Every company has one number that defines its success more than any other. For sensor-chip specialist InvenSense (NYSE:INVN), that number is ...
That's negative $55.5 million, and it's InvenSense's free cash flow over the trailing 12 months. InvenSense's free cash flow has been in virtual freefall over the past year, from more than $30 million on a trailing 12-month basis to the current $55.5 million bleed. InvenSense has only been a public company for 12 quarters (it went public in late 2011), and for the past four quarters, its quarterly free cash flow has been weaker than it was in the prior-year quarter:
There are a number of reasons why InvenSense might be hemorrhaging so much cash -- it's now bled out roughly 20% of its trailing 12-month revenue -- and rising capital expenditures are part of the reason, but they don't really explain the recent shortfall, since InvenSense's operating cash flow had already begun a descent far into negative territory at the same time that its capex began to rise:
There's nothing inherently wrong with higher levels of capital spending, of course. Long-term investors should cheer InvenSense for its strengthening commitment to its business, and CFO Mark Dentinger has affirmed that the bulk of his company's capex is "to ensure that we have sufficient capacity to support our revenue growth." However, revenue growth at the expense of profitability can only be tolerated for so long before investors start wondering when the bottom line will boom as well.
Fool semiconductor specialist Ashraf Eassa has covered InvenSense's recent quarterly disappointment in detail. His conclusion -- widely shared in the analyst community -- is that some of InvenSense's recent bottom-line weakness can be blamed on inventory writedowns, but some of it can be blamed on high-volume low-margin sales to two major customers. Those customers, Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF), collectively accounted for a full two-thirds of InvenSense's accounts receivable, and 55% of its revenue during the second quarter of its 2015 fiscal year (the most recent quarter).
InvenSense's extreme reliance on these two wildly popular smartphone makers has helped it nearly triple its top line on a trailing 12-month basis over the past three and a half years, but it's also resulted in gross margins dropping by 22%. Belt-tightening might have made up some of the difference between gross margins and the bottom line, but InvenSense has poured money into research and development over the past year, spiking R&D's share of all revenue from less than 15% to more than 25% today:
As with capex, there's nothing inherently wrong with a larger commitment to R&D. This is particularly true in the semiconductor industry, where most products are essentially commodities that can only be differentiated through superior performance, lower costs, or a combination of both. As a long-term investor, I can certainly appreciate a company with a strengthening commitment to R&D, just as I can appreciate one that's willing to invest larger amounts into capital expenditures today so that its infrastructure can handle tomorrow's demand.
However, as a long-term investor, what I don't like to see is a company that will paper over financial difficulties by repeatedly diluting existing shareholders. InvenSense has been gradually increasing its share count since its IPO and now boasts 14% more shares than it did when it went public. Even so, the company's cash on hand is now over 20% lower today than it was just after its IPO:
If InvenSense's cash flow troubles continue, it's bound to force the company to sell more shares eventually, but even at its current rate of cash burn, InvenSense has enough resources to fund more than two years of operations. But there are some reasons why the company could return to positive free cash flow in the future.
First, InvenSense does not expect to sustain R&D spending at 25% of its revenue over the long term, as it's targeting a return to the earlier R&T-to-revenue range of 13%-15% as it grows larger. Analysts expect the company to earn $444 million in revenue for its 2016 fiscal year, which will begin next June. Spending 15% of that much revenue on R&D would only result in a total R&D spend of about $66.6 million -- 7% less than what it's already spent over the past four quarters. I would hope that InvenSense would not reduce its commitment to developing cutting-edge chips, at least on a nominal basis, but past a certain level of development most of the company's advancements may only need to be iterative rather than truly innovative.
Second, InvenSense's ongoing capex growth and its weakened margins are two sides of the same coin. Investing more into its manufacturing processes now will help the company produce chips more efficiently later. Part of the reason why InvenSense's margins are weak now is because it was forced to crank out a large number of its latest chip designs for Apple and Samsung before the manufacturing process had resulted in an optimized wafer yield (InvenSense couldn't get as many chips out of each production run as should eventually be possible).
Until the start of this year, InvenSense had a consistent track record of positive free cash flow and a price-to-free-cash-flow ratio that was quite modest for a company boasting such strong top-line growth. That obviously changed in 2014. However, if InvenSense can return to generating at least $35 million in trailing 12-month free cash flow in the future, it would reclaim a P/FCF ratio of about 39, based on its current market cap. If you believe that InvenSense can get there, or even surpass that level (its trailing 12-month free cash flow topped out at more than $40 million in early 2012), and you feel that such a ratio is reasonable for a company with InvenSense's history of growth, you should certainly keep your eye on its stock over the coming months.