As investors following InvenSense (NYSE:INVN) are likely aware, the company recently reported weaker-than-expected gross margins as a result of two key factors. The first was an inventory writedown of older-generation products, but the second was due to "a shift in revenue mix toward lower margin, high volume customers," responsible for a five-point gross margin reduction.

From the perspective of a long-term investor, the one-time inventory write-off doesn't perturb me too much; the company will get past it, and it'll be but a distant memory within a few quarters. However, one thing I think worth exploring is whether management adequately signaled the likelihood of the gross margin compression that resulted from the company's "high volume" customers.

What did the CEO actually claim?
On InvenSense's most recent earnings call, CEO Behrooz Abdi made the following statement:

As we talked at the last earnings call, what we said was that to the extent that our Tier 1 customer mix changes and they become more dominant that, it will be more difficult to hit the gross margin early on until we get to full production yielded and kind of a steady state run rate.

Going back to InvenSense's earnings call in July, here's exactly what Abdi said (emphasis mine):

While we expect gross margins to some of our top tier customers to remain under pressure as a result of high volume pricing as well as lower initial manufacturing yields as we ramp new products into production. We believe our higher value systems solutions combined with our aggressive manufacturing cost reductions will keep our overall gross margins at consistent levels.

So, Abdi's claim checks out: Investors were made well aware that high-volume customers typically get discounted pricing because of the sheer volumes that they bring to the table.

Another thing to keep in mind is that Apple (NASDAQ:AAPL) and Samsung (NASDAQOTH:SSNLF) typically use some of the latest and greatest chips from InvenSense. A fact of life for most chip companies is that the latest, most complex chips are often harder to manufacture at first.

Over time, both the chip designer and its manufacturing partner(s) get better at maximizing the number of "good" chips that come out of a particular wafer, which leads to cost structure improvements. However, Abdi did warn that the latest chips going to these high-volume customers at discounted prices would have "lower initial manufacturing yields," so investors did know that if Apple and/or Samsung became a larger-than-expected part of the equation, gross profit margins would come down.

What does the long-term picture look like?
On the most recent earnings call, CFO Mark Dentinger did state flat-out that the company doesn't expect to be back to the 50% gross margin level that it's targeting "for the next couple of quarters at least." He did, though, state that moving into the next fiscal year, the following factors could help drive gross margins back up:

  • More value-add products
  • Other, non-mobile markets

While I'm not totally convinced InvenSense will be able to hit its long-term model of a gross margin percentage in the "mid-50s," I wouldn't be surprised if the company was able to hit quarterly gross margins of between 47% and 50% in time, as the factors mentioned above come into play. This also assumes InvenSense can differentiate its products sufficiently to keep the share it has without compromising much more on margins.

Foolish bottom line
While some investors may be disappointed with InvenSense's gross margin and profitability last quarter, and in the guidance for the current quarter, I do think expectations have now been sufficiently reset. This means InvenSense now has a lower, and perhaps more realistic bar to jump, but if it can do so, investors should see the stock deliver slower, but more sustainable, gains over the long term.

Ashraf Eassa owns shares of InvenSense. The Motley Fool recommends Apple and InvenSense. The Motley Fool owns shares of Apple 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.