One of the cheapest stocks in our All Investable – Stock Screener is InterDigital, Inc. (NASDAQ:IDCC).

InterDigital Inc (InterDigital) designs and develops advanced technologies that enable and enhance wireless communications and capabilities. Since 1972, InterDigital engineers have designed and developed a wide range of innovations that are used in digital cellular and wireless products and networks, including 2G, 3G, 4G and IEEE 802-related products and networks. The company is a leading innovator in the wireless communications industry and a recognized thought leader in 5G and the IoT technology.

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A quick look at the company’s share price (below) over the past twelve months shows that the price is up 59% to $85.45 compared to March 2016. That is 17% off its 52 week high of $102.30.

(Source, Google Finance)

InterDigital recently released its Q4 2016 and FY2016 earnings report. The company stated FY2016 total revenue of $665.9 million compared to $441.4 million in 2015, a 51% increase. This shows that InterDigital had its best ever year. While that was clearly great news for the company, investors chose to focus instead on the company’s short term outlook for Q1 2017 revenue, which is expected to be in the range of $91 million and $96 million, and subsequently sold off shares, resulting in a one day drop of 14% from $101 to $87 on February 23.

This is exactly the type of short-term vision that presents longer term investors with an opportunity to capitalize on what is now an undervalued successful business. Here’s why.

It’s important to understand the type of business in which InterDigital operates where revenues can be lumpy.

Most of the company’s patent license agreements are structured on a royalty-bearing basis, while others are structured on a paid-up basis or a combination thereof. Upon entering into a new patent license agreement, the licensee typically agrees to pay consideration for sales made prior to the effective date of the license agreement (i.e., past patent royalties) and also agrees to pay royalties or license fees on licensed products sold during the term of the agreement. It is generally expected that new license agreements will follow this model.

Almost all of InterDigital’s patent license agreements provide for the payment of royalties based on sales of licensed products designed to operate in accordance with particular standards (convenience-based licenses), as opposed to the payment of royalties if the manufacture, sale or use of the licensed product infringes one of the company’s patents (infringement-based licenses).

Basically, what that all means is that InterDigital can receive significant revenues in one quarter followed by much lower revenues in a following quarter depending on a number of variables. A quick look at the company’s last five quarters below illustrates the point.

Fiscal Period (Amounts in Millions)Dec16Sep16Jun16Mar16Dec15
Revenue273.9208.375.9107.8112.1

(Source, Company reports)

What’s more important than the outlook for the next quarter is the consideration of what the company achieved in 2016 and how that will impact its future. Prior to 2016 InterDigital already had a patent licensing agreement with Samsung, the world’s largest manufacturer of smartphones. Samsung accounted for approximately 10% of the company’s total revenues in 2016. During FY2016 the company also secured two other significant licensing agreements.

Huawei

During Q3 2016, InterDigital secured a multi-year, worldwide, non-exclusive, royalty-bearing patent license agreement with Huawei, the world’s third largest manufacturer of smartphones. The agreement covers sales of Huawei and its affiliates’ 3G and 4G terminal unit products and sets forth cash payments to InterDigital and a process for the transfer of patents from Huawei to InterDigital. More importantly, the agreement includes a co-operation component regarding ongoing joint research and development.

Regarding the co-operation component CEO Bill Merritt said, “We love agreements to have a cooperation component because experience has shown that these are the easiest to renew and because we are confident in our InterDigital’s labs team’s ability to drive or deliver great value.”

Under the terms of the patent license agreement with Huawei, InterDigital recorded $154.8 million of revenue during 2016, including $121.5 million of past sales. The company will record future revenue under the agreement on a straight-line basis over its term.

What sometimes gets overlooked is that part of the agreement included patents from Huawei. InterDigital received half of the patents as of December 31, 2016, and we will receive the remaining patents by June 30, 2017. Of the $154.8 million of revenue recorded under the agreement to date, 95% related to cash receipts and 5% related to the patents transferred to date. The company has chosen to defer recognition of revenue related to the patents yet to be transferred, as their value will not be determinable until the completion of the transfer process.

Apple Inc

During Q4 2016, InterDigital secured a multi-year, royalty-bearing, worldwide and non-exclusive license agreement with Apple, the world’s second largest manufacturer of smartphones. The agreement sets forth terms covering the sale by Apple of its products and services, including, but not limited to, its 3G, 4G and future generation cellular and wireless-enabled products.

The agreement gives Apple the right to terminate certain rights and obligations under the license for the period after September 30, 2021, but has the potential to provide a license to Apple for a total of up to six years. Our agreement with Apple is a multiple-element arrangement for accounting purposes.

InterDigital recorded $169.3 million of revenue under this patent license agreement during 2016, including $141.4 million of past sales, and will recognize future revenue under the agreement on a straight-line basis over its term.

That means InterDigital now has the top three vendors in the world under agreement which provides the company with more revenue stability and visibility.

“In fact the recurring revenue from those agreements combined with the past sales collection and contribution from our other license fees, resulted in our finest financial year ever. And it’s from that incredibly solid foundation that we believe we can grow the business even further.”, said CEO Bill Merritt during his latest earnings call.

In addition to the two new contracts with Huawei and Apple, the company also acquired Hillcrest Laboratories, Inc.

Acquisition – Hillcrest Laboratories, Inc

One of the company’s major objectives in 2016 was to make acquisitions that would drive its core business even further. In December 20, 2016 InterDigital met its objective when it acquired Hillcrest Laboratories, Inc. (Hillcrest) for approximately $48.0 million in cash.

Hillcrest is a recognized leader in sensors and sensor fusion. Sensor processing and sensor fusion is an important emerging technology area, with multiple applications in IoT, augmented and virtual reality, robotics, and other areas. Hillcrest fits perfectly into the company’s M&A strategy providing additional areas of deep competence that complement InterDigital’s very strong position in wireless technology. That new area of competence not only includes a strong technology offering and patent portfolio but also the R&D capability to allow those elements to grow.

In terms of the R&D capability provided by Hillcrest, CEO Bill Merritt said during his latest earnings call, “Indeed, that is the bedrock of our successful R&D backed licensing business. It is not that we just have patents, it is that we have recognized core strength in an area of importance to mobile devices, a strength that is embodied in the extreme competence

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