The iPhone Supplier That Didn't Make the Cut

The iPhone 5 launch on Wednesday, Sept. 12 is sure to be the most important event for tech investors this year. The Motley Fool will be hosting a live chat where our top tech analysts will answer your questions and break down what the announcement means for Apple and tech investors everywhere. Be sure to swing by Fool.com at 12:45 p.m. EDT next Wednesday for all your coverage of Apple's next big announcement.

Ouch.

Audio-signal processor Audience (Nasdaq: ADNC  ) got absolutely clobbered in after-hours trading on Thursday, down more than a gut-wrenching 50%, after the company disclosed that it now thinks it is "unlikely" that Apple (Nasdaq: AAPL  ) plans on using its processor IP in the iPhone 5.

All the better for Siri to hear you with, my dear
Historically, Audience has sold standalone digital signal processors to Apple for use in iPhones. Starting last year with the iPhone 4S, Apple transitioned its business to licensing Audience's technology instead of just buying hardware.

Source: Audience.

Source: Audience.

Audience's earSmart Technology was built into the A5 chip powering the iPhone 4S and helps isolate relevant noises. Some analysts hypothesized that this is why Siri was exclusive to the iPhone 4S, since prior chips didn't have this IP built in so recognition wouldn't be as accurate. This wouldn't fully explain it, since ambitious hackers were able to get Siri running just fine on older models.

Can you hear me now?
Audience recognizes royalty revenue one quarter after the related device is sold through. That means that for iPhones shipped in Q4 2011, Audience will recognize its royalties in Q1 2012. That was the first time Audience recorded licensing royalties as it transitions away from hardware sales.

Source: SEC filings.

Source: SEC filings.

With Apple having long been Audience's biggest customer in some form or fashion, it had seemed that would continue. Based on Audience's SEC filings, the company appeared confident that Apple would again incorporate its IP in the iPhone 5, much as it did in the iPhone 4S, although it was upfront that this may not come to pass:

We have granted a similar license to [Apple] for a new generation of processor IP; however, [Apple] 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 [Apple] 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.

Source: prospectus.

Even if the iPhone maker decided to use the IP, there was always an unspecified lifetime maximum on royalties that Audience could receive.

Ouch
That adds some context to the announcement last night that Audience unfortunately doesn't believe its technology will be featured in the iPhone 5:

Audience now believes that it is unlikely that [Apple] will enable Audience's processor IP in its next generation mobile phone. Audience is not aware of any intended changes by [Apple] to its use of Audience's processors or processor IP in prior generations of [Apple's] mobile phones.

Source: press release.

So long as Apple continues to sell and incorporate the technology in the iPhone 4 and iPhone 4S, Audience should at least continue to see sales related to those devices. Missing out on the iPhone 5 would of course be a major setback, but at least there's a sliver of consolation.

Apparently, Audience's place isn't nearly as secure as fellow audio specialist Cirrus Logic (Nasdaq: CRUS  ) , which provides the audio codecs that work with the audio processors.

Audience competes with several larger rivals for mobile-device audio subsystem components, including both Qualcomm (Nasdaq: QCOM  ) and Texas Instruments (Nasdaq: TXN  ) . Both of those players happen to sit comfortably in the iPhone as well, so it's possible that one of them may have swept in and stolen the seat.

Raising guidance?
Third-quarter results won't be affected by this because of the aforementioned revenue recognition policy, and second-quarter unit sales are already in the bag. In fact, the company modestly raised its third-quarter outlook based on strong hardware shipments.

Third-quarter sales are expected between $35 million and $38 million, up from the previous guidance of between $33 million and $36 million. The bottom-line outlook was also given a slight bump, up from $1.1 million to $2.1 million to a new range of $2.6 million to $3.5 million. The company did not provide any longer-term outlook.

Game over or game on?
Naturally, the company is quite "disappointed by this development" but has worked to diversify its business beyond simply Apple and is also looking to expand into other markets like smart TVs, cars, and laptops.

Apple's arch-frenemy Samsung has continued to grow its business with the small company, up from 16% of sales a year ago to 42% of revenue last quarter. Google's Nexus One, released in 2010, was one of the first devices to use Audience's chips, and a whole slew of Android devices currently use them. That includes Samsung's current flagship phone, the Galaxy S III, which is selling quite well.

Audience is getting destroyed from its apparent loss of the iPhone 5, but it's not game over for the company as earSmart gains traction among other OEMs. This plunge might even very well be an opportunity to invest in a company with a lot of potential as an important component supplier in the next generation of mobile devices, iPhone or otherwise.

I recently included a special iPhone 5 report in our new Apple research service, and I highlighted Audience as one way to potentially profit on the iPhone 5, while acknowledging it as one of the riskier candidates. Risky indeed, considering today's drop. However, I also named several companies that are better and less risky iPhone suppliers -- ones that have virtual locks on their spots thanks to competitive advantages. Grab the iPhone 5 report today when you sign up to learn more.

Fool contributor Evan Niu owns shares of Apple and Qualcomm, but he holds no other position in any company mentioned. Check out his holdings and a short bio. The Motley Fool owns shares of Qualcomm, Cirrus Logic, and Apple. Motley Fool newsletter services have recommended buying shares of Google and Apple and creating a bull call spread position in Apple. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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