Shares of Imagination Technologies Group (LSE: IMG) fell by up to 70% on Monday morning, after the firm warned that tech giant Apple plans to stop using its chips in new products.
This is a huge blow for Imagination, whose chip designs are used in Apple’s iPhones, iPads, iPods, TVs and watches.
According to the firm, Apple has been developing its own graphics technology. Imagination chips will be phased out of new products in “15 months to two years’ time”.
The news comes almost exactly one year after Apple ruled out speculation that it might bid for Imagination. Now we know why — Apple decided to develop its own chips instead.
What’s the impact?
The potential impact on Imagination is huge. Licensing and royalty fees from Apple accounted for £60m of the group’s total revenue of £120m last year.
However, I believe the impact on profit is likely to be even greater. In this morning’s statement, Imagination said that it “has minimal direct costs associated with this revenue stream.” My reading of this is that Apple generates more than half of Imagination’s profits.
It’s not over yet
Imagination’s management is understandably trying to fight back. In today’s statement, the firm said it believes that it would be “extremely challenging” for Apple to develop replacement products without infringing Imagination’s intellectual property rights.
I suspect legal action is likely, but this could be a high-risk gamble for Imagination, which had net debt of £40m at the end of October and only £9m in cash.
Imagination also says that it is discussing “potential alternative commercial arrangements” with Apple. I’d imagine the group is trying to extract some extra cash from Apple. This might be through contract termination fees or perhaps additional charges to support ongoing development of key products.
However, without knowing more about the companies’ existing contracts, I don’t think it’s possible to take a view on the likely outcome of these discussions.
Can Imagination survive without Apple?
Apple provides half of Imagination’s revenue and — I suspect — more than half of its profits. Given Apple’s plans to stop using Imagination chips in new products, we could see a steady decline in sales and profits from mid-2018 onwards.
I’d be surprised if Apple reverses this decision. The US tech giant must already be heavily committed to developing its own alternative products, and can easily afford to challenge any legal action from Imagination.
Although Imagination does have other customers, this loss of licensing and royalty volumes could mean that the group’s other operations become unprofitable. A second risk is that Imagination may struggle to sign new customers if it is locked in a costly legal battle with Apple.
In my view, there’s no way for investors to accurately value the remainder of Imagination’s business. Even after today’s fall, I’m not convinced that the shares are cheap enough to be worth buying speculatively.
I’d rate Imagination Technologies stock as a sell.
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Roland Head has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Apple. The Motley Fool UK owns shares of Imagination Technologies and has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.