Undervalued InterDigital Inc, Well Positioned For Growth In 5G And The IoT

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)	Dec16	Sep16	Jun16	Mar16	Dec15
Revenue	273.9	208.3	75.9	107.8	112.1

(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 of our engineering teams, the accuracy of our forward vision, our leadership positions in a standards bodies, the size and quality of the patent portfolio, and how often people reference InterDigital as a thought leader in our space.”

Competitive Advantage

In addition to the company’s continual pursuit of accretive and value add acquisitions, InterDigital has developed a strong competitive advantage through its collaboration with standards bodies, equipment manufacturers, and software solution providers.

In 2016 InterDigital joined Avanci, the industry’s first marketplace for the licensing of cellular standards-essential technology for the Internet of Things (IoT). The licensing platform brings together some of InterDigital’s peers in standards-essential technology leadership, and makes 2G, 3G and 4G standards-essential patents available to IoT players in specific product segments with one flat-rate license. The Avanci licensing programs in specific product segments for the IoT industry will provide access to the entire applicable standards-essential wireless patent portfolios held by all of the platform participants, as well as any additions to their portfolios during the term of the license.

Cooperating with Avanci, partners like Qualcomm, Ericsson and others represented the most effective and efficient means of pursuing the licensing of what will be a vast and diverse market. So far the company is said to be very happy with the progress being made by Avanci.

Another example is InterDigital’s recent strategic technology partnership with CA Technologies, a leading software solution provider.

This collaboration will offer a comprehensive IoT solution with CA Technologies’ market leading mobile app development, API management, and advanced security capabilities. “As part of their journey toward Digital Transformation, organizations are investing more heavily in IoT. This requires a modern app architecture that supports seamless integration, but at the scale and with the security necessary to support billions of connected devices to the enterprise,” said Richard Pulliam, Vice President, Strategy, CA Technologies. “In collaboration with InterDigital, our customers can rely on an enterprise grade mobile and IoT solution to meet the needs of a wide range of verticals, including Energy & Utilities and Smart Cities.”

InterDigital’s comprehensive standards-based IoT platform enables solution providers to consolidate varied and disparate data feeds, enable real-time monitoring and data analysis while enabling back-end systems integration. “CA Technologies is a leader in enterprise software and security and we are pleased to embark on this partnership to help meet the demands of a rapidly evolving market,” said Jim Nolan, EVP, IoT Solutions, InterDigital. “The interoperability benefits of an open horizontal platform and data truly materialize in applications that InterDigital has been creating with its premier partners such as CA.”

Yet another example was the company’s 2016 partnership with Harman, a connected technologies company for automotive, consumer and enterprise markets.

As part of the initial roll-out, HARMAN and InterDigital will be offering the company’s oneMPOWER™ based IoT solution to companies in the smart infrastructure market, including smart home, commercial real-estate, smart retail and smart manufacturing applications.

Combining InterDigital’s oneMPOWER IoT platform and HARMAN’s excellence in IoT systems integration and service management, the two companies will provide customers a unique way to accelerate the definition and deployment of tailored, scalable and interoperable IoT solutions aimed to maximize business results.

“There is a massive space for further growth in IoT applications that will benefit a broad range of market segments,” said InterDigital’s James Nolan, EVP, IoT Solutions. “This collaboration with HARMAN, a long standing global provider of connected services, provides an exciting opportunity to bring our horizontal oneM2M compliant oneMPOWER IoT platform and expertise in wireless connectivity across a number of growing verticals.”

It’s these types of collaborations, combined with the company’s smart acquisitions, like the 2016 acquisition of Hillcrest, combined with the sizeable opportunities in 5G and IoT that will sustain InterDigital’s revenue growth and strong position into the future.

Well Run Business

What sometimes gets overlooked by investors is just how well InterDigital is managed from a financial perspective. InterDigital has an extremely low cost based with gross margins of 83% (ttm) and operating margins of 66% (ttm). The result is that most of the top line revenue filters through to the bottom line net income margins of 47% (ttm).

The real strength of the company however, lies in its very strong balance sheet and free cash flows. A quick look at the company’s balance sheet ending December 2016 below shows that InterDigital had cash and cash equivalents of $953 million and total debt of $272 million, or a net cash minus total debt amount of $681 million. InterDigital is therefore well placed to pursue sought after acquisitions.

Fiscal Period (Amounts in Millions)	Dec16
Cash And Cash Equivalents	404.1
Marketable Securities	548.7
Cash, Cash Equivalents, Marketable Securities	952.8
Current Portion of Long-Term Debt	—
Long-Term Debt	272

(Source, Company Reports)

Loads of Free Cash Flow

When you combine the company’s strong balance sheet with its significant amounts of free cash flow, you start to get an idea of the real value of InterDigital.

A quick look at the company’s trailing twelve month cash flow statements below shows InterDigital generated $431 million (ttm) in operating cash flow. At the same time, the company had just $43.5 million (ttm) in capex, which equates to $387 million (ttm) in free cash flow. With a current market cap of $2.93 Billion that means the company has a FCF/Price yield of 13% (ttm).

Fiscal Period (Amounts in Millions)	Dec16	Sep16	Jun16	Mar16
Cash Flow from Operations	233.3	-10.2	191.4	16.2
Capital Expenditure	-10.9	-9.4	-9	-14.2
Free Cash Flow	222.4	-19.6	182.5	2.1

(Source, Company reports)

Valuation

In terms of the company’s valuation, if we subtract the $681 million in net cash and cash equivalents from the company’s current market cap of $2.93 Billion and factor in minority interests that means InterDigital has an Enterprise Value (EV) of $2.26 Billion. With $387 million (ttm) in free cash flow, that means InterDigital has a FCF/EV Yield of 17%.

We favor EV over market capitalization as it includes additional liabilities–like debt, preferred equity and non-controlling interests–if you were to purchase the entire company. EV is calculated as:

Market Cap + Preferred Equity + Non-Controlling Interests + Total Debt – Cash and Equivalents.

With an Enterprise Value (EV) of $2.26 Billion and Operating Earnings* of $440 million (ttm), that means InterDigital is currently trading on an Acquirer’s Multiple of 5.15 or, 5.15 times Operating Earnings*.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

With a FCF/Price Yield of 13% (ttm), a FCF/EV Yield of 17% (ttm) and an Acquirer’s Multiple of 5.15, or 5.15 times Operating Earnings*, that places InterDigital squarely in undervalued territory.

Summary

InterDigital is a leading innovator in the wireless communications industry and a recognized thought leader in 5G technology. Despite posting a 51% increase in FY2016 revenue compared to the pcp, short-term investors have recently chosen to focus on the company’s short term Q1 2017 revenue which presents a great opportunity for longer term focused investors.

What seems to have been overlooked by these short term investors is that by the end of 2016 InterDigital had the top three smartphone manufacturers in the world; Samsung, Apple, and Huawei, under agreement which provides the company with ongoing revenue stability and visibility. Add to this the company’s strong competitive advantage, which has been achieved through its collaboration with standards bodies, equipment manufacturers, and software solution providers. This was highlighted with InterDigital joining Avanci in 2016.

Cooperating with Avanci, partners like Qualcomm, Ericsson and others represented the most effective and efficient means of pursuing InterDigital’s licensing of what will be a vast and diverse market. Other collaboration examples include InterDigital’s recent strategic technology partnership with CA Technologies, a leading software solution provider and Harman, a connected technologies company for automotive, consumer and enterprise markets.

It’s these types of collaborations, combined with the company’s smart acquisitions, like the 2016 acquisition of Hillcrest, combined with the sizeable opportunities in 5G and IoT that will sustain InterDigital’s revenue growth and strong position into the future.

InterDigital is an extremely low-cost operation with gross margins of 83% (ttm), operating margins of 66% (ttm), and net income margins of 47% (ttm). The company is operationally efficient with a strong balance sheet and loads of free cash flow.

In terms the InterDigital’s valuation. The company is currently trading on a FCF/Price Yield of 13% (ttm), a FCF/EV Yield of 17% (ttm) and an Acquirer’s Multiple of 5.15, or 5.15 times Operating Earnings*. Add to this the company’s P/E of 9.75 and InterDigital remains squarely in undervalued territory.