How OmniVision Keeps Its Edge

Few fields move as rapidly as technology. Businesses creating outsized profits and returns for shareholders quickly get a bull's-eye painted on their back as they become targets of other companies looking to disrupt their products by selling cheaper alternatives that still prove "good enough." Not only that, but even if a company continues to dominate its particular field, other changes in technology can shift spending away from their products. Think about how Microsoft still dominates PCs but feels pressure from the sales shift toward mobile devices such as smartphones and tablets.

With that in mind, today we're looking at how OmniVision (NAS: OVTI) innovates.

Technology companies can innovate either through acquisitions or by spending more money on research and development. We'll compare OmniVision's spending in these areas with that of its closest peers and assess whether the company is investing enough in its future.

Research and development
Over the past five years, OmniVision has spent an average of 12% of revenues on R&D. The following summarizes how OmniVision's R&D expenditures relative to revenues compare with some of the company's closest peers.

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period.

Finding good competitors for OmniVision is an exercise in futility. Even if a competitor sells camera image sensors, it's usually a smaller side business. So while STMicroelectronics has much larger R&D, that's largely a function of its other advanced semiconductor divisions. Likewise, Himax's main focus is on flat-panel displays, and camera sensors form a small part of its business. OmniVision's largest rival is probably Sony (NYS: SNE) , which once again is extremely diversified, so R&D comparisons are difficult.

However, finagling over specific R&D rates aside, is there any question that OmniVision is one of the most exciting innovation stories in recent technology history? The company ramped up spending in the latter half of the past decade, essentially banking its future on backside illumination technology, or BSI, that improves low-light performance. Despite insistence that the technology was too expensive, OmniVision pushed forward and drove costs down. The end result is that BSI technology is now extremely popular across the exploding smartphone industry.

The most prominent victory for OmniVision is securing the image sensor in Apple's (NAS: AAPL) iPhone 4. Every generation of iPhones comes with battles over the varying internal components, it appears that barring technical difficulties such as low yields on next-generation sensors, the iPhone 5 camera slot is OmniVision's to lose.

Acquisitions
In technology, some of the best companies have turned growth through acquisitions into an art. IBM has adeptly spun off capital-heavy businesses such as the hard-drive and PC segments, while it focused on acquiring additional services and software expertise that have transformed its business model.

On the opposite end of the spectrum, Hewlett-Packard is often criticized for underinvesting in R&D, to the point that it has to overpay on acquisitions to catch up with its competitors.

Investors should remember, most of all, that companies are valued by the cash flow they can bring in for their shareholders over time. If companies need to continue making purchases in perpetuity to keep growing, that amounts to a reduction in cash flows, and investors should treat acquisition spending as a continuing outflow against cash flow.

Let's take a look at OmniVision's free cash flow over the past five years against cash spent on acquisitions.

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period.

OmniVision isn't an overly acquisitive company. For the most part, the company has funded advancements through internal research. In part, that's attributable to a lack of buying options in the industry; there simply haven't been many available deals, and camera sensor M&A has largely been the result of the shedding of struggling sensor divisions at larger companies. The most notable example is Micron's (NAS: MU) spinoff of its sensor division to a private-equity firm in 2009.

Final thoughts
OmniVision has managed to deftly use R&D to transform itself into the image sensor technology leader. As smartphones rapidly adopt advanced cameras, that's an enviable position to be in. For example, while other popular iPhone plays such as audio-chip maker Cirrus Logic (NAS: CRUS) and RF specialist TriQuint (NAS: TQNT) can both claim their own unique advantages that should keep them in future iDevices, neither invented a technology as revolutionary and differentiating as OmniVision's BSI has been for the iPhone.

Now, the tough act for OmniVision is keeping that lead and continuing to innovate as its larger peers chase it down.

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At the time thisarticle was published Eric Bleekerowns shares of no companies listed above. You canfollow him on Twitterto see all of his technology and market commentary. The Motley Fool owns shares of Cirrus Logic, Microsoft, Apple, and TriQuint Semiconductor.Motley Fool newsletter serviceshave recommended buying shares of Microsoft and Apple, creating a bull call spread position in Apple, and creating a covered collar position in Microsoft. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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