I Was Wrong About OmniVision

I'm not a Fool of grand gestures. When I tag a stock as a "screaming buy," I hope you listen -- because I don't say it very often.

But I went gung-ho on camera chip designer OmniVision Technologies (NAS: OVTI) recently. Years of close scrutiny had convinced me that OmniVision's technological leadership was secure until at least 2012 and maybe even 2013. Only then could Sony (NYS: SNE) , Sharp, Panasonic (NYS: PC) , and other rivals hope to catch up to the manufacturing efficiencies of the company's backside illumination sensors.

The setup
So when OmniVision issued timid guidance last quarter and the rumor mill started whispering about Apple (NAS: AAPL) going elsewhere for the next iPhone's camera needs, I stood up on the rampart. "OmniVision Just Became a Screaming Buy," blared my headline. In the article, I argued that a lost Apple opportunity would make a liar out of CEO Shaw Hong. The soft guidance, after all, rested on macroeconomic uncertainty and a terrible PC market, not on smartphones of any kind.

"This particular seller stampede is based on pure speculation," I said, "and on assuming that OmniVision is lying to analysts and investors." And then I opened a real-money position myself. Options and not straight-up shares, mind you, because: "I'm so confident of a near-term bounce that I'm willing to put some leverage behind this investment."

The downfall
As it turns out, Sony did in fact steal at least some of the Apple account, and I have yet to see evidence that OmniVision chips power the main camera in any iPhone 4S units. OmniVision shares have dropped by 50% since that fateful first-quarter report and from my options investment. Second-quarter results came in, and while somewhat stronger than analyst estimates, they're not reassuring at all. Management gave early warning of even softer sales than the meek guidance that started this sordid drama and the outlook for next quarter isn't any better.

The midpoint of third-quarter guidance lands at sales of $170 million and adjusted earnings around $0.11 per share. That's down from $218 million and $0.48 per share, respectively, in the just-reported period. Last year's third quarter was a beast with $0.84 of non-GAAP earnings per share on sales of $266 million.

Any way you slice it, the next quarter will be terrible. And it's becoming an unsettling pattern.

What's wrong, honey?
This time, management admits that smartphones are a drag. The disappointing guidance comes from macroeconomic uncertainty and continued "order cutbacks that we experienced in our second quarter for the various key projects that are currently in production."

The second-generation BSI technology that's supposed to save OmniVision's bacon is most certainly not shipping in iPhones. The chip is part of at least one product today, but in limited volumes. And as sales VP Ray Cisneros puts it, "it's a low volume type of product that's in the marketplace," and not a small slice of a large pie such as the iPhone.

Well that's nice. But at the same time, Sony's stuff is obviously good enough and cheap enough to replace OmniVision's vaunted BSI chips today. Sharp just introduced an even higher-end BSI solution, designed for ultra-thin smartphones. And who knows what Panasonic and STMicroelectronics (NYS: STM) might be up to?

In short, OmniVision's technology lead has evaporated much earlier than I had thought possible. There goes the very foundation of my investment thesis. And it explains why once-rampant sales growth has turned negative, too.

Is OmniVision still a screaming buy?
Management is keeping a stiff upper lip and staunchly claims to have lots of long-term catalysts in front of the company. But I don't see it anymore.

Even bullish analysts reacted to this sobering report by slashing price targets. OmniVision still has $450 million of net cash versus a $683 million market cap, yielding a leaf-thin enterprise value of just $226 million today. In this light, the stock remains ridiculously cheap even when compared against deep-value plays Micron Technology or Seagate Technology.

But that's only a value if OmniVision can bounce back from these dark days. That won't happen if the industry really has caught up to the company's technology lead.

I'm not going to panic-sell here. The calls in my synthetic long position will expire totally worthless while the puts become pricey shares in a few weeks. So that surefire value play has backfired. I'll give management another quarter to show me some traction with the fancy new BSI-2 chips, but I just might be grabbing on to a falling knife here.

The iPhone does have its fair share of hidden winners -- it's just too bad that OmniVision isn't among them this time. To see how you can invest in the smartphone revolution without ever touching shares of a handset maker, take a peek at this free report.

At the time thisarticle was published Fool contributor Anders Bylund owns shares of Micron and a synthetic long position in OmniVision but holds no other position in any of the companies mentioned. The Motley Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinion, but we all believe that considering a diverse range of insights makes us better investors. Check out Anders' holdings and bio, or follow him on Twitter and Google+. We have a disclosure policy.

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