Investors who were long Audience (ADNC) and ignored, or were unaware of, the "boiler plate" risk factors in ADNC filings just saw their investments get demolished in the Sept. 7, 2012, trading session. The stock fell $11.96, or 63.4%, to close at $6.90 when it announced in a press release that Apple (AAPL) would no longer use its processor in its next-generation phones. The release stated:
Audience sells processors and licenses its processor IP to Apple Inc. and certain of its subsidiaries (collectively, OEM) for inclusion in the OEM's mobile phones pursuant to a Master Development and Supply Agreement (MDSA). Pursuant to a statement of work under the MDSA, amended in March 2012, Audience developed and licensed a new generation of processor IP for use in the OEM's devices. However, the OEM is not obligated to use Audience's processor IP.
Audience now believes that it is unlikely that the OEM will enable Audience's processor IP in its next generation mobile phone. Audience is not aware of any intended changes by this OEM to its use of Audience's processors or processor IP in prior generations of the OEM's mobile phones.
Rating downgrades before the morning bell by some "respected" analysts only added fuel to the fire. But we believe this fire is far from being tamed and the stock will continue to trade lower.
ADNC shareholders should be furious that analysts did not see the AAPL news coming, or that the company was not more proactive in telegraphing it as a high probability event. On July 26, 2012, ADNC disseminated its 2012 second-quarter financial press release, its first earnings release since going public on May 10, 2012.
In its 2012 second-quarter 10-Q filed on Aug. 7, 2012, ADNC sneaked in a risk factor disclosure on page 13 that mentioned that it was named in a patent infringement lawsuit. More interestingly, the suit made reference to "our OEM" as also being involved in the suit, but failed to specifically mention who the OEM was, which we will soon show is AAPL.
On July 3, 2012, a patent infringement lawsuit was filed by a company called NoiseFree.
On July 3, 2012, Noise Free Wireless, Inc. filed a lawsuit in U.S. District Court for the Northern District of California against one of our OEMs and against us. The complaint:
- alleges that our products infringe U.S. Patent No. 7,742,790 held by Noise Free Wireless and that our OEM infringes the same patent based on its alleged use of our products
- alleges that we misappropriated Noise Free Wireless' trade secrets and engaged in unfair business practices based on the alleged patent infringement and trade secret misappropriation
- makes additional allegations against our OEM
The complaint seeks unspecified monetary damages, costs and fees and injunctive relief against us. The costs associated with any actual, pending or threatened litigation could negatively impact our operating results regardless of the actual outcome. Due to the preliminary status of the lawsuit and uncertainties related to litigation, we are unable to evaluate the likelihood of either a favorable or unfavorable outcome. We cannot currently estimate a range of any possible losses we may experience in connection with this case. Accordingly, we are unable at this time to estimate the effects of this complaint on our financial condition, results of operations or cash flows.
While the July 26, 2012, press release was positive overall, it omits a huge potential negative to ADNC's story. It's an omission that, when combined with information in its 2012 second-quarter 10-Q and court documents, leads us to believe that the words "our OEM" was a clear attempt by management to delay knowledge of who this original equipment manufacturer is.
The keys to what we consider were manipulative actions taken by management come from two facts:
- It is very obvious who the OEM mentioned in the suit is. It clearly lists that AAPL is actually the first defendant in the suit.
- Court documents pertaining to the suit were filed on July 3, 2012, well in advance of the 2012 second-quarter press release or related 10Q.
We surmise that AAPL may have left the building just less than six months after inking an amended licensing agreement with ADNC due to the existence of the patent infringement suit. We also believe it is plausible that there is risk that ADNC's other customers and its manufacture of processors could consider severing ties before they are mentioned in future suits. AAPL's move could imply that its legal team found some merit in the patent infringement suit.
In addition to the obvious negative "reputation" repercussions that arise from our findings, several other negative ramifications could result from this development, including impacts on cash flow streams and relationships with its customers other than AAPL and its supply chain entities.
Equally as eye-opening is that ADNC could be on the hook for legal fees of customers who use its products. Here is another risk factor quote from ADNC's filings:
Third parties may also assert infringement claims against our OEMs. Claims against our OEMs may require us to initiate or defend potentially protracted and costly litigation on an OEM's behalf, regardless of the merits of these claims, because we generally agree to defend and indemnify our OEMs with which we have long-term agreements from claims of infringement and misappropriation of proprietary rights of third parties based on the use or resale of our products. Other OEMs, with which we do not have formal agreements requiring us to indemnify them, may ask us to indemnify them if a claim is made as a condition to awarding future design wins to us. A party making an infringement claim against our OEMs, if successful, could secure an injunction or other court order that could prevent our OEMs from producing or selling their mobile devices incorporating our products. Any such claims or injunction against our OEMs could seriously harm our business, financial condition, operating results and cash flows.
We believe that investors who are banking on ADNC cash per share of around $5.50 ($113 million divided by 20 million shares) to serve as a bottom could be making a serious miscalculation.
The Aug. 7, 2012 news only highlights one of many risk factors present in the ADNC story and investors should not take solace in management's attempt to coddle them:
...we are confident in the diversification of our business and see sustainable growth in 2012 and beyond. As such we are raising guidance for the third quarter of 2012. Looking ahead, we believe our expansion into adjacent markets such as Smart TVs, automotive, and notebooks, will continue to bring growth in 2013 and beyond.
We take these comments with a grain of salt. We do not think the benefits of its customer or product diversification goals are right around the corner or guaranteed. In reality, as we plan to show in a follow-up article, ADNC is basically a one product segment company that now, after the loss of AAPL, largely depends on one customer (Samsung) for the majority of its revenues. In its going public prospectus filed on May 10, 2012, the company readily admits that its dependence on a limited amount of customers will continue to be the norm for the foreseeable future.
We came across an article on Investopedia that attempted to interject a silver lining in the news about AAPL development. Unfortunately, the author does not discuss the patent litigation case or several other risk factors present in the ADNC story. Furthermore, his silver living included the following statement:
Not a Fatal Blow at This Point
Apple has been a significant customer for Audience for a while now, and losing that relationship has always been a risk factor. However, it's important to note that Apple was not Audience's only customer. The company also relies heavily on Samsung for revenue (over 40% in the last quarter), and that relationship seems to be secure. Likewise, the company has announced recent wins with HTC, Huawei and GOOG.
We performed some research regarding this passage and found that HTC, Huawei, and Google (GOOG) have been customers of ADNC for a period of time, well before the existence of the patent infringement suit we highlighted. The question bears asking: Will the AAPL development spread to other customers once they become aware of it?
The hit to ADNC financials is something we don't take lightly. AAPL's revenue contribution model (not shared by other ADNC customers) was built on licensing fees paid to ADNC based on a fee per each phone AAPL sells that incorporates ADNC processor. A good deal of margin is captured by ADNC since the company was licensing the intellectual property to AAPL and not manufacturing processors for AAPL. This helps to provide a significant boost to net income. Now that the AAPL licensing revenue stream is gone, it makes sense to assume that ADNC has to replace it with a greater share than what it lost.
The loss of the AAPL relationship is significant for several reasons:
- Investors and analysts that were hanging their hat on an AAPL takeover to support ADNC stock now need to look at pure valuation and market metrics to provide them with a bottom.
- Historically, ADNC sold its products primarily to OEMs, distributors and contract manufacturers (CMs) whose customers include OEMs of mobile devices. Beginning in the 2012 first quarter, the ADNC/AAPL relationship was changed to that of a licensing structure. We postulate that this move was partly made to improve margins that had been on a precipitous decline. With the loss of AAPL as a major customer, a revenue stream that was providing some stability to a business with unpredictable margins is gone, once again exposing the company to margin volatility.
- We estimate that without AAPL's licensing business ADNC may report losses beginning in the 2012 fourth quarter when its effect will be first felt.
- Revenues not related to AAPL (hardware sales) for the first six months of 2012 have declined, which should give investors pause when assessing potential revenue growth of ADNC's remaining business.
- The big elephant in the room now becomes AAPL's abandonment of ADNC's processor, no longer including it into its new generation phones. Even if it was not as a result of the patent infringement suit, apparently ADNC technology may not be the gold standard and the best one out there, contradicting its "Leading Provider" status boasted in its company description. This begs the question: Who is AAPL now using? Will other customers, namely Samsung, soon jump ship?
- Did AAPL analyze the details surrounding the filing patent infringement lawsuit and determine that it may be valid, realizing financial risk exists to companies who use ADNC's processors? If so, will others do the same?
With so many uncertainties (including another lawsuit discussed in its going public prospectus), how can any rational investor not see significant risk to a long investment in ADNC shares, even at current levels?
We believe that most investors will eventually assume a worst case valuation scenario of ADNC's proper cash per share of around $5.50. However, we believe this assumption could be short sighted. It takes into account an assumption that its relationship with its OEM customer Samsung is strong and that two patent infringement lawsuits against the company (the second also against AAPL) are frivolous, leading to no cash drain on operations. It further ignores the big possibility that the loss of AAPL related revenues will result in a cessation or significant reduction in cash flows. Lastly, it assumes that its customers other than AAPL or the companies it outsources the manufacturing of its processors to will not follow in AAPL's footsteps.
In summary, our valuation is not so much based on the attractiveness of the market ADNC serves, but more on the possible negative ramifications of:
- Risk of the unknown
- Lack of customer diversification
- Lack of product diversification
- Two patent infringement lawsuits, one filed just days before its IPO, and another neatly tucked away in its 2012 second-quarter filing
- Observed recent and expected trends in revenue streams
- Degrading margins
- Samsung sales to the U.S. may be negatively impacted by its loss of a patent litigation suit initiated by AAPL
We are continuing to do more due diligence on the story, and will provide more insight in the following days if warranted.
Disclosure: I am short ADNC.