By Ben Strubel of Strubel Investment Management
In June 2011 we profiled InterDigital in our monthly newsletter to client (you can subscribe for free here). InterDigital (IDCC) is a company that develops wireless technology for mobile devices, networks, and services. The company is relatively unique in that it is a “non-practicing entity” or NPE meaning that it does not manufacture any products based on the technology it develops but instead licenses the technology to other manufacturers, typically mobile handset makers. InterDigital owns more than 8,600 patents and has an additional 10,000 on application. The patents cover a broad variety of wireless and wire line communication, including 2G, 3G, 4G, and LTE, as well as IEEE 802.
There are several different types of NPEs. Some types are pejoratively called “patent trolls.” They simply buy up existing patents or patent portfolios and then use an army of lawyers to search out companies to sue. Sometimes those companies are legitimately infringing on the patents, but many times it’s simply blackmail where the threat of a long expensive lawsuit is used to extort a settlement.
In contrast to the “patent trolls” some companies are like InterDigital. They research and develop their patent portfolio in house (95% of InterDigital’s patents are self-developed). InterDigital employs 180 engineers to develop new technology and last year spent $71.5M on R&D.
Why Is It Such a Great Business?
Multiple aspects of InterDigital’s business make it attractive and allow it to earn outsized returns.
First, InterDigital is not in a proprietary technology business. That means that InterDigital designs technology that conforms to existing communications standards. This is very important. It means that other companies are essentially forced to license InterDigital’s patents.
How important is that? Take the story of Rambus (RMBS). Rambus was the opposite of InterDigital in that it developed proprietary technology, specifically a type of memory (RDRAM) used in computers. RDRAM had some very strong advantages over the current memory technologies then in use, but the licenses to use and produce RDRAM were expensive. So computer and memory manufacturers did the sensible thing and simply invented an alternative technology and used that. It should be noted that they did end up using several Rambus patents, however, royalty rates were decreased dramatically. Rambus’ flagship technology was dead in the water.
InterDigital takes the opposite approach. Instead of trying to develop exciting new groundbreaking technologies, it works with the different standards bodies worldwide that govern technical specifications for wireless technology. In fact, InterDigital has representatives on many of those standards bodies. IDCC then develops technology that best helps wireless companies build equipment to meet those standards. That means that companies generally do not have a choice about whether or not they use InterDigital patents in their equipment. I mean that literally. InterDigital technology is found in all cell phones shipped to date. That includes 2G, 3G, and 4G/LTE.
Second, InterDigital also has an advantage in that the business has low capital requirements. IDCC can be thought of as the R&D portion of a traditional company. IDCC doesn’t need to maintain large inventories of product. It doesn’t constantly spend money upgrading factory equipment. The downside is that if a business has low capital requirements, then competitors tend to spring up frequently since it is cheap to enter the business. Here again InterDigital’s close relationship with standards bodies and decades-long history of developing wireless technology provides a sizable barrier to entry. InterDigital’s main advantage then is more one of accumulated specialized knowledge coupled with high initial capital expenditure costs in the form of R&D that take many years to be recovered.
The final advantage, and possibly most attractive aspect of InterDigital, is that the company’s variable costs do not increase with each additional dollar of revenue. This means that most revenue growth flows right through to the bottom line. For instance, suppose IDCC entered into a license agreement with company ABC where IDCC receives $1 in license fees for each 4G phone ABC sells. The first quarter ABC sells 10,000 phones, so IDCC receives $10,000 in royalties. The next quarter ABC sells 12,000 phones, and IDCC receives $12,000. The entire $2000 increase in income was accomplished without IDCC spending another dime.
We can look at the ratio of revenue and earnings before interest and taxes (EBIT) to net fixed assets to see how IDCC has been able to leverage its asset base into higher and higher revenue and EBIT per dollar of fixed assets.
The graph below shows the ratio of IDCC’s revenue and EBIT to Net Fixed Assets (NFA)
As you can see, over the past 15 years IDCC’s ratios have improved. This means that for each additional dollar in earnings the company does not need to invest a proportional amount in fixed assets. InterDigital’s patent portfolio gives it a strong competitive advantage, which it can use to leverage higher earnings without much additional investment. Contrast this to most businesses where each dollar of additional earnings requires a proportional capital investment. The chart below shows the ratio of revenue and EBIT to Net Fixed Assets for Ford.
We can see that Ford is a far less attractive business. This makes sense as each additional vehicle Ford sells requires additional inventories and manufacturing plant and equipment.
If InterDigital Is So Great, Why Is It Cheap?
Well, it was a lot cheaper when we first started purchasing it for clients in the $20s and $30s, but we still think it is cheap today.
One of the aspects of InterDigital’s business that makes it so attractive also can work in reverse. We saw that IDCC does not need to spend much additional capital on fixed assets or on other variable costs to increase earnings and revenue, but the same holds true in reverse. If sales begin to fall, it will be harder for IDCC to cut costs. It can’t very well layoff engineers or close R&D labs as it needs those assets to generate future sources of revenue.
Contrast that with a company such as Ford, which can reduce costs as sales fall (at least in theory anyway). When sales start to drop, Ford can close down manufacturing lines and shutter plants. It can lay off workers. It can close dealerships and do away with redundant brands. Of course, that doesn’t really happen in real life. The UAW makes downsizing the workforce and closing plants exceedingly difficult. Franchise laws make closing dealerships and killing of a brand marquee cost more money than the company might save. Reducing R&D spending on certain unpopular slots in a brand vehicle line-up (e.g. neglecting small or mid-size cars) is also a dicey proposition.
InterDigital’s other problem is that its cash flow can be lumpy. IDCC gets paid in any combination of ways either back payment for past sales, fixed fees, or per unit royalty payments. For example, a recent patent license agreement (PLA) with Samsung saw IDCC receive $400M in equal installments over the course of 18 months. Other agreements have IDCC receiving royalties on a per device sold basis.
IDCC might sign a big agreement this quarter and then have two quarters with no major announcements. Humans abhor randomness. In fact, they dislike it