3 Reasons InvenSense Stock Could Fall

Shares of InvenSense are still trading closer to their 52-week low than the all-time high shares reached last summer. With a few troublesome earnings reports behind it, though, and a strong secular trend in motion sensing devices, InvenSense is poised for a rebound. Still, there are a few things that could cause more grief than relief for shareholders. Here are three of the biggest risks facing InvenSense today.

Source: InvenSense.

Second sourcingInvenSense is closing in on reaching nearly 100% market share of its second biggest customer,Samsung . It also, naturally, has nearly 100% market share with Apple . While that's an excellent sign that its chips are the best in breed and its pricing is competitive, it also means the company is now more vulnerable than ever to second sourcing.

Both Bosch and STMicroelectronics make chips that are pin-to-pin compatible with InvenSense's, which would make it easy for Apple or Samsung (or any of its other customers) to swap out InvenSense's chips for the competition. Should that happen, it would result in lower unit sales, cutting into revenue. At the very least, it will keep pricing pressure on InvenSense, which will keep margins depressed.

Speaking of margin pressureDuring InvenSense's third-quarter earnings call, CFO Mark Dentinger told analysts that they should expect gross margin to remain in the 46% to 47% range.

Apple and Samsung will continue to put pressure on InvenSense's gross margin going forward, and that's what Mr. Dentinger reiterated on the call. He noted that the short-term outlook is based on its customer mix staying the same.

So, in the case of gross margin, InvenSense's smaller customers offer a key counterbalance to the big smartphone OEMs. If any of those companies like Xiaomi or LG decide to switch suppliers, we could see gross margin decline even further.

On the other hand, increased orders from Samsung or Apple could lead to gross margin decline as well. With the Galaxy S6 around the corner and the potential for InvenSense to be in the Apple Watch, we could see outsized orders from Apple and Samsung in the near future putting even more pressure on gross margin.

Oh, and speaking of the Apple WatchIf InvenSense doesn't have a design win in the Apple Watch, it could be a big blow to InvenSense's share price. Not necessarily because the Apple Watch presents a big revenue opportunity, but because most investors expect it to be in the Apple Watch (including me).

Those expectations come with good reasons. InvenSense currently holds 100% of the market in wearable devices. It has the leading technology in low-power MEMS chips. And most notably, Apple switched to InvenSense just ahead of launching the Apple Watch. Why else would it change suppliers if it didn't plan to include the same supplier in its wearable?

If for some reason InvenSense missed out on the design win, it could cause the stock to drop and, what's more, negatively impact InvenSense's earnings. It's worth noting that InvenSense's inventory declined just $7 million -- less than 10% -- going into a seasonally slow quarter. That is a strong indicator that InvenSense at least planned to be in the Apple Watch. If it isn't, it could mean another inventory writedown like we saw in the second quarter.

What can InvenSense do to protect itself?There are a couple things InvenSense can do to protect itself from these risks, and it's already doing them. First, it needs to continue developing best-in-class chip designs in order to maintain its position with its top customers. InvenSense rapidly increased its R&D expense over the last year to qualify its design with Apple. Spending is expected to level off this year, but with its market share nearing saturation at the two biggest OEMs, that isn't worrisome.

Second, InvenSense can increase the amount of content per smartphone. More content -- like software, microphones, or pressure sensors -- with interoperability with its motion sensors increases the stickiness of its design. Naturally, it also increases the amount of revenue and gross margin the company generates.

While there are certainly risks with InvenSense, management has taken the appropriate steps to mitigate them.

The article 3 Reasons InvenSense Stock Could Fall originally appeared on Fool.com.

Adam Levy owns shares of Apple and 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.