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Bull of the Day

Ambarella (AMBA - Free Report) was my "Stock to Double" pick in early June for a special Zacks report when it was trading under $45 right before their first quarter earnings.

Here's what I wrote on June 2...

Ambarella will be the tech comeback story of the next year. The primary driver will be their state-of-the-art HD and Ultra HD video chips solutions.

That's because Ambarella's video compression and image processing semiconductors use proprietary technology to capture stunning footage with low bandwidth and power usage.

Qualcomm is reportedly working on similar technology, but no one is competing yet with AMBA's secret sauce.

But isn't AMBA still just a GoPro story?

While customer GoPro (GPRO - Free Report) struggles with product sales, has delayed launch of the Hero 5, and is discontinuing some cameras as they are forced to drop prices to unprofitable levels, the fate of Ambarella is not tethered to this single user of its chips.

Case in point, the new Xiaomi Yi 4K Action Camera. As GoPro suffers from excess channel inventory and delayed product launches, Xiaomi is challenging GoPro for market leadership with the launch of their YI 4K Action Camera which uses Ambarella's A9SE processor and offers lower power and longer battery life than the Hero4 Black.

In addition, the YI 4K includes an accelerometer and gyro for image stabilization, higher speed Wi-Fi, lens distortion correction, slow motion support, Bluetooth, and a touchscreen display. Best of all, the YI 4K is priced at $250 vs. $499 for the GoPro Hero4 Black.

The sports/action camera market is still Ambarella's primary revenue source, but other important product segments are also growing including automotive, security and surveillance, police wearables, and drones.

And virtual reality (VR) applications are around the corner in what should be another growth market because VR has a high video appetite that only AMBA processors may be able to feed.

Summary thesis: Ambarella has very few competitors that can meet the company's ability to deliver high-quality 4K video with using less than 2W of power. With a market cap back down under $1.5 billion, I think the company entertains a very attractive buy-out proposition near $40 per share.

Back to a Zacks #1 Rank

What's happened since that June report? AMBA shares climbed over 50% from the June 3 post-earnings close of $46.47 to late-August highs above $72.

And the company just reported Q2 results on September 1 that also impressed investors and analysts.

AMBA delivered revenues and non-GAAP EPS of $65.1 million and $0.54 vs. Street expectations of $64.3 million and $0.38.

Revenue upside was driven by increasing adoption of home surveillance cameras. Management indicated that this market now represents a high single digit percent of total revenue.

While revenues are still expected to show flat to slightly negative growth for the full year, the company gave guidance for the October quarter of $95-$99 million. The midpoint of $97 million was above the Wall Street consensus estimate of $95.7 million.

The upward estimate revisions following the report were surprisingly strong as most of the Street wasn't expecting the beat or the raised guidance. The stock is back to a Zacks #1 Rank with this year's consensus GAAP EPS jumping almost 20% from $1.29 to $1.54 and next year getting a 10% boost.

The company reported about $2-4 million of revenue impact in Q2 from the earthquake that damaged Sony’s CMOS image sensor facility and probably caused fewer new design launches. Management expects there may be a slight impact during Q3, but no lasting impact beyond that quarter.

Competition and Valuation Headwinds

While my thesis has been that Ambarella's powerful HD video SoC (system-on-a-chip) technology would make it a take-over target for a larger player like Intel (INTC - Free Report) , Qualcomm (QCOM - Free Report) , or NXP Semiconductor (NXPI), all of these players are working on their own solutions in this field.

But whenever the stock dips under a $2 billion market cap, I think it's a buy. And I still believe this chip company is unique enough that it will maintain a "take-out" premium in its shares and can therefore trade at 35X next year's $2.16 estimate, or $75.

Analysts at Stifel Nicolaus are even more optimistic. From my June report...

Stifel Nicolaus analysts led by Kevin Cassidy were looking for an earnings beat (Q1) and they reiterated their $86 price target based on 25X next year's $3.50 EPS estimate. Cassidy has been the stalwart bull on AMBA since the IPO. In fact, his analysis first made me a buyer of the stock in 2014 during the run from $40 to $120.

His team noted in May "Longer term, we expect GoPro to produce 1.5mn Hero 5 sports cameras based on Ambarella's A9SE video SoC (system-on-a-chip) in the October ending quarter. With this and all other markets growing, Ambarella will resume its year-over-year revenue growth."

After the Q2 report, Cassidy still felt the same way with the same targets.

Finally, while talking about take-overs is mere speculation, look at the $33 billion NVIDIA (NVDA - Free Report) , who we already knew was moving swiftly into the automotive video market, partnering up with Baidu (BIDU) to build autonomous cars.

Deals will keep happening in specialty chip companies, especially those with intelligent video applications.

Now, which stocks should you sell?

As a Zacks Rank #1 Strong Buy, this Bull of the Day deserves consideration. But today there are 220 Zacks Rank #5 Strong Sells that demand even more urgent attention. If any of these are lurking in your portfolio, they should be removed immediately. Since 1988, such stocks have actually performed more than 11X worse than the S&P 500. See all Zacks Strong Sells and Strong Buys absolutely free >>.