In the equity markets, there's no such thing as a sure thing. But what we as investors need to be on the prowl for are opportunities that offer compelling risk-to-reward ratios. The first (and quite likely the most important) step in making an informed decision to invest in any company is understanding the risks involved. Let's take a look at one of the key risks facing InvenSense (NYSE:INVN), a developer of motion sensing/tracking solutions for various consumer electronics applications such as smartphones.
InvenSense is heavily dependent on Samsung
Anybody familiar with former hot chip play Cirrus Logic (NASDAQ:CRUS) -- a mixed signal/analog chip player that derives the majority of its revenue from Apple (NASDAQ:AAPL) -- knows all about the risks associated with having a business that is very concentrated on a few big customers. InvenSense is not unaware that its business, too, is concentrated with a number of large customers, as indicated in the following from its most recent form 10-K filing:
We expect that sales to these customers will continue to account for a substantial portion of our net revenue for the foreseeable future. The loss of, or a substantial reduction in orders from, any of these customers would have a significant negative impact on our business and our operating results. For fiscal 2014 one customer accounted for 35% of total net revenue. For fiscal 2013, three customers accounted for 24%, 18% and 11% of total net revenue.
It's no secret that the large customer in fiscal 2014 was Samsung (NASDAQOTH:SSNLF), the world's largest handset vendor, known for its popular Galaxy line of smartphones. The good news is that this isn't a Cirrus Logic/Apple type of concentration (where over 80% of Cirrus' revenues comes from Apple), but this is still something to be aware of.
The problem with this kind of concentration is that if, for whatever reason, Samsung decides that it needs to cut costs, it would start by squeezing the suppliers that both depend heavily on Samsung's business and for which there are many alternatives. Additionally, while InvenSense's technology is solid, it is not inconceivable that Samsung could also pursue in-house efforts as part of its long-term strategy.
What should investors watch for, then?
The obvious way to fight a customer concentration issue is to, unsurprisingly, add more customers. Fortunately, one of the things that makes the InvenSense story so attractive is that even though the high end of the smartphone market is slowing down, the company does have the following opportunities open to it:
- Vying for Apple's business. While Apple's iOS devices today use MEMS sensors from Bosch Sensortec, InvenSense could still potentially win some Apple business down the road. If it were to do so, then it could reduce its customer concentration risk and meaningfully grow its top and bottom lines.
- More exposure to the low-end. The smartphone market outside of Samsung and Apple is pretty huge, particularly as the white box vendors in China and Taiwan continue to aggressively ramp low-cost phones. As time passes, those low-cost phones will sport additional capabilities, potentially driving broad-based incremental opportunities for InvenSense.
- Beyond smartphones. Opportunities outside of smartphones, such as wearable devices, could drive greater customer diversity and product diversity.
Foolish bottom line
No investment is without risk, and InvenSense, as a hot small-cap play with perhaps a bit more customer concentration than some would like, certainly carries it. But with a potentially very long runway ahead of it in the smartphone market, coupled with opportunities outside of mobile, that risk today looks outweighed by the potential rewards should InvenSense execute.
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Ashraf Eassa has no position in any stocks mentioned. The Motley Fool recommends Apple and InvenSense. The Motley Fool owns shares of Apple, Cirrus Logic, and InvenSense. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.