Did Audience Underwriters Understand (And Communicate) The Risks? (ADNC, AAPL, FB)

Audience, Inc. (NASDAQ: ADNC) is now the worst IPO of the year.  News surfaced last night from the company that its main customer, one Apple Inc. (NASDAQ: AAPL) was unlikely to use its technology (chips for audio quality) in the iPhone5.  Whoops.  What is so interesting is that Audience just came public back on May 10.  The IPO price was $17.00 and that now compares to a low of $5.80 today.

It does not matter that Audience actually raised its guidance nor that the company believes smart television sets, tablets, and other markets can drive strong sales.  What matters is the risk of Apple in-housing the technology.

What we want to know is just how much the underwriters really gave attention to about the risks here.  Audience now feels like Facebook Inc. (NASDAQ: FB), with the primary difference that the post IPO drop came overnight rather than over a weekly basis for weeks in a row.  Now these are the two worst performing IPOs from before this summer.

At the time of the IPO, it was roughly 5.3 million shares priced at $17 per share and that was above the $14 to $16 indicated range. It is interesting if you review old articles that its business had dropped because Apple had switched from buying its chips to licensing its intellectual property.

The underwriting syndicate was J.P. Morgan, Credit Suisse, Deutsche Bank Securities, and Pacific Crest Securities.  Should you be shocked that ALL FOUR of these brokerage firms had the equivalent of “buy” ratings on the stock, but all four downgraded the stock today?

The company did outline the risks here in the RISK FACTORS in its IPO filing.  It noted:

We sell our products to Foxconn International Holdings, Ltd. and its affiliates (collectively, Foxconn) and Protek (Shanghai) Limited and its affiliates (collectively, Protek), each a major CM that produces mobile phones containing our processors almost exclusively for Apple. We also license our processor IP to this OEM. In 2010, 2011 and the three months ended March 31, 2012, this OEM, Foxconn and Protek collectively accounted for 82%, 75% and 62% of our total revenue, respectively. We entered into an agreement with Apple in 2008, which governs our relationship and under which we sell custom processors to Foxconn and Protek and license our processor IP to this OEM for other mobile phones. For a detailed description of this agreement, see “Business—Customers” beginning on page 89. Historically, we have sold Foxconn and Protek our processors on a purchase order basis. We anticipate that Foxconn and Protek will continue to purchase our processors for multiple mobile phone models that they produce but we expect their purchases to continue to decline over time as we continue to transition to a partial licensing model with this OEM.

And here are even more specifics on the Apple relationship:

Commencing in the three months ended December 31, 2011, Apple has integrated our processor IP in certain of its mobile phones, and we recorded our first royalty revenue in the three months ended March 31, 2012. Pursuant to our agreement, this OEM will pay us a royalty, on a quarterly basis, for the use of our processor IP for all mobile phones in which it is used. We have granted a similar license to this OEM for a new generation of processor IP; however, this OEM is not obligated to incorporate our processor IP into any of its current or future mobile devices. For the new generation processor IP, the royalty this OEM is required to pay us is subject to a lifetime maximum, after which we would not receive royalties for shipments of devices into which our processor IP has been integrated. Under our agreement with this OEM, we have entered into statements of work to set forth terms and conditions specific to licensing processor IP. Pursuant to both the agreement and statements of work, this OEM may cancel a statement of work for a new custom processor upon 30 days prior written notice to us. This OEM has no obligation to, and we do not know the extent to which the OEM will continue to, license our processor IP for integration into mobile devices it produces.

This is one of those instances where “caveat emptor” (buyer beware) applies.  The only question is how long that the investment community should have known about this loss of business.  For those investors who merely bought based upon the Apple halo-effect, this should be a lesson learned.  It is no secret that Apple routinely takes on suppliers, learns tricks and traits of the technology used, and then turns the table in some fashion.

Audience shares are down 63% at $6.93 in active volume and the market cap is now listed as only $139.3 million.

The Risk Factors section of the IPO Filing is rather long at 16 pages (literally) and these are just the headings without the long detail on each, and this does not even take the risks related to regulations:

Due to the length of the Risk Factors section, we put this on a PAGE 2…

JON C. OGG

We are substantially dependent on a single OEM and its CMs, for our revenue and our relationship with this OEM is undergoing a significant transition from the sale of voice and audio processors to the license of our processor IP, which may have a material and negative effect on our business, financial condition, operating results and cash flows.

We depend on a small number of OEMs for a substantial portion of our revenue and the loss of, or a significant reduction in orders from, one or more of our OEMs could adversely affect our revenue and significantly harm our business, financial condition, operating results and cash flows.

If we are unable to diversify our revenue by maintaining or extending our relationships with our current OEMs or establishing new OEM relationships, our growth may be limited, and our business, financial condition, operating results and cash flows could be adversely affected.

We have a history of losses, and we may not be able to sustain profitability in the future.

Our operating results may fluctuate significantly as a result of a variety of factors, many of which are outside of our control, and you should not rely on our quarterly comparisons as an indicator of future performance.

The market for mobile device components is highly competitive and includes larger companies with significantly greater resources than we have. If we are unable to compete effectively, we may experience decreased sales or increased pricing pressure, which would adversely impact our business, financial condition, operating results and cash flows.

If the market for mobile devices with improved sound quality and the demand for our products do not continue to grow as we expect, our business, financial condition, operating results and cash flows could be materially and adversely affected.

If the average selling prices of our products decrease, our revenue and gross margins could decline.

If we are unsuccessful in developing, selling or licensing new products that achieve market acceptance, our ability to attract and retain OEMs could be impaired, our competitive position could be harmed and our revenue could be reduced.

Our sales cycles can be long and unpredictable. Our sales efforts often require substantial time and expenses and are often more than a year in advance of the first commercial sale of the mobile devices including our products.

If we are unable to adequately control our cost of revenue, our gross margins could decrease, we may not sustain or maintain profitability and our business, financial condition, operating results and cash flows could suffer.

We may experience difficulties demonstrating the value to OEMs and MNOs of newer, higher priced and higher margin products if they believe our existing products are adequate to meet user expectations regarding sound quality, which would cause our revenue to decline and negatively affect our business, financial condition, operating results and cash flows.

We are dependent on sales of mobile devices that incorporate our voice and audio processors and our processor IP, and a decline in the demand for these mobile devices could harm our business.

If our voice and audio processors fail to integrate or interoperate with our OEMs’ product designs, including various system control and audio interface protocols, we may be unable to maintain or increase market segment share and we may experience reduced demand for our processors.

We are subject to business uncertainties that make it difficult to forecast demand and production levels accurately and to have our products manufactured on a timely basis, which could interfere with our ability to deliver our processors and generate sales.

We rely on a limited number of manufacturing, assembly, packaging and test, as well as logistics, contractors, in some cases single sources, and any disruption or termination of these arrangements could delay shipments of our voice and audio processors and reduce our revenue.

Our voice and audio processors may fail to meet OEM or MNO specifications or may contain undetected software or hardware defects, either of which could cause degradation in sound quality that might result in liability to us or our OEMs or MNOs, harm to our reputation, a loss of OEMs and a reduction in our revenue.

If we are unable to maintain or expand our relationships with MNOs or establish new MNO relationships, we may not be able to affect MNO demand for mobile devices that meet high sound quality specifications, which may limit our growth and adversely affect our business, financial condition, operating results and cash flows.

Our ability to benefit from net operating loss carryforwards (NOLs) may be impaired as a result of future ownership changes or changes in tax laws.

Our future effective income tax rates could be affected by changes in the relative mix of our operations and income among different geographic regions and by proposed and enacted U.S. federal income tax legislation, which could affect our future operating results, financial condition and cash flows.

We may not be able to sustain or manage any future growth effectively. If we fail to manage our growth effectively, we may be unable to execute our business plan, sell our voice and audio solutions successfully and adequately address competitive challenges. As a result, our business, financial condition, operating results and cash flows may suffer.

If we are unable to attract and retain highly qualified personnel, our business, financial condition, operating results and cash flows would be harmed.

We may make acquisitions in the future that could disrupt our business, cause dilution to our stockholders, reduce our financial resources and harm our business.

The political and economic conditions of the countries in which we conduct business and other factors related to our international operations could adversely affect our business, financial condition, operating results and cash flows.

If we need additional capital in the future, it may not be available to us on favorable terms, or at all.

We are exposed to fluctuations in currency exchange rates that could negatively impact our business, financial condition, operating results and cash flows.

Our business is vulnerable to interruption by events beyond our control, including earthquakes, fire, floods, disease outbreaks and other catastrophic events.