Why InvenSense Inc's Operating Margin Should Improve This Year

By Markets Fool.com

One excellent signal that a big opportunity is on the horizon for a company is an increase in research and development expenses. I noted last spring that InvenSense was ramping up R&D spending, and the payoff came last fall, when the new Apple iPhone models used InvenSense's 6-axis sensors.

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Even now that InvenSense has grabbed majority shares at the top two smartphone OEMs, it can't stop investing in R&D. It's the chipmakers' job to stay ahead of device makers by improving on existing capabilities and predicting what new features they might want. But it does look as if the future holds some relief for InvenSense's growing R&D expense.

The ramp-up
Over the past two years, InvenSense has significantly ramped up its R&D expenditure. In its fiscal third quarter, the company spent $24.4 million ($19.7 million on a non-GAAP basis) on developing new products. That's up from $6.7 million ($6 million) in the same period two years ago.

INVN Research and Development Expense (Quarterly) Chart

Those efforts only recently paid off with a significant increase in revenue thanks to Apple, which accounted for 45% of the company's $115.9 million in revenue last quarter. Apple helped InvenSense increase its revenue 74% year over year. All told, Apple accounted for about 78% of the company's total revenue growth last quarter.

Clearly, the ramp-up in R&D paid off handsomely for InvenSense, and the run may not be over. CFO Mark Dentinger expects R&D to continue ramping into the fiscal fourth quarter, guiding for a $1 million to $2 million sequential increase in operating expenses. That's an indication that the company sees further potential in the market for MEMS sensors, with CEO Behrooz Abdi noting that there's strong potential for growth in optical image stabilization, microphones, and wearable applications.

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The level off
Dentinger gave investors a glimpse into how fiscal 2016 could play out for the company. He expects R&D spending to level off for at least the first half of the year, if not the full year. That will allow more of the additional revenue from Apple as well as its other design wins and organic growth to make its way to InvenSense's bottom line.

As InvenSense has ramped up its R&D spending, the company's operating margin fell into negative territory. Notably, the company experienced some gross margin pressure from its deal with Apple in the second quarter, but its rebound last quarter to around 9% is a great indication that the company will continue to turn an operating profit going forward with R&D spending at its current level.

INVN Operating Margin (Quarterly) Chart

Even if SG&A expenses continue to climb around 40% -- as they did last quarter -- InvenSense could spend around $130 million to $140 million in total operating expenses (on a non-GAAP basis) in fiscal 2016. With a 46% gross margin, which Dentinger said should be the norm for the next few quarters, that puts the company's operating margin between 14% and 16.5% based on analysts' estimates.

While that number is still a long way from the company's long-term target set last year of the mid- to high-20% range, that goal was also set when the company foresaw long-term gross margins in the low- to mid-50% range. Accounting for the gross-margin pressure, Dentinger gives investors reason to expect InvenSense to perform very well in 2016 from an operations standpoint.

Gross margin could improve in the long run
While Dentinger expects the company to stop growing R&D spending, it's still pumping $20 million-plus per quarter into developing new products. Recently, the company has shifted its focus to more software-based development to produce full-fledged processors, not just sensor chips that offload processing to the device's main processing unit.

Software naturally carries a higher gross margin, and value-added chips carry a higher selling price. Big customers such as Apple will still want to take care of their own software, but smaller manufacturers will find value in InvenSense's all-in-one solutions. As a result, the long term has the potential for gross margin to climb back up near 50%, which will improve operating margin as well.

The article Why InvenSense Inc's Operating Margin Should Improve This Year 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.