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ADNC > SEC Filings for ADNC > Form 10-Q on 6-Nov-2012All Recent SEC Filings

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Form 10-Q for AUDIENCE INC


6-Nov-2012

Quarterly Report


ITEM 2. Management's discussion and analysis of financial condition and results
of operations

The following discussion and analysis of our financial condition and results of our operations should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q, the consolidated financial statements and notes thereto for the year ended December 31, 2011, and with management's discussion and analysis of our financial condition and results of operations included in our prospectus filed pursuant to Rule 424(b) under the Securities Act of 1933, as amended (Securities Act) with the U.S. Securities and Exchange Commission (SEC) on May 10, 2012 (Prospectus).

This Quarterly Report on Form 10-Q, including this "Management's discussion and analysis of financial condition and results of operations", includes a number of forward-looking statements that involve many risks and uncertainties. Forward-looking statements are identified by the use of the words "would," "could," "will," "may," "expect," "believe," "should," "anticipate," "outlook," "if," "future," "intend," "plan," "estimate," "predict," "potential," "targets," "seek" or "continue" and similar words and phrases, including the negatives of these terms, or other variations of these terms, that denote future events. These statements reflect our current views with respect to future events and our potential financial performance and are subject to risks and uncertainties that could cause our actual results and financial position to differ materially and adversely from what is projected or implied in any forward-looking statements included in this Quarterly Report on Form 10-Q. These factors include, but are not limited to, the risks described under Item 1A of Part II - "Risk factors," Item 2 of Part I - "Management's discussion and analysis of financial condition and results of operations," elsewhere in this Quarterly Report on Form 10-Q and those discussed in other documents we file with the SEC. We make these forward-looking statements based upon information available on the date of this Quarterly Report on Form 10-Q, and we have no obligation (and expressly disclaim any such obligation) to update or alter any forward-looking statements, whether as a result of new information or otherwise except as otherwise required by securities regulations.

Overview

We are the leader in advanced voice and audio processing for mobile devices. We collaborate with leading auditory neuroscientists to understand the human auditory system and have developed purpose-built processors that combine science and technology to function like human hearing. Our low power, hardware-accelerated digital signal processors and associated algorithms substantially improve sound quality and suppress noise in mobile devices. As the primary driver of the mobile device market, the mobile phone continues to play an increasingly prominent role in peoples' lives. Voice communication is a primary function of mobile phones, and we expect voice to increasingly complement touch as a core user interface, heightening the importance of voice and audio quality in mobile devices.

We work with original equipment manufacturers (OEMs) to have our voice and audio processors designed into their products, which we refer to as design wins. Once our voice and audio processor is designed into a mobile device, we generally sell our processors to OEMs on a purchase order basis that incorporate them into their mobile devices, or to contract manufacturers (CMs) retained by OEMs on a purchase order basis, and the CMs incorporate them into the mobile devices that they build for the OEMs. We sell a limited portion of our products indirectly to OEMs through distributors. For a single OEM, we also license semiconductor intellectual property (processor IP), which that OEM has integrated into the 2011 model of its mobile phones. In the nine months ended September 30, 2012, we began to recognize royalty revenue for the use of our processor IP in the 2011 model of the mobile phones of a single OEM. Although we had made available the processor IP for the 2012 model of the mobile phones to the OEM to which we license our processor IP, in November 2012, we received a royalty report from this OEM which indicated that our processor IP had been included but not enabled in the 2012 model of its mobile phones. As a result, we anticipate that royalty revenue from this OEM will decline significantly commencing in the three months ending March 31, 2013. We also anticipate that sales of our processors to CMs for this OEM for an older generation model of its mobile phones will decline as newer models take market share from this older model.

On May 15, 2012, we closed our initial public offering (IPO) of 6,060,707 shares of our common stock inclusive of 270,180 shares of common stock sold by certain selling stockholders and the 790,527 shares of underwriters' over-allotment option. The public offering price of the shares sold in the offering was $17.00 per share. The total gross proceeds from the offering to us were $98.4 million and after deducting underwriting discounts and commissions, the aggregate net proceeds received by us was approximately $91.5 million before offering expenses. We also received $81,000 from the exercise of stock options by certain selling stockholders. Upon the closing of the IPO, all shares of our outstanding convertible preferred stock converted into shares of common stock on a one to one basis and all outstanding warrants to purchase convertible preferred stock converted into warrants to purchase shares of common stock.

Our total revenue was $40.8 million and $105.2 million for the three and nine months ended September 30, 2012, respectively; and $26.3 million and $79.7 million for the three and nine months ended September 30, 2011, respectively. Our net income was $3.7 million and $12.2 million for the three and nine months ended September 30, 2012, respectively, and $2.4 million and $13.9 million for the three and nine months ended September 30, 2011, respectively.


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Business factors affecting our performance

Creation of voice and audio improvement as a new category for users. Our success will depend, in part, on increasing market awareness among OEMs, mobile network operators (MNOs), operating system companies and applications vendors of the importance of voice and audio quality on the user experience. User demand for new levels of voice and audio quality will depend on our ability to provide solutions that continue to improve the user experience and our ability to convey the impact of our solutions on the mobile device ecosystem.

Design wins. We closely monitor design wins by OEMs and their mass production releases because we consider these to be important indicators of future revenue. The revenue that we generate from each design win can vary significantly and in some cases, our OEMs may cancel projects for which we have been awarded a design win. Our long-term sales expectations are based on forecasts from OEMs and internal estimations of demand factoring in the expected time to market for final mobile devices incorporating our solutions and associated revenue potential. Our ability to implement our product roadmap and introduce new products will facilitate the adoption of our solutions into future generations of mobile devices.

We estimate the life cycle of our OEMs' mobile devices on the basis of our history with the OEM, the type of mobile device and discussions with our OEMs. A given design win for our processors or processor IP can generate a wide range of sales volumes for our voice and audio processors, depending on the market demand for our OEMs' mobile devices. The market demand for our OEMs' mobile devices, in turn, can depend a number of factors, including the reputation of the OEM, the geographic markets in which the OEM intends to introduce the mobile devices and whether the MNOs on whose networks the mobile devices are designed to operate provide marketing and subsidies for the mobile devices.

Revenue driven by significant customers. Historically, our revenue has been significantly concentrated in a small number of OEMs, CMs and distributors and we expect that concentration to continue for the foreseeable future. Foxconn International Holdings, Ltd. and its affiliates (collectively, Foxconn), a CM, accounted for 14% and 15% of our total revenue for the three and nine months ended September 30, 2012, respectively, and 51% and 70% of our total revenue for the three and nine months ended September 30, 2011, respectively. Samsung Electronics Co., Ltd. (Samsung), an OEM, accounted for 55% and 45% of our total revenue for the three and nine months ended September 30, 2012, respectively, and 30% and 17% of our total revenue for the three and nine months ended September 30, 2011, respectively. Protek (Shanghai) Limited and its affiliates (collectively, Protek), a CM, accounted for less than 10% of our total revenue for both the three and nine months ended September 30, 2012, and 10% of our total revenue for both the three and nine months ended September 30, 2011. In addition, Apple Inc. (Apple), one of our large OEMs, began to license our processor IP for a royalty in connection with the 2011 model of its mobile phones. We began to recognize royalty revenue in 2012, which accounted for 21% and 31% of our total revenue for the three and nine months ended September 30, 2012, respectively. See "-Our arrangements with one of our OEMs." No other OEM, CM or distributor accounted for 10% or more of our total revenue for the three and nine months ended September 30, 2012 and 2011.

While we strive to expand and diversify our OEM base and we expect our customer concentration to decline over time, we anticipate that sales to a limited number of OEMs will continue to account for a significant percentage of our total revenue for the foreseeable future. Our customer concentration may cause our financial performance to fluctuate significantly from period to period based on the device release cycles and seasonal sales patterns of these OEMs and the success of their products. The loss of or any significant decline in sales to these OEMs may have an adverse effect on our financial condition and results of operations.

Pricing and gross margins of our products. Our gross margin has been and will continue to be affected by a variety of factors, including the timing of changes in pricing, shipment volumes, new product introductions, changes in OEM concentration and product mixes, changes in our purchase price of fabricated wafers and assembly and test service costs and inventory write downs, if any. In general, products with higher performance and a higher number of features tend to be priced higher and have higher gross margins. We expect our gross margin to fluctuate over time, in part from the impact of competitive pricing pressure. Erosion of average selling prices as products mature is typical in the semiconductor industry. Consistent with this historical trend, we expect that the average selling prices of our products will decline as they mature. As a normal course of business, we will seek to offset the effect of declining average selling prices on existing products by reducing manufacturing costs and introducing new and higher value-added products. If we are unable to maintain overall average selling prices, our gross margin will decline.

Relationships with MNOs. MNOs determine product specifications for OEM products, thereby influencing the design and components selected by OEMs, which specifications have generated demand for our products. We have invested and continue to invest significant resources in working with MNOs to increase awareness of the potential and benefits of our


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processors. We intend to continue our work with MNOs to educate them about the impact of sound quality on the user experience. MNOs may not continue to value the improvements in sound quality that our products can provide and may not require their OEMs to meet certain sound quality specifications.

General economic conditions and geographic concentration. A global economic slowdown or financial crisis, similar to the one that occurred beginning in late 2008, would likely have a significant impact on the mobile device industry and our financial results. As the economy slows, consumer confidence may decline and, because our products serve the mobile device market, any decline in purchases by consumers of new mobile devices would adversely affect our revenue. Moreover, because our sales have been concentrated in a few selected markets, including China, Taiwan and Korea, our financial results will be impacted by general economic and political conditions in these markets.

Our arrangement with one of our OEMs

On August 6, 2008, we entered into an agreement with Apple. Pursuant to the terms of the agreement with this OEM, we develop, supply and support our custom voice and audio processors for use in certain mobile devices which this OEM purchases from Foxconn and Protek; however, we cannot assure you that Foxconn and Protek will continue to purchase our processors in similar volumes, or at all. To date, Foxconn and Protek have purchased a custom version of our voice processor that Foxconn and Protek have incorporated into the 2010 model of the mobile phones for this OEM and this OEM licensed our processor IP for the 2011 model of its mobile phones. Pursuant to our agreement, this OEM pays us a royalty, on a quarterly basis, for the use of our processor IP in mobile phones in which it is integrated. In the first quarter of 2012, we began to recognize royalty revenue for the use of our processor IP in this OEM's 2011 model of its mobile phones. In comparison to a business model with OEMs that purchase our processors on a stand-alone basis to incorporate into their mobile devices, the licensing of our processor IP represents a multiyear process, and we may not receive royalties for several years, if at all, after we agree to license our processor IP.

We granted a similar license to this OEM for the 2012 model of its mobile phones; however, this OEM is not obligated to incorporate our processor IP into any of its current or future mobile devices. For the new generation of our processor IP that we agreed to license to this OEM, the royalty is subject to a lifetime maximum, after which we would not receive royalties for shipments of devices into which that processor IP is integrated. We and the OEM amended the statement of work for this generation of processor IP in March 2012 and we made available the processor IP in the spring of 2012. In September 2012, we concluded that it was unlikely that our processor IP would be enabled in this OEM's 2012 model of its mobile phones and announced our expectation. Based on this OEM's November 2012 royalty report to us, we believe that our processor IP has been included but not enabled in this OEM's 2012 model of its mobile phones. As a result, we anticipate that royalty revenue will decline substantially commencing in the three months ending March 31, 2013.

Although we may continue to provide our processors on a stand-alone basis to Foxconn and Protek to incorporate into this OEM's mobile phones in which they are currently designed, Foxconn, Protek and this OEM are not obligated to continue to incorporate our processors. Foxconn and Protek may also elect to stockpile inventory of these processors in anticipation of the time that the 2010 model of this OEM's mobile phones may reach the end of their product lifecycles. We also anticipate that sales of our processors to CMs for this OEM for the 2010 model of its mobile phones will decline as newer models take market share from older models.

Under our current license agreement, royalties from our processor IP that we license are based upon the number of mobile phones shipped that integrate our technology. We recognize royalty revenue based on mobile phone sales when and as reported to us. The amount of revenue we recognize is determined by the agreed upon royalty rate, multiplied by the number of mobile phones sold in which our processor IP is integrated. Our royalty revenue lags the sales of the products that integrate our processor IP by one quarter.

The licensing of our processor IP does not require the manufacture, assembly, packaging, test or shipment of integrated circuits by us. Our royalty rate per licensed unit is lower than our average selling price for our processors. As we transition to a partial licensing model with a single OEM, we expect our revenue from the sale of processors to this OEM and its CMs to decrease substantially in the long term, as the mix of revenue shifts from stand-alone processor sales to royalties. We also expect that our total revenue from this OEM and its CMs may also decrease as a result of lower royalty revenue per mobile device under the licensing model. Our total revenue may decline if sales to other OEMs do not increase sufficiently to offset the decline. As the cost of revenue associated with the licensing of our processor IP is substantially lower than our cost of revenue for processors, we expect our gross margin on our royalty revenue to continue to be higher than our gross margin on our processor revenue.


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Components of our results of operations

Revenue

To date, we have generated hardware revenue from sales of our voice and audio processors and we expect the sale of our processors to continue to represent the substantial majority of our revenue. We sell processors through three separate channels. First, we ship a significant portion of our products to the inventory hubs of CMs and recognize the related revenue as the CMs notify us in writing that they have drawn our products from the hub, at which point delivery and transfer of title and risk of ownership has occurred. Our sales to Foxconn are an example of this type of arrangement. Second, for certain OEMs, we ship our voice and audio processors directly and recognize revenue at the time of delivery and title transfer. Our INCOTERMS 2000 commercial shipping terms are typically free carrier (FCA), delivered at terminal (DAT) and delivered at place (DAP) shipping point. Third, we ship a small portion of our products to our distributors under our shipping terms, which are typically ex works (EXW) or free on board (FOB) shipping point. These distributors tend to buy from us at the request of specific OEMs, and we recognize revenue on sales to distributors when the distributor notifies us in writing of the final resale of our products.

We anticipate that in the future as significant OEMs prepare worldwide launches of their products, we may see substantial increases in revenue shortly before the launch. We also anticipate that for some period before the OEM begins building new inventory for the new mobile device or following the launch, we may see reductions in revenue related to our products incorporated in prior generations of devices, as the OEMs reduce their inventories of those products.

Under a license agreement we entered into in 2008, we began to recognize royalty revenue in the three months ended March 31, 2012. As part of our 2008 license, we receive a royalty for each mobile device that is sold incorporating our processor IP and, for mobile devices other than mobile phones, in which our processor IP is enabled. We entered into an additional license agreement in 2010 relating to a new generation of our processor IP, but we do not expect to receive material revenue from this subsequent generation of mobile phone as the OEM has not enabled our processor IP. We do not expect to offer this arrangement to other OEMs and expect a single OEM to be the sole source of our royalty revenue for the foreseeable future.

We recognize royalty revenue on the basis of the number of mobile phones sold that incorporate our processor IP. We are reliant on the accuracy of shipment reports, which we receive not later than 45 days after the OEM's fiscal quarter end, in order to calculate our royalty revenue. Our royalty revenue lags the sales of mobile phones that integrate our processor IP by one quarter. We have limited rights to audit the shipment data we receive, which limits our ability to verify calculated royalty revenue or seek redress for reports we believe are not accurate and we have limited experience in testing and evaluating the accuracy of the data we receive. Although mobile phones integrating our processor IP commenced shipping in the three months ended December 31, 2011, we did not recognize royalty revenue related to those mobile devices until the three months ended March 31, 2012. We expect our royalty revenue to decrease as the OEM transitions to the 2012 model of its mobile phones and demand for the 2011 model of its mobile phones in which our processor IP is enabled declines. We also expect our hardware revenue from this OEM's CMs to decrease substantially in the long term as the 2010 model of its mobile phones reach their end of life.

We maintain sales operations, which include our direct sales force, third-party sales representatives and distributors, in Asia, North America, Japan and Europe. Substantially all of our revenue from the sale of our processors has been generated by sales to CMs and OEMs that manufacture their products in Asia and we expect sales to such CMs and OEMs in Asia to contribute a majority of our revenue for the foreseeable future. Because our OEMs market and sell their products worldwide, our revenue by geographic location is not necessarily indicative of where mobile device sales occur, but rather of where their manufacturing operations occur. Since our inception, our sales in Asia have represented substantially all of our processor revenue. Our revenue from the licensing of processor IP is generated in the jurisdiction where the OEM has its headquarters. As we continue to recognize royalty revenue, we anticipate that the geographic distribution of our revenue will continue to change as our royalty revenue is attributed to the location of the licensor's headquarters rather than the location of its CMs' manufacturing operations.

Cost of revenue and gross margin

The largest components of our cost of revenue are costs of materials and outsourced manufacturing costs for the fabrication, assembly, packaging and test of our voice and audio processors. To a lesser extent, cost of revenue also includes expenses relating to cost of personnel, stock-based compensation, logistics and quality assurance, royalty expense, shipping, provisions for excess and obsolete inventories, if any, and an allocation of overhead. We intend to continue to manage our cost of revenue through both cost improvements and economies of scale.

We expect our gross margins to fluctuate over time depending on the mix of newer, higher margin products and older products, whose margins have declined over time, as well as the mix between sales of processors and license of processor IP. In general, new products with higher performance and more features tend to be priced higher and have higher gross margins.


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Consistent with trends in the semiconductor industry, we have reduced the price of certain of our products over time and may continue to do so in the future. As a normal course of business, we seek to offset the effect of declining average selling prices by reducing manufacturing costs of existing products and introducing new and higher value-added products. The license of our processor IP does not require the manufacture, assembly, packaging, test or shipment of integrated circuits, resulting in higher gross margins than for the sale of stand-alone processors.

Operating expenses

We classify our operating expenses as either research and development or selling, general and administrative. Personnel-related costs, including salaries, benefits, bonuses and stock-based compensation, are the most significant component of each of our operating expense categories. In the near term, we expect to hire a significant number of additional employees in order to support our anticipated growth. In any particular period, the timing of additional hires could materially affect our operating expenses.

Research and development. Our research and development expenses consist primarily of personnel-related costs for the design and development of our products and technologies. Additional research and development expenses include nonrecurring engineering expenses, product prototypes, external test and characterization expenses, depreciation, amortization of design tool software licenses and allocated overhead expenses. We also outsource portions of our research and development activities. We record all research and development expenses as incurred, except for capital equipment, which we depreciate over its estimated useful life. We have engineering development teams in the United States and outsourced engineering teams in the United States and India. In 2012, we opened our own design center outside of the United States and reduced the extent to which we rely on outsourced research and development teams. We expect research and development expenses to increase in absolute dollars for the foreseeable future as we continue to improve our product features and increase our portfolio of solutions. From time to time, our OEMs retain us to provide nonrecurring engineering services. Our OEMs reimburse us at contractually predetermined rates for the costs we incur to provide these services. We apply these cost reimbursements against research and development expense when acceptance occurs, which is generally upon cash receipt.

Selling, general and administrative. Selling, general and administrative expenses consist primarily of personnel-related costs for our sales, business development, marketing, applications engineering, executive, finance and human resources activities. Additionally, selling, general and administrative expenses include promotional and other marketing expenses, third-party sales representative commissions, travel, professional fees, depreciation and allocated overhead expenses. Professional fees principally consist of legal, audit, tax and accounting consultation services. We expect selling, general and administrative expenses to increase in absolute dollars for the foreseeable future as we hire additional personnel, make improvements to our infrastructure and incur significant additional costs for the compliance requirements of operating as a public company, including the costs associated with public reporting, Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act) requirements and insurance.

Other income (expense), net

Prior to our IPO, we classified our outstanding convertible preferred stock warrants as a liability on our balance sheet and recorded changes in their fair value from period to period in other income (expense), net. The convertible preferred stock warrants were exercised or became warrants to purchase common stock upon the closing of our IPO and the liability related to those warrants was reclassified as stockholders' equity.

Although a majority of our sales are outside of the United States, we incur a substantial majority of our expenses and receive all of our revenue in U.S. dollars. As a result, our foreign currency related expense and income are charged to this classification.

Income taxes

For all periods presented through December 31, 2011, we have not paid or incurred material income taxes due to our net operating loss carry forwards (NOLs) and tax credits in the United States, for which we have a full valuation allowance. Effective January 1, 2012, our new international structure became operational. Our effective tax rate in the periods presented on or after January 1, 2012 is the result of the mix of income earned in various tax jurisdictions that apply a broad range of income tax ranges. The rate at which the provision for income taxes is calculated also differs from the U.S. federal . . .

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