Will InterDigital Finally Get Some Respect?

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Includes: AAPL, BBRY, ERIC, GOOG, HTHIY, IDCC, KYO, LGERF, NOK, PCRFY, SNE
by: Beacon Asset Managers

InterDigital (NASDAQ:IDCC) has long been the Rodney Dangerfield of the wireless Telecom sector, as it just “can’t get no respect,” from either Wall Street or many of the big wireless players.

However, that may finally change later this summer as the world’s leader in cell phone sales, Nokia (NYSE:NOK), could decide to come to terms with IDCC rather than face a possible U.S. importation ban on its smart phones.

IDCC has been seeking respect and revenues from its technology and patents since it was founded in 1972. Its attempts to generate revenues from its proprietary wireless phone system resulted in significant operating losses, but the company realized that its patented cell phone technologies–those used both in handsets and for transmission (base stations)–were crucial to the development of the fledgling worldwide cell phone system.

The big cell phone players, however, basically decided that IDCC’s patented technologies were not “essential” to the system, and balked at paying the royalties InterDigital sought, forcing the company to seek redress through the court system.

In 1995, InterDigital lost a crucial patent infringement case against the biggest cell phone maker of that time period, Motorola (MOT), which reputedly made other companies even more hesitant to license with IDCC and pay for the company’s technology. This despite the fact that the U.S. Patent Office, and several European patent offices, revalidated and affirmed the disputed patents in 1999.

A 10-year legal battle Ericsson (NASDAQ:ERIC) resulted in a settlement in 2003, but the settlement itself disappointed Wall Street as it appeared that IDCC, which had reportedly been seeking more than $1 billion in damages, accepted “pennies on the dollar” (the settlement gave IDCC $34 million for past infringement and established a new license with rates of between .5 percent to .75 percent for handsets and a flat $6 million per year for base stations).

However, Wall Street did get excited because IDCC announced that the Ericsson settlement initiated licenses and multi-million dollar payments from Samsung and Nokia under licensing frameworks (basically agreements to pay whatever Ericsson agreed to pay) IDCC had in place with those two companies, and the stock rose from about $14 to reach a high of $27.14 within two months.

Of course, both Nokia and Samsung claimed foul, initiated arbitration and began other legal maneuvering (Nokia has initiated more than 10 separate legal actions–most of which ultimately proved unsuccessful–in the U.S. and abroad in a strategy some call “delay and obfuscate”) to get out of paying IDCC anything for its patented technology.

Ultimately, after arbitration awards granted to IDCC, appeals of those awards and other legal maneuvering by the defendants, Nokia in 2006 paid $253 million for their use of IDCC patented technology up to the year 2006, while Samsung in late 2008 settled for a reported $400 to $500 million to cover both past infringement and a royalty bearing license good until 2012.

At this point in the story it should be noted that most of the above mentioned legal saga revolved around 2G (or second generation) cell phone patents. IDCC has also been a key player in the development of 3G technologies (which resulted in “smart phones” and is used extensively in wireless computing) and served on the international standards body that coordinated the development of 3G for commercial application. The standards body reportedly accepted about 300 IDCC contributions of patented technology as either essential to the system or commercially attractive.

Starting in about 2003, InterDigital began publicly announcing that its goal was to get paid for every 3G device sold worldwide, and that it was aiming to receive from between $1 to $2 per every device. Since then, IDCC has managed to license more than 50 percent of the 3G market with companies such as LG Electronics (OTC:LGERF), Research in Motion (RIMM), Apple (NASDAQ:AAPL), Panasonic (PC), NEC, Hitachi (HIT), Kyocera (NYSE:KYO), High Tech Computer (OTC:HTCCF), Arima, Toshiba (OTCPK:TOSBF), and, most recently, Samsung, coming to terms with the company.

And now Nokia, which remains the biggest hold-out, is facing an August 14 “initial determination” on whether the International Trade Commission (ITC) should ban the importation of Nokia handsets into the U.S. due to infringement of IDCC patents.

The ITC case mirrors the one IDCC had with Samsung prior to their settlement, in that it involves some of the same patents and that the ITC staff have recommended a finding of “no violation” (and thus, no importation ban) against the alleged infringer. Samsung agreed to settlement just weeks prior to the “initial determination” deadline in its case, and many pundits believe Nokia will do the same.

While the ITC staff recommendation would appear to favor Nokia, ITC judges are not under any obligation to follow the staff recommendation, and, in fact, often rule contrary to them. And, like Samsung, Nokia just cannot afford even the risk–a sword of Damocles–of an importation ban due to the scale of the potential economic disruption it could cause.

If Nokia settles as expected, the rest of the 3G market, including Sony-Ericsson and Motorola, is expected to quickly follow. In fact, IDCC officers have alluded to a 3G license framework the company has with Sony-Ericsson that dictates the terms under which that company will take a 3G license, and many analysts believe the primary dictate to be that IDCC licenses Nokia to 3G.

A Nokia 3G license would boost IDCC’s annual revenues by at least 30 percent, and adding the other holdouts to the mix should represent a doubling of revenues. While the company has been aiming for licensing terms of between $1 to $2 per 3G device, it appears that the company has been getting terms of between $0.50 to $1.25.

However, this still adds up to hundreds of millions of dollars in revenues per year, most of which will flow to the bottom line as the company generates almost 100 percent gross margin on licensing revenues.

And these revenues should continue to increase every year for the foreseeable future as the number of 3G devices being sold every year continues to grow. Under InterDigital’s own projections for the year 2012, with 75 percent of the 3G market licensed at $1 per device the company would earn about $700 million in 2012. With 100 percent of the market licensed at $1 per device this figure almost reaches $1 billion.

The company has more than 3,000 patents issued worldwide, with another 9,000 pending, and was ranked 141 among companies worldwide for the number of patents issued by US Patent Office in 2007. Its patents cover 3G wireless, the future 4G wireless, wireless LAN and Mobility/Convergence. Its roster of current 3G licensees represents a “who’s who” of the wireless business and currently help the company earn more than $1 per share (excepting a recent $37.1 million repositioning charge).

The addition of Nokia and other holdouts, along with a growing market for 3G devices, could easily raise the company’s earnings to between $2 to $3 per share by late 2010.

With a current P/E of around 109 and a price to sales ratio of 3.6 we cannot argue that the stock is cheap, however we would argue that the P/E is misleading given the repositioning charge. We believe that future positive news flows, earnings surprises, new licenses, and growing revenues make the stock especially attractive on a forecasted 2010-2011 P/E of 9.5. We expect investors to drive the price back up to the $32 to $36 range by the end of the year.

Disclosure: Long IDCC