case of CMOS, despite years of development of CCD technology, with the advent of small portable applications CCD proved unsuitable because of its high power consumption and relative bulkiness. Thus, in my view, for CMOS to be displaced, there would first have to be a large market opportunity where CMOS are not practical or cost-efficient.

Finally, OVTI is a very attractive acquisition candidate. While I doubt that management would be inclined to sell at current prices, OVTI would clearly be a very accretive and strategic acquisition to a large semiconductor company interested in the space or to a competitor who currently is technologically behind. Even at 2x the current price, OVTI would be very accretive to most semiconductor companies.

Catalyst

Continued strong cash flow generation is the most likely and best catalyst. Meaningful sales into the 5pm digital still camera market or a few design wins announcements in the camera-cell phone market would also be catalysts in the second half of 05. Beyond the second half of 05, successful penetration of high volume applications for the auto market would also confirm the current undervaluation of OVTI.