InvenSense (NYSE:INVN) was my first FORENSICS pick, originally released on June 5, 2014. The stock is up 28% since I initiated coverage at $19.40. During the last 10 weeks, INVN hit a peak return of 38%.
InvenSense was founded by Steve Nasiri in 2003 with $500,000. Nasiri created an ingenious MEMS-fabrication platform by bonding all chip components into one package, simplifying the manufacturing process, and improving quality. InvenSense believes that the cornerstone of its technology is its patented fabrication platform (Figure 2) that "gives us a sustainable and differentiated competitive advantage."
In 2006, the company began providing gyroscopic image-stabilization components to various digital camera manufacturers. In 2008, InvenSense created a name for itself and proved that it could scale up production when it landed Nintendo as a customer and supplied $50m worth of gyroscope sensors for the Nintendo Wii game console. In 2011, InvenSense went public and raised $75m through the company's initial public offering. In October, 2012, Steve Nasiri stepped down as CEO and was replaced by current CEO Behrooz Abdi.
The company did not skip a beat under the leadership of Abdi. Forbes refers to Abdi as a "management expert who can scale the company." Nasiri, as InvenSense's founder and longtime CEO, was known as a visionary, but Abdi sees advantages to the change in leadership. "As we get bigger, it really gets more complex," he says. "People felt it needed a new phase of leadership."
InvenSense's Competitive Edge: The Complete Package of Hardware with Integrated Software
InvenSense has and continues to invest heavily in software that sits on a mini processor that is attached to sensors which handle simple computations that would otherwise be performed by a phone's or tablet's main processor. This setup ultimately reduces power consumption and improves battery life. One of the company's key initiatives in fiscal year 2014 was new product development, which included the expansions of software and algorithm capabilities to extend its competitive edge. InvenSense's focus on hardware and software innovation enables the company to deliver lower system power with increased performance, as well as shorter time to market for its customers. As of May 2014, the company reported that its registered development community was over 14,000, which represents an increase of almost 75% over the 8,000 developers that were reported in July 2013.
Macro Economic Outlook: Smartphones
Jérémie Bouchaud, director and senior principal analyst for MEMS and sensors at IHS Inc., expects the two-horse race between Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF) to give way to faster-growing Chinese OEM leadership in 2015. Laurent Robin, activity leader for Inertial MEMS Devices and Technologies at Yole Development in France, believes that smartphones will go from 12 MEMS chips today to as many as 20 in the near future, led by more integrated solutions, such as 9-axis sensors. A December 2013 note from Reynders McVeigh Capital Management, LLC indicated that the InvenSense average selling price (ASP) per mobile device is expected to rise from $1 to $2-3 over time.
According to the IDC, China is expected to see smartphone shipments top 450 million units in 2014, which represents a 25% increase over the 360 million units that were shipped in 2013. By 2017, smartphone shipments in China are expected to hit almost 550 million units; however, the number of units sold will not only benefit InvenSense but also the Air Interface mix. One of the biggest drivers of InvenSense mobile growth is network speeds. As more carriers in China adopt LTE, the demand for gaming and navigation will explode, and so will the adoption of InvenSense's sales of gyroscopes in China. LTE smartphone sales are expected to jump from 100 million units in 2014 to 250 million units by 2017, which is an annual growth rate of 35%. InvenSense has seen sensor attachment rates increasing, as well as its overall market share increasing in China over the last several quarters. InvenSense's largest customers include Samsung, Xiaomi, and LG - each of these companies represent greater than 10% of InvenSense's most recent quarterly revenue.
InvenSense indicated in 2013 that it expects faster network speeds in China to drive the mobile industry adoption of its gyroscopes in China. InvenSense is very confident that it will be well-positioned in China, as Chinese mobile carriers improve on network speeds and shop for a total solution option. The company's leading integrated solution, which combines hardware and software, makes it much easier for customers to adopt its technology.
Macro Economic Outlook: Wearable Devices
Wearable devices are expected to take center stage during the second half of 2014, led by Apple's highly-anticipated iWatch. Apple's iWatch is expected to leverage various sensors to monitor the user's fitness and health metrics. Analysts are expecting Apple to sell as many as 60 million iWatches in the first 12 months following the initial product launch, which is expected to debut in September 2014. Google (NASDAQ:GOOG) (NASDAQ:GOOGL) Glass are expected to arrive later this year, with sales coming in at just under 1 million units. Sales are expected to approach 21 million units per year by 2018, according to statista.com. IMS Research believes that the wearable device market will grow a CAGR of 71% between 2012 and 2016, with annual unit sales hitting 170 million in 2016. The trouble with research estimates is that they are always wrong - very wrong. I found an IDC forecast of connected devices that was published in March 2012. The IDC connected devices forecast estimated that 2013 smartphone sales would be approximately 800 million units. However, the actual smartphone sales in 2013 exceeded 1 billion units. The IDC forecast was off by 200 million units or over 25% when the research firm looked less than two years out into the future. Apple created a market for media players and tablets, and over the past few years, the company has put in a significant amount of R&D to create a new market for wearable devices, which will likely focus on health monitoring. As Apple creates new markets, others will follow. If you believe that Apple can succeed in creating a new market for wearable devices, then the industry unit estimates for wearable devices will end up being very, very conservative. I not only think Apple will create a new marketplace for wearable devices but also believe InvenSense will be listed as a component supplier after the iWatch tear down is completed in the fall of 2014. Don't worry. I'm basing this Apple size assumption not only on good faith but also on comments made by management over the past few years, as well as InvenSense's leading technology.
InvenSense Lays Down Pieces for "Major Ramp" in Future Sales
InvenSense indicated that the sales life cycle for new customers can be lengthy. However, one strategic move that a great management team will do is to start laying down the pieces in advance of a ramp in future sales and required capacity. In March 2012, InvenSense expanded the size of its fabrication capacity when it locked up Global Foundries as its second fabrication partner to help share the future load with TSMC. In January 2013, in advance of future demand, Reuters reported that InvenSense was "more than tripling" its production capacity at its contracted fabrication partners Global Foundries and TSMC.
InvenSense's Staggering Inventory Build That Will Be "Consumed of the Next 2 Quarters"
During the January 2014 conference call, InvenSense indicated that the inventory build "will be mostly consumed in the coming three quarters, while allowing us to increase our capacity in a more linear fashion" (Seeking Alpha Transcript). When InvenSense reported its results in May 2014, inventory levels were still rising, which only leaves the next two quarters for the company to relieve its excess and extraordinary level of inventory. The other interesting part of the equation is that the company has not only been adding inventory but has also been increasing its monthly capacity to produce more goods. In order to reduce inventory levels, the company has to sell a tremendous amount of goods. Not only will InvenSense need to take a bite out of its excess inventory, but the company also will need to break quarterly sales records just to consume the inventory being produced from its recently ramped up fabrication partners. The bottom line is that InvenSense is preparing for a significant pickup in orders from an existing customer or from the addition of a new top-tier customer that is large enough to consume $50m in excess inventory over the next two quarters. Either way, it's a great position to be in.
As you can see from the chart below, InvenSense began increasing its capacity and accumulating inventory during the Q1 2014 reporting period. Over FY 2014, InvenSense has increased its inventory levels from $24m to $73m, an increase of nearly $50m. Also, during the last 12 months, the maximum capacity (Sales plus Inventory Build) has increased from $60m a quarter to nearly $90m. If I smooth out the average maximum capacity over the last 3 quarters, it comes out to $79m, trailing a three-quarter average or an annual run rate of $316m. If I take into account the $49m of excess inventory on top of the annual maximum capacity run rate of $316m, it amounts to an a FY 2015 revenue forecast of $365m versus the analyst estimate of $324m, which represents a beat of $41m or 13%. My bear case estimate based strictly on capacity and excess inventory is for InvenSense to earn $0.78 EPS for FY 2015 and $1.06 for FY 2016, versus a consensus of $0.71 for FY 2015 and $0.95 for FY 2016.
FY 2015 Will Be the Year That InvenSense Lands the "Big Apple" Account
In January 2013, a Reuters article not only indicated that InvenSense was tripling its capacity but also highlighted one interesting comment made by CEO Behrooz Abdi. Adbi declined to comment specifically on Apple but said that "he expects to provide sensor chips to all top-tier phone makers this year." Reading between the lines, the InvenSense CEO is bullish that Apple will be donning an InvenSense sensor at some point in the not-so-distant future. Forbes writer Karsten Strauss published a story in October 2013, and in it, the InvenSense CEO made some additional bullish comments on the likelihood of landing Apple as a customer in the near future. "You will see a very marked difference in the future of the company," he says, "maybe even in the next tear down of an Apple device." The company also indicated that one of the key initiatives in fiscal 2014 was to increase investment in R&D to support three primary areas of activity. One of these areas was "increased costs associated with extensive new customer qualification activities."
It is important to keep in mind that InvenSense already has a terrific market share of Android-related devices, including a significant market share of Samsung's product line. Therefore, it is highly unlikely that any existing customers could take a significant bite out of the company's excess inventory total of nearly $50m. The only likely way to consume nearly $50m of excess inventory is by way of a new major tier 1 player, and Apple certainly seems to fit the bill. The other reason Apple may switch over some of its products to InvenSense is because of performance. Apple experienced some negative PR last year after the gyroscope, onboard compass, and accelerometer were reported by Gizmodo to be "totally screwed up." Apple's upcoming iPhone 6 and iWatch will be under close scrutiny, and the last thing Apple can afford is another "sensorgate," which further strengthens the case for Apple to adopt InvenSense sensors in FY 2015.
2015 Management Outlook
InvenSense expects 25-35% revenue growth driven by its existing customer base and products. InvenSense management indicated that its 2015 revenue outlook:
"excludes potential market share gains or losses and the potential for accelerated growth in new opportunities we have discussed, such as audio, optical image stabilization and consumer electronics wearable devices."
The issue I have with the management's 2015 guidance is that it has two very exciting opportunities coming online in FY 2015 that have not been factored into the FY 2015 forecast. The first opportunity is wearable devices, and the second is optimal image stabilization for camera modules for smartphones. InvenSense management indicated that the wearable market is an exciting segment for InvenSense: "It is fast-growing and fully leverages our high-performance MotionTracking sensors, DMP, algorithms and software." InvenSense's FY 2014 sales totaled $252.5 million. If InvenSense captures a relatively small percentage of the wearable device marketplace and achieves the adoption of its optimal image stabilization application, it will result in a 10-20% increase to management's top-line guidance.
The second very exciting opportunity that InvenSense has been discussing is the company's optimal image stabilization application. InvenSense has been discussing optimal image stabilization since the fall of 2012 and has been looking forward to seeing significant adoption in 2015 smartphones for over two years. InvenSense indicated that it had design wins at "6 or 7 of the prominent optical module, camera module makers." The only uncertainty is the timing surrounding the adoption, but management set expectations over two years ago that FY 2015 would be a breakthrough year for optimal image stabilization adoption rates.
InvenSense has several irons in the fire that will drive top-line and bottom-line growth for years to come. InvenSense is well-positioned in China and will reap the benefits of LTE network build-outs over the next several years. Network build-outs in China will drive increased attachment rates, as well as an increase in the number of sensors per device, which will improve InvenSense's ASP per mobile device over time. InvenSense's ASP per device may rise from $1 to over $2 over the next several years due to the expected rise in the number of chips per device, which is currently being forecasted by Yole. Over the course of FY 2014, the company linearly ramped up its wafer capacity and nearly tripled its inventory levels over historic averages and is expected to consume the excess inventory over the next two quarters. InvenSense's management has been very confident that they will be with every top-tier phone makers in the very near future and even stated that InvenSense may be found in the next tear down of an Apple device. Lastly, the wearable market will drive significant growth for years to come for InvenSense above and beyond historic averages driven by Apple's leadership. InvenSense will enjoy a significant increase in sales from wearable device unit sales over the next several years even if Apple does not elect to tango with InvenSense. InvenSense already has a strong foothold on Android devices as well as the Chinese mobile marketplace and will continue to rely and grow those markets even if the company does not land Apple in 2014.
Bear Case Valuation - $29 - 12-month PT
My bear case estimate based strictly on capacity and excess inventory is for InvenSense to earn $0.78 EPS for FY 2015 and $1.06 for FY 2016 versus a consensus of $0.71 for FY 2015 and $0.95 for FY 2016. My $29 PT is based on a 27 P/E based on my $1.06 FY 2016 EPS estimate.
Medium Case Valuation - $39 - 12 month PT
My middle-of-the-road estimate is based on a continued ramp of quarterly production in FY 2015, as well as the FY 2016 growth rate of 45% (10% over management's FY 2015 guidance), driven largely by wearable devices, optimal image stabilization, and an ASP average increase of 10% beginning in FY 2015. Under my medium-case scenario, I'm forecasting that InvenSense will earn $0.90 EPS in FY 2015 and $1.43 in FY 2016, versus a consensus of $0.71 for FY 2015 and $0.95 for FY 2016. My $39 PT is based on a 27 P/E, based on my $1.43 FY 2016 EPS estimate.
Bull Case Valuation - $53 - 12 month PT
My bull-case estimate is based on the same assumptions of my middle-road estimate, but it includes InvenSense landing Apple in FY 2015 and booking a full year of revenue in FY 2016. In my bull-case scenario, I'm forecasting that InvenSense will earn $1.10 EPS in FY 2015 and $1.93 for FY 2016, versus a consensus of $0.71 for FY 2015 and $0.95 for FY 2016. My estimated impact on EPS from Apple is $0.20 is FY 2015 (partial year) and $0.50 in FY 2016 (full year impact). My $53 PT is based on a 27 P/E, based on my $1.93 FY 2016 EPS estimate.
I believe shares of INVN are currently worth $46 or 27x my 2016 EPS estimate of $1.71 slightly less than my fully priced in bull-case estimate of $53.
My Bottom Line
The bottom line is no matter how you look at this one, there is potential for at least a 50% return over the next 12 months. If Apple chooses to tango with InvenSense, I believe its share price could rise as much as 165% over the next 12 months from its current share price level of just under $20 per share as of May 31st, 2014.
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