Shares in Imagination Technologies (LSE: IMG) lost more than half of their value yesterday after the company revealed that its primary customer, Apple has decided to bring some of its microchip production in-house and is therefore no longer going to require Imagination’s services.
Imagination and Apple’s relationship goes back years, and the former has become dependent on the latter for more than half of its total revenues. This year, it’s expected Apple will pay nearly £65m in royalties to Imagination. In 15 to 24 months time, this figure will fall to zero.
However, even though it now appears Imagination will struggle to survive after the break-up, this is not a simple case.
Indeed, some City analysts believe Imagination has a strong case to take Apple to court as, while the tech giant may have a multi-billion dollar research and development budget, building graphics processing units from scratch (similar to those provided by Imagination) will be challenging unless the company has acquired intellectual property rights or mastered reverse engineering.
With this being the case, according to the Financial Times, the Apple/Imagination relationship may still have some life in it yet. Imagination holds a significant number of patents around low-power graphics processors and may have the bargaining power to discuss new commercial terms with Apple for the use of this intellectual property without a costly legal battle.
Despite its size, if it comes to a full intellectual property lawsuit, Apple seems to be on the back foot. iPhones have been built using Imagination’s chips for a decade now, and as the company has so far failed to provide evidence showing how the technology it plans to use going forward differs from that provided by Imagination, its intentions certainly look suspicious.
Still, even though Imagination may have the upper hand if it comes to a legal battle, there’s no denying that the company’s outlook has now changed significantly for good. A legal battle is likely to cost a lot of money and time, two commodities it lacks. When the Apple revenues completely vanish, the firm will return to a lossmaking position, and the company’s debt is already growing. It rose from £35m to £45m in 2016.
If Imagination’s management has no appetite for a costly, lengthy legal battle the company’s future looks bleak. But if management can negotiate an out-of-court settlement to continue the relationship on a smaller scale, the group may be able to buy itself some time to cut costs and move into other markets.
The bottom line
Overall after yesterday’s news, Imagination’s outlook has changed drastically, there’s just no other way of putting it. If the group takes Apple to court over intellectual property rights, it may be awarded a substantial reimbursement, but such an outcome is almost impossible to predict and would not happen fast.
Unfortunately, without more information on how management intends to tackle Apple and rebase the Imagination business to profit without its large US partner, it is not possible to place a value on the shares.
Rupert Hargreaves 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.