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| ADNC > SEC Filings for ADNC > Form 10-K on 4-Mar-2013 | All Recent SEC Filings |
4-Mar-2013
Annual Report
The following discussion and analysis of our financial condition and results of our operations should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this Annual Report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the sections titled "Risk factors" and "Special note regarding forward-looking statements and industry data" included elsewhere in this Annual Report.
Overview
We are the leading provider of intelligent voice and audio solutions that improve voice quality and the user experience in 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 DSPs and audio codecs 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 recorded total revenue of $143.9 million, $97.7 million, and $47.9 million for 2012, 2011 and 2010, respectively. We recorded net income of $15.6 million, $8.3 million and $4.8 million for 2012, 2011 and 2010, respectively.
We work with 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 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 small portion of our products indirectly to OEMs through distributors. For a single OEM, we also license processor IP, which that OEM has integrated into certain of its mobile phones and we began to recognize royalty revenue for the use of our processor IP from this OEM in 2012. Our OEMs' products are complex and require significant time to design, launch and ramp to volume production. As a result, our sales cycle is lengthy. We typically commence commercial shipments of our products nine months to one year following a design win. Because the sales cycle for our products is long, we incur expenses to develop and sell our products, regardless of whether we achieve a design win and well in advance of generating revenue, if any. In addition, achieving a design win from an OEM does not ensure that the OEM will begin producing the related product in a timely manner, if at all, or that the design win will ultimately generate additional revenue for us.
On May 15, 2012, we closed our 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.
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, 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. For 2012, Samsung, Apple, and Foxconn revenue accounted for 48%, 27% and 14% of total revenue, respectively. In addition, with respect to the 2011 model of Apple's mobile phones, Apple transitioned from the purchase of our processors to licensing of our processor IP for a royalty. We began to recognize royalty revenue in 2012, which accounted for 25% of total revenue for 2012. For 2011, revenue from two CMs, Foxconn and Protek, and from one OEM, Samsung, accounted for 65% 10%, and 20% of total revenue, respectively.For 2010, revenue from Foxconn accounted for 81% of total revenue. No other OEM, CM or distributor accounted for 10% or more of our total revenue for 2012, 2011 and 2010.
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 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. 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. For this new generation of our processor IP that we agreed to license to this OEM, the royalty revenue is subject to a lifetime maximum, after which we would not receive royalties for shipments of devices into which that processor IP is integrated. 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 and February 2013 royalty reports to us, our processor IP has been included but not enabled in this OEM's 2012 model of its mobile phones. As a result, our royalty revenue declined substantially in the three months ended December 31, 2012 and we expect it to continue to decline thereafter. In addition, we believe that it is unlikely that this OEM would enable our processor IP or license new processor IP for future mobile phones or other devices. The OEM is not obligated to license additional processor IP from us or utilize the processor IP it has already licensed.
With respect to an older model of mobile phone for which we sell our processors to this OEM, the OEM or its CMs may also elect to stockpile inventory of these processors in anticipation of the time that this model may reach the end of its product lifecycle. As a result, we expect sales of our processors to CMs for this OEM for older generation mobile phones will decline as newer models take market share from older models.
We believe that our royalty revenue from the 2011 model of this mobile phone will begin to decline as consumers focus on this OEM's 2012 model mobile phone. Although we are unable to determine when this OEM will stop production of the 2011 model of its mobile phones, we expect that over time, the OEM will sell fewer of the 2011 models of its mobile phones and at some point we will cease to receive royalty revenue from this model.
Our royalty revenue lags the sales from this model 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 such data from this OEM.
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, for certain OEMs, we ship our voice and audio processors directly and recognize revenue at the time of delivery and title transfer. The transfer of risk and reward of ownership to the customers is typically complete at the time of shipments as per our shipping terms. Second, 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. Third, we ship a small portion of our products to our distributors under our shipping terms. 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 are entitled to receive a royalty for each 2011 model of mobile device that is sold incorporating and, for the 2012 model of this mobile device, incorporating and enabling our processor IP. We entered into an additional license agreement in 2010 relating to a new generation of 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 no later than 45 days after the OEM's fiscal quarter end, in order to calculate our royalty revenue. Our royalty revenue will lag 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 no experience in testing and evaluating the accuracy of the data we will 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. Our royalty revenue declined substantially in the three months ended December 31, 2012 and we expect it to continue to decline thereafter. In addition, we believe that it is unlikely that this OEM will enable our processor IP or license new processor IP for future mobile phones or other devices.
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 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 in 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 hardware revenue.
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 royalties from the license of processor IP. In general, new products with higher performance and more features tend to be priced higher and have higher gross margins. 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. Historically, from time to time, one of our OEMs retained us to provide nonrecurring engineering services, which enhanced our proprietary technology. This OEM reimbursed us at contractually predetermined rates for the costs we incur to provide these services. We applied these cost reimbursements against research and development expense when acceptance occurred, which was 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 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 has not been material to date.
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 carryforwards and tax credits in the United States, for which we had 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 rates. The rate at which the provision for income taxes is calculated also differs from the U.S. federal statutory income tax rate primarily due to the income tax benefits from the partial valuation allowance release on U.S. federal deferred tax assets and different tax rates in foreign jurisdictions where income is earned and considered to be indefinitely reinvested.
Our effective tax rate may be affected by such factors as the additional release or re-establishment of a valuation allowance against our remaining U.S. deferred tax assets, changes in tax laws, regulations or rates, changes in interpretation of existing laws or regulations, the impact of accounting for stock-based compensation, changes in our international organization and shifts in the amount of income before tax earned in the United States as compared with other regions in the world.
Backlog
We do not believe that our backlog as of any particular date is meaningful, as our sales are made primarily pursuant to purchase orders. Only a small portion of our orders is noncancelable, and the dollar amount associated with the noncancelable portion is not significant.
Critical accounting policies and estimates
Our consolidated financial statements and the related notes included elsewhere in this Annual Report are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require our judgment in its application. In other cases, our judgment is required in selecting among available alternative accounting policies that allow different accounting treatment for similar transactions. The preparation of our consolidated financial statements also requires us to make estimates and assumptions that affect the reported amounts of our assets, liabilities, revenue, costs and expenses and related disclosures. We base our estimates on our historical experience and various other assumptions that we believe are reasonable under the circumstances. Our actual results could differ significantly from the estimates we make. To the extent that there are differences between our estimates and our actual results, our future financial statement presentation, financial condition, results of operations and cash flows would be affected. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving our judgments and estimates.
Revenue recognition
We derive hardware revenue from the direct sale of voice and audio processors to CMs and OEMs and indirect sales of processors to OEMs through distributors. We recognize revenue from sales to CMs and OEMs
when persuasive evidence of an arrangement exists, the selling price is fixed or determinable, product delivery has occurred, which is when the risk and reward of ownership pass to the customer, and collectability of the resulting receivable is reasonably assured. The transfer of risk and reward of ownership to the customers is typically met at the time of shipment as per our shipping terms. We also 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.
Although we do not recognize hardware revenue from sales to our distributors upon shipment, the title and the risk of ownership for the products typically transfers to the distributor upon shipment as per our shipping terms, and the distributor is obligated to pay for the products at that time. We do not offer distributors, CMs or OEMs return rights, rebates, price protection or other similar rights. However, in the past, we have occasionally accepted returns from . . .
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