Following InvenSense's (NYSE:INVN) less-than-stellar earnings report, a number of investors have -- shockingly enough -- been quite negative about the company's business with Samsung (NASDAQOTH:SSNLF) and Apple (NASDAQ:AAPL), respectively. While it is true that these are large, powerful customers and sales to those customers are generally lower margin than sales to smaller customers, their business is still crucial to InvenSense.
"Low margin" isn't necessarily evil
The major complaint that investors seem to have with respect to InvenSense's Apple and Samsung businesses is that they are relatively "low margin." While it is clearly true that a dollar of revenue from either of the two afoementioned smartphone giants doesn't quite generate as much gross profit as a dollar of revenue from a smaller smartphone vendor, it's important to keep in mind that volume is also a key consideration.
To help investors understand this, consider the following hypothetical example. Suppose it costs InvenSense $1 to build a six-axis MotionTracking device. Now, suppose that Apple is willing to pay $1.50 per sensor and is committed to buy 15 million of those sensors per quarter. Next, suppose that LG is willing to pay $2 per sensor, but is only willing to buy 2 million of such sensors.
From a gross margin percentage per unit perspective, the LG business is "higher margin," as InvenSense will keep $1 for every $2 in revenue it collects from LG. With the hypothetical Apple business, it keeps only $0.50 for every $1.50 that it collects from Apple. Does this automatically mean that the "higher margin" business is necessarily better?
While the hypothetical LG business above is higher margin per unit, it will only generate $1 million in gross profit while the hypothetical Apple business would generate $7.5 million in gross profit.
What's so bad about the Apple and Samsung businesses, then?
The biggest issue with the Apple and Samsung businesses for InvenSense isn't necessarily their gross margin profiles, but instead the risk profile that they bring with them. Given how large a part of InvenSense's revenue base depends on these two customers, InvenSense is inherently risky.
Why is it risky? Well, although InvenSense routinely touts technological superiority as how it differentiates, there is always the risk that a customer like Apple or Samsung will want to dual source parts or simply design InvenSense out altogether.
As an extreme example, there was once a chip company known as PortalPlayer. According to a piece published in the EETimes (via Wikipedia), "over 90%" of PortalPlayer's net revenue came from sales of chips into Apple's iPod. According to that same article, PortalPlayer did not win the media processor slot for Apple's "mid-range and high end flash based iPods."
So, it's not that the Apple and Samsung businesses are bad -- without the revenue from these two behemoths, InvenSense would not have the ability to invest in future technologies -- but that the high dependence on these two customers creates a risk that investors need to be mindful of.
Will it get better?
There are two dynamics playing out in the smartphone market. The first is that other non-Apple and non-Samsung like Xiaomi, LG, and Lenovo are actually gaining ground, according to research firm IDC, in the overall smartphone market. This opens up more vendors that InvenSense could potentially sell into, which could lower the company's risk profile.
However, there's another broad trend that runs counter to that. InvenSense has typically done well at the high end of the smartphone market, particularly as it has been able to differentiate with feature-rich products.
However, with InvenSense having now locked down the high-end phone vendors, and with much of the broader smartphone growth coming from low-end and mid-range phones, InvenSense's ability to compete in the more price-sensitive segments of the smartphone market will be critical to the next "phase" of this growth story.
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.