Virtual Reality Headset On Male

Image source: Getty Images.

There’s little doubt that the Internet of Things will fundamentally change the way we do things in America over the coming decade. By allowing all of our devices to talk to one another, we will no longer have to deal with the rote, mundane tasks that normally consumed our time.

On the surface, this should be a huge boon for InvenSense (NYSE:INVN) investors. The company’s sensors and microelectromechanical systems (MEMS) are widely regarded as some of the best in the industry. They have become hugely popular in allowing smartphones to function based on movement, and have runways for growth in both virtual reality and drone stabilization. Insiders own over 14% of shares outstanding, and these shares trade hands for a reasonable 19 times free cash flow. What’s not to love?

But things aren’t always as they appear. And while InvenSense may end up being a great investment, there are enormous risks that investors -- especially beginners -- need to be aware of.

Heavily reliant on just a few customers

By far the most important function of InvenSense’s products is the company’s place in smartphones. Its MEMS allow the phones to react to movements in the phone, like when a picture rotates to match the angle at which it’s held.

The problem is that a few players dominate the smartphone industry. A look at InvenSense’s history shows that the company has long relied on just a few customers to provide a huge slice of revenue. In investing lingo, this is called “concentration risk,” as in “You’ve got too much of your sales concentrated in just a few customers.”

Data source: InvenSense annual reports.

As you can see, Nintendo (NASDAQOTH: NTDOY) once provided a large chunk of sales, mostly because of the popularity of its Wii remote controls. Since then, both Apple (NASDAQ:AAPL) and Samsung have conquered the smartphone world, and contribute over half of InvenSense’s revenue. During the most recent quarter, Apple bumped all the way up to 46% of revenue.

The problem for InvenSense is that one decision by one committee in Cupertino, California (Apple) or Suwon, South Korea (Samsung) to switch providers on the next-gen smartphone could cause InvenSense’s sales to plummet almost overnight.

Becoming commoditized

“But being the industry leader,” you might argue, “means that there’s no way anyone would go with another provider.” Therein lies the second big risk with investing in InvenSense: commoditization. This is what happens when you have no real moat -- or sustainable competitive advantage -- surrounding your business.

STMicroelectronics (NYSE:STM) also designs and manufactures technology similar to InvenSense’s. In fact, while it generally isn’t regarded as superior to InvenSense, STM’s chips won the battle for inclusion in its Galaxy S7 and S7 Edge phones.

Because of the presence of STM, InvenSense will have trouble expanding margins. Companies like Apple and Samsung don’t necessarily need the best sensors out there; they just need ones that are “good enough” for end users. If those are provided by STM and at a cheaper price, then InvenSense will lose business. That’s commoditization in a nutshell.

Don’t get me wrong: InvenSense could easily end up being a big winner. It is a very high-risk stock, and with high risk comes the potential for high rewards. But for me, those risks outweigh potential gains.

Brian Stoffel owns shares of Apple. The Motley Fool owns shares of and recommends Apple and InvenSense. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. 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.