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.
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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 so much that the human brain tends to repetition after something happens only two times in a row. Scott Huettel, a neuroeconomist at Duke University, conducted an experiment where researchers showed subjects a series of squares or circles. He told them that the next shape to appear was random. When people saw a single square or circle before the random shape they didn’t know what to expect. When they saw two of the same shapes preceding the random shape they automatically expected a shape of the same type as the ones preceding it–even after having been told the shape was random.
In a world where Wall Street traders move retail stocks 10% or 20% based on monthly results, it’s no surprise that a company with uncertain licensing agreements that sometimes take years to negotiate could be mispriced.
Because of the nature of InterDigital’s business, it is difficult to make exact predictions for the future. There are, however, some good signs. First, InterDigital’s core market is growing. Gartner estimates the current mobile handset market at $203B and projects it to grow to $283B in 2014. The wireless infrastructure market is estimated at $45B currently and is expected to grow to $53B by 2014. Finally, ABI Research projects the currently hot wireless consumer electronics (think iPad and other tablets) to grow to $11B in 2014 from its current $3B number.
The nice thing about IDCCs business model is that it’s vendor and device neutral. Will it be the iPhone or Android? Will it be the iPad or something else? Kindle or Nook, or will e-readers and tablet computers end up being combined in to one device? None of those questions matter to IDCC. As long as consumers want wireless features, then the vendor will likely need to license technology from IDCC.
Avenues for future revenue growth can be broken down into three categories. The first group is unlicensed handset and device manufacturers. IDCC currently has about 80% of the 2G market licensed and 50% of the 3G market licensed. Currently licensees include Samsung, Apple, LG, RIM, HTC, and most recently Acer. Unlicensed manufacturers include Huawei, Motorola, ZTE, Sony Ericsson, and Nokia. The second group is unlicensed terminal unit manufacturers. This group represents a minority of IDCC’s business. The third group is existing customers for 2G and 3G who are in talks to either license the LTE portfolio or extend their 2G and 3G licenses.
Also, because of InterDigital’s business model, most if not all of the additional revenue generated by new or extended PLAs will be flow right through to the bottom line.
Convertible Bond Issue
InterDigital also recently raised funds through a $230M convertible bond offering on April 4. The terms for the bond were very attractive; the notes are due in 2016 and carry an interest rate of 2.5%. Furthermore, there will be no dilution of existing shareholders until the stock price hits $66.35. For such a cash-rich ($527M in cash and short term securities as of March 31) company, the issuance seemed rather bizarre–that is, until one considers that Nortel’s patent portfolio is being auctioned off and Google has entered a “stalking horse” bid of $900M. Although InterDigital’s management has been tight lipped about its interest, it is difficult to believe that IDCC won’t be making a bid on at least part of the portfolio, likely just the wireless patent portion.
With good management, a great balance sheet, and a very attractive patent portfolio, InterDigital looks set to continue to thrive. While not as cheap as it once was, it still could make a good investment at current prices, especially with a favorable outcome in its court case with Nokia and a pickup in 3G and LTE licensing activity.
Disclosure: Long IDCC