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Executives

Patrick Van de Wille – VP, Communications and IR

Bill Merritt – President and CEO

Rich Brezski – CFO

Analysts

Charlie Anderson – Dougherty & Company

Anil Doralda – William Blair

Eugene Fox – Cardinal Capital Management

InterDigital, Inc. (IDCC) Q3 2013 Earnings Call October 31, 2013 10:00 AM ET

Operator

Good day. And welcome to the InterDigital, Third Quarter Earnings Conference Call. Today’s conference is being recorded. At this time I would like to turn the conference over to Mr. Patrick Van de Wille. Please go ahead sir.

Patrick Van de Wille

Thank you very much. Good morning, everyone and welcome to InterDigital third quarter 2013 earnings conference call. With me this morning are Bill Merritt, our President and CEO and Rich Brezski, our CFO. Consistent with the last quarter’s call, we’ll offer some insights about the quarter and our outlook and then we’ll open the call up for questions.

Before we begin our remarks, I need to remind you that in this call we will make forward-looking statements regarding our current beliefs plan and expectations which are not guarantee the future performance and are subject to risks and uncertainties that could cause actual results and events to differ materially from results and events contemplated by such forward-looking statements.

This risks and uncertainties include those set forth in our earnings release published today. Our annual report on form 10-K for the year ended December 31, 2012. Our quarterly report on form 10-Q for the quarter ended June 30, 2013 ran those details from time to time and our other filings with the Securities and Exchange Commission.

This forward-looking statements are made only as of the date hereof. And except it [ph] is required by law, we undertake no obligation to update or revise any of them, whether as a result of new information, future events or otherwise.

With that, let me turn the call over to Bill.

Bill Merritt

Thank you, Patrick, and good morning, everyone. As you saw in this morning’s release, we delivered another strong quarter with strong revenue and profitability. The meaningful portion of that revenue was driven by some recent arbitration wins and we expect those wins will help drive future quarters as well.

Let me start with those arbitration decisions as well as an update on the overall ligation landscape and how that is driving licensing. Following that I’ll talk a little bit about the Signal Trust for Wireless Innovation which we launched recently. Last I will provide a brief update on our innovation successes.

So first on the arbitrations, we had two significant wins. One in the third quarter involving one of our technology solution customer and the second in early October involving Apple.

In the first arbitration the panel confirmed that we are entitled to the full amount of royalties specified under this technology license agreement with that customer for those products that were the subject of the arbitration.

The customer haven’t [ph] been paying royalties but had done so under reservation pending the arbitration result. For that reason we differed recognizing the cash collected as revenue.

With the arbitration panel now having ruled we are recognizing $52 million in past payments, this full amount we differ to the products that were involved in the arbitration. We also expect to recognize solid incremental royalties based on the customers’ future quarterly sales of the product involve in the arbitration.

We also secured a positive result in our arbitration with Apple. With the panel confirmed that our patent license agreement with them was limited in scope. The arbitration war [ph] declared that Apple’s iPad and any Apple products that operated in CD-May 2000 [ph] or LTE networks are not licensed under the Apple PLI [ph].

This is particularly important as Apple is not a manufacturer but typically purchases it’s products from Asian suppliers. As you know we have patent license agreements with this significant number ODMs in Taiwan and China. Currently all of our agreements with the ODMs are running royalty agreements with very solid royalty terms.

Generally those agreements provide for the payment of running royalty buy the ODM on any sales to a company of products that are not licensed by InterDigital. So if a company purchases a product from one of our ODM licenses and that product is not licensed by the buyer, then typically that ODM will pay us royalties pursuing to the terms of their agreement.

This dynamic laid out in the second quarter whether as the result of the – an arbitration with Pegatron over this type of issue. We recognize approximately $23 million in past sales revenue committed to Pegatron sales of certain cellular terminal [ph] products through June 2012.

During this quarter, we recognized another $12 million based upon Pegatron sale of additional products from June 2012 through March 2013. For fourth quarter 2013, we project that we will recognize approximately $27 million in past sales revenue related to these products as well as other products that have been determined not to be licensed under the agreement we have with Pegatron’s customers. In addition we expect Pegatron will also contribute to recurring fourth quarter licensee revenue based on current sales of these products.

We’re obviously happy with these arbitration decisions. Combined they have driven nearly $90 million in added revenue in the second and third quarters and are expected to drive at least another $27 million in revenue next quarter perhaps more depending upon Pegatron’s levels of third quarter sales.

In addition we expect to see a very solid incremental revenue contributions in the quarter beyond that. An exact amount of technology solutions and patent licensing revenue will depend upon actual sales volume from our technology licensee customer and the license success of our licensed ODM suppliers in securing orders from key customers.

From that regard, Apple has talked about further diversifying its supply chain, while we do not have a license agreement in place with Hon Hai which is the largest Apple supplier, we have agreements with other ODMs that have been indicated as potential suppliers to Apple.

So as an example of Hon Hai would lose [ph] orders to an InterDigital licensee, we could benefit from that shift. Of course we would like to put in place the comprehensive relationship with Apple around all of its cellular products on fair terms. Hopefully we will be able to do so. Until then though, we are securing significant royalties on those unlicensed Apple products being manufactured by our licensed ODM.

Beyond Apple, we continue to press forward on securing licenses with other key manufacturers in the market. As we recently reported, the U.S. Supreme Court denied Nokia’s petition for review of the domestic industry issue in our prior ITC case against them.

We have written to the commission asking that they promptly pick up the matter and once and for all issue an exclusion order against Nokia’s 3GWCD in their handset [ph]. We believe we should prevail on all necessary items but then [ph] an exclusion order is appropriate this time.

As it was also reported as the result of the partial U.S. Government Shutdown, the ITC moved the target date for the commissions’ decision in the case against Huawei, ZTE and Nokia from October 28, 2013 to December 19, 2013.

We continue to believe that we have a very strong case on review. And as the fact demonstrate that we are entitled to an exclusion order with the Supreme Court [ph] in Nokia, ZTE and Huawei’s 3G related products.

In our most recent ITC case with Nokia, ZTE, Huawei and Samsung involving those 3G and LTE patent the trial is currently scheduled for February 2014. We continue to believe we have a very strong case there as well.

The disputes for these parties and the discussions are very intense as you would expect. The result is both incentives for the parties to discuss settlement but also answer litigation [ph] as the defendant seek to gain leverage. For example, ZTE and Huawei have filed a number of patent validation proceedings against us in China. To date, we are served very [ph] well in those cases, prevailing in most.

Huawei has filed a number of cases against us in China including one seeking to have refund rate [ph] determined for our Chinese standard essential patent. And [indiscernible] we have violated China anti-monopoly law by asking for what they allege to be excessive royalties.

The People’s Court in China recently affirmed lower court decisions in Huawei’s favor but we believe those decisions are fundamentally flawed those legally and factually. In particular, in determining our refund rate [ph], the court applied a completely incorrect economic analysis by evaluating our Apple agreement in high sight [ph].

And DDA, LGA and [ph] our ITC case considering it substantially full record completely rejected this approach. Moreover the Chinese court applied incorrect fact particularly in a view of the recent arbitration decision which confirmed that our license agreement with Apple is limited in scope.

We intend to appeal these rulings. And while we are not happy with the Chinese court access to date, the decisions apply only to the Chinese standard essential patent in the case and we don’t see these decisions having a material impact on our worldwide licensing program. So that’s the litigation update.

Although then [ph] we’ve done a very – we’ve done very good work in protecting our intellectual property in a somewhat more challenging environment. As a result of those efforts the debt through our portfolio [ph] and the strength of our business, we believe we are well-positioned as we could be to drive new license agreements with some of the key industry participants.

We will continue to work hard in coming up with creative and viable ways to do so. Next few months will be very important in terms of closing new deals and we are very focused on delivering strong results.

Let me move now to the Signal Trust for Wireless Innovation. Two weeks ago, we announced the formation of the Trust. The result of a number of months of activity in the company looking at the number of different options to monetize our very valuable patents related to cellular infrastructure.

Let me provide a little bit more background on why we form the Trust, what assets we transferred to the Trust, how it works and what we would expect to get out of it? As you know, InterDigital innovations are used across the entire wireless ecosystem.

To date, our core licensing program has been focused on terminal unit. Our strategic plan is to drive even greater value from our history of innovation by among other things securing value from other parts of the wireless ecosystem.

As we’re considering a number of options including patent sales, we determine that a Trust structure was the best way for us to pursue the infrastructure market. First, the Trust structure allows us to have a focused effort with dedicated licensing personnel.

Second, while we could have created that focused effort internal to InterDigital, the Trust structure also minimizes any dilution in the value of the infrastructure portfolio, particularly where a licensing customer may have a large terminal unit operations but relatively smaller infrastructure businesses.

By operating independently from InterDigital, the Trust is incentivized to maximize the value of those infrastructure assets. And we believe those assets are impressive. For over a decade but we’re certain to follow [ph] behind them, we believe that more than 500 patent assets transferred to the Trust represent one of the largest cellular infrastructure paten portfolios held outside of the infrastructure manufacturers themselves.

Moreover a considerable number of the assets transferred to the Trust have been declared to the standard bodies as potentially essential to the 3G or LTE standards. Also important portfolio has no meaningfully incumbent [ph].

For that reason we have tighten for the [ph] Trust in terms of the licensing revenue we can generate. The infrastructure market is a $29 billion market today. And it’s expected to increase will be added in a small sales and other infrastructure equipment advances.

The Trust is also led by two industry veteran, Roger Striker who has a long history at Lucen [ph] and is very familiar with this industry. And Bruce Bernstein who ran InterDigital licensing programs for a number of years and is extremely skilled at licensing in the cellular market.

Together InterDigital’s innovations, the patent assets, the market and licensing team should deliver solid financial benefit to InterDigital. And the signal foundation for wireless innovation an InterDigital owned subsidiary created to promote [indiscernible] research on intellectual property, which together are the soul beneficiaries of the [indiscernible].

So between our terminal unit licensing program and now the Trust, we have in place two licensing programs and in fact it’s addressing the [ph] two ends of the wireless link, the infrastructure and the terminal units.

Our innovation programs are intended to refresh those licensing opportunities with new inventions and also allow us to address the value that is created by what travels between those links in terms of content, context and data between people, machines and networks that underpin new exciting business model.

That innovation is being driven by our labs, partners and solutions groups, all operating to create what we now call the living network. To give it like a human body, a living thing, the transportation and communication networks of a variety of types interconnected, operating in unison, self-healing and instinctive.

These are the technologies that we are working on today like the smart office [ph] manager that intelligently creates the right communication path moment-to-moment. The machine-to-machine which interconnects everything-to-everything, technologies that almost counter-intuitively take the network from being highly visible like the little strength bar on your phone to being completely in the background, just how you do the transfer of information in your body from moment-to-moment. You don’t track – you don’t track [ph] up information get to your brain, to your hand, the information just flows and so all the data in the living network.

To drive this vision, our innovation teams are quite different today from what they were two years or even a year ago. While we continue to have our core wireless teams driving innovation into the new wireless standards, that team now works alongside other teams driving other critical technologies.

The team is also more geographically diverse as we have open new R&D centers and also engaged with more individual inventors, universities and independent research centers to drive our innovation. The result is a far more diverse innovation set all focused around creating a living network. We are seemingly happy with the quality and quantity of the innovation coming at our new innovation structure.

This innovative structure has gotten significant external validation. Two of our solutions that are contributing to our living network vision, Smart Access Manager or SAM and our Dynamic Spectrum Management Technology were recently highlighted by experts externally.

In the case of SAM, it has been included in operator trial with the top tier operator. Interestingly of the several solutions the operators choose to test, ours was the only solutions that included a full client site technology which we think is key to a full solution.

We also venture these recently highlighted InterDigital Dynamic Spectrum Management Technology as one of the probable winners in the growth of TV White Space as a component of a network solution.

In summary, the financials of the company were very strong with the ability to repeat. As I mentioned earlier, we understand the critical period we are going through. We believe we are managing our way very well through what can be choppy waters. Our goal is very simple, get adequately compensated for the use of our many innovations. We believe we have the tools and the result to do so. With that let me turn the call over to Rich.

Rich Brezski

Thanks Bill. We are very pleased to report over $110 million of revenue in third quarter of 2013. This represents our highest level of quarterly revenue, not including patent sales in the last three years.

Importantly, the third quarter results also exemplify the operating leverage of our business model. Our third quarter revenue nearly doubled the run rate for the first half of this year. Yet, third quarter operating expenses are up just 4%. If you do not include incentive compensation adjustments which are one of the few variable components of our cost structure, our operating expenses for the third quarter would actually have decreased from the first half run rate.

When you consider this against the backdrop of our successful arbitrations and their impact on our existing licensee base, you can begin to understand why we are confident about our business. Later in the additional potential represented by currently unlicensed market participants and you can see why we are very excited about our future.

Having said that, we remain committed to careful expense management. Last year at this time I told you we would reduce our internally funded development by $15 million to $20 million from our annualized run rate of $68 million.

And add further [ph] investments in development would be funded by customer projects. While after netting out $6.1 million of funding year-to-date from our Convida joint venture, we are in lined to meet our target while continuing to generate the same quantity of innovation with even more diversity.

I also told you a year ago that we would reduce administrative expenses by $3 million to $5 million from our annualized run rate of nearly $38 million. Tier two, we are in line to meet that target.

Expensed management is important to us not because we are focused on a certain level of expenses but rather because we’re committing to creative – excuse me, because we are committed to creating as much value as possible for our shareholders.

This is evident when you see our litigation and arbitration expense, rise and fall over the years. As I’ve discussed in prior quarters, we feel this is one of our most important investments. We are pleased with the decisions we received this year from three arbitrations, the U.S. Court of Appeals for the Federal Circuit and the U.S. Supreme Court.

And of course, we are anxiously awaiting word from the International Trade Commission on two of our ITC matters.

Looking beyond litigation, we will continue to invest both in organic and inorganic opportunities with the same discipline and the goal of increasing shareholder value. And without high regard for whether such investments result in additional decreases or increases to our operating expenses.

One of the areas we chose to invest in during the third quarter was the Signal Trust. We expect this investment will amount to a very small increase in our operating expenses since we have already developed the technology that we contributed to the trust.

However, the trustees are incentivized to deliver meaningful value to InterDigital shareholders and we expect that overtime they will do just that.

With that let me turn the call back over to Patrick.

Patrick Van de Wille

Thanks Rich. And now I will invite to begin the question and answer session.

Question-and-Answer Session

Operator

Thank you, (Operator instructions) We’ll go to our first question from Charlie Anderson with Dougherty & Company.

Charlie Anderson – Dougherty & Company

Yes, good morning, thanks for taking my question. So just how I understand it correctly if you’re to sign a comprehensive licensing with Apple that incorporated the LTE and tablets, would that in effect sort of cancel anything from Pegatron so you don’t get double paid?

Bill Merritt

Right, typically with that we don’t seek to get double payments. You can get the payment at different levels and you can mix and match the payment at different levels but ultimately you’re getting a seal of payment on each device.

So with [ph] comprehensive relationship with Apple, covering all the products based on [indiscernible] sort of royalties from their suppliers.

Charlie Anderson – Dougherty & Company

So I’m curious, Bill, how you think this is going to pay out. I mean, do you think Apple will resist in any way because they’ll say,

look some of our suppliers have this and just go to the rest of our suppliers, just any thoughts on that.

Bill Merritt

Yes, you know, I don’t believe their selection of suppliers depends upon our licensing status but again, it’s more – they have much more important things to think about in terms of quality production and other things.

I think it does – there are two things, they’re on one end. We have – because we’re now collecting significant royalties, we have a level of patients in terms of getting the right deal done because we’re already being paid on a good portion of the production.

I do think it creates an opportunity to – and the comprehensive relationship which – in that type of relationship you wouldn’t have the uncertainty, only shifts in the supply mix, right, that we would give credit for that in terms of how we would price that out.

So, I think we’re in good shape here. Obviously we – our desire is to put in place a fair agreement with Apple, hoping to do that and it’s good – it’s an open channel communication system [ph] and we’ll work to get that done.

Charlie Anderson – Dougherty & Company

And what would be some of the – excluding the on-high, other ODMs that’s out there where you could capture some volume that we should pay attention to?

Bill Merritt

I think the one, I saw reported was Wistron. That’s being reported as a potentialized supplier [indiscernible] and Wistron is one of our ODM suppliers. So I think we have our list of licensees on the side [ph] until you can – and Apple has been and this is a lot of analyst discussion around the diversification of Apple supply chain, it’s pretty easy [ph] to match up potential suppliers with what our relationship with those suppliers might be.

Charlie Anderson – Dougherty & Company

Perfect and then just a couple of housekeeping questions, Rich I wondered of you have the percent of revenue contributed by the Japanese per units that you guys have given the past?

Rich Brezski

I don’t have that offhand Charlie, we do have – we just put out our 10-Q this morning and I think both in the 10-Q and the press release we have our 10% licensees. As for the Japanese licensees I don’t have that percentage offhand.

Charlie Anderson – Dougherty & Company

Got it and then on the [indiscernible] administration licensing if I exclude out legal, looks like that is sort of taking upward on year-over-year or in a just [ph] quarterly basis. I’m just kind of curious what’s going on there.

Bill Merritt

A part of that I think we mentioned there were some incentive compensation adjustments driven by the successful arbitrations. So that would be at least the component of that uptick.

Charlie Anderson – Dougherty & Company

Got you, thanks so much.

Rich Brezski

Thanks, Charlie.

Operator

We’ll go to our next question from Anil Doralda with William Blair.

Anil Doralda – William Blair

Hey guys, a couple of questions. Bill, is it fair to say that over the next couples of ears, you guys are going to rely on the Chinese Courts systems? In others words are you going to rely more on them or are you going to try to rely less on them? [indiscernible] given the whole ecosystem from the manufacturing to delivery, is there – and we’re seeing kind of better branded handset audience coming out of China. So how do you look at yourself in addition, this will be the Chinese Court system?

Bill Merritt

So a lot of production has moved into China and Taiwan but obviously sales are still dominant in other places around the world. And so, while we, I’ll say first, we don’t principally rely on a legal system. We rely on negotiations with folks, and typically pretty successful there. So look at our list of licensees, the vast majority didn’t come from any litigation.

We’ve historically relied on U.S. Court only because they’re more convenient that we’re here. And our legal strategies could change depending upon a number of factors.

So there’s other places as well. I mean the European Courts and other place that we could cover [ph] again, we try to do things without litigations. So there are – obviously the experience we had to date from China has been frustrating because we think that the decision is completely wrong and completely at odds [ph] with what’s very, very well accepted licensing practice.

So, I wouldn’t say that our experience with China to date would say we want to spend more time in those courts. But we’ve got more opportunity with respect to those cases too and we have an opportunity to go up in the Supreme Court in China. The profits in China is one where you could think you’ll have to see in [ph] the Supreme Court level and I think as we move down the path in terms of the Chinese court, we do believe we have a good opportunity to refine what our currently pretty flawed decisions.

Anil Doralda – William Blair

Okay. So when I look at you per unit royalty business, obviously the key players in that have some structural issues, one more than the other. But, do you think 2014 would be a growth year for your per unit royalty business based on obviously your existing licensees, but potentially some new ones that could pop in? So is that a growing segment or a declining for 2014, you think?

Bill Merritt

Yes, if you exclude the past sales that we recognized this year in 2013, I would expect that 2014 would be a growth year for per unit. And again, that is a result of somebody’s arbitrations that we expect, some of the ODM royalties to increase more than you’d expect decreases in any of the other existing per unit licensees. And of course, there’s always the opportunity to add additional licenses as we move forward in time.

Anil Doralda – William Blair

If I strip out in 2013 the past licenses and there are no past licensing in 2014, you’re saying that organically per unit royalty business will grow in 2014?

Bill Merritt

Yes, that’s what I would expect based on the recent developments.

Anil Doralda – William Blair

Okay, great. And then coming back to Apple, obviously, to Pegatron, there is a lot of commentary around Apple but I get the impression that there’s more activity on that front when I compared it for like nine months or a year ago. Now, Apple gets over some time towards the end of 2015, are you – do you believe that you guys will come to some kind of negotiation before the expiration of that licensing deal? And it won’t turn out to be like a Samsung or something like that?

Now I know it’s a tough question to ask but I get the impression that there seems to be more active with Apple, is that a fair way to characterized it?

Rich Brezski

I think we’ve been very active on the variety of fronts sorry, [ph] with respect to not only Apple but it’s supply chains in terms of agent’s [ph] Pegatron, didn’t agree what we had with a key supplier.

So some of it wasn’t always visible for the outside but now more of it is. So there is a very, very – a lot of activity within the company on that.

Second, the agreement expires in June of 2014 but unlike the Samsung agreement, when the Apple agreement expires it’s actually – since as an example, we’re collecting royalties from any – from Pegatron with respect to any unlicensed sales and link back [ph] continued beyond June of 2014.

If you don’t have that click [ph] event that you had in Samsung, in fact, you know, it – given the modest amounts we get paid by or not paid by Apple, if given, what happen to their sales, the royalty agreement really [indiscernible].

It actually creates simply more opportunity now that any remaining product that are licensed under there, we have an opportunity to talk about as well. So, I think it’s very different than the Samsung situation. I think we’ve done a – frankly a very good job in terms of positioning ourselves to get appropriately compensated here.

Again, the companies that we open to creative deals that fairly compensate us and so we would hope to do that with Apple.

Bill Merritt

The only thing I’ll add to that is as we kind of discussed here, we get compensated from the ODMs now to the extent that they produce product that is unlicensed and currently, you know, Apple does have certain products under license.

When those – at the end of June, all of their products would be unlicensed as to Apple. So therefore any product that is produced by one of our other licensed ODM would now be – will be rolling that time.

Anil Doralda – William Blair

Okay, great. Thanks a lot and best of luck guys.

Bill Merritt

Thank you.

Operator

(Operator Instructions) We’ll take our next question from Eugene Fox with Cardinal Capital Management.

Eugene Fox – Cardinal Capital Management

Thanks so much. Any further thoughts Bill on the situation with Nokia and their handset business?

Bill Merritt

I think obviously, as we talked about before, the sale of that business the Microsoft increase, we think some opportunities since Nokia was running the business in a certain way and some constraints, either made for marketable [ph] environment with them, Microsoft, for once, I have a stronger balance sheet. So we think that there’s opportunities with them. We think that it doesn’t – the transfer should not affect the – like the ITC cases that we have since surviving [ph] the entire business.

So, just like other folks, we’re open to getting things resolved with those folks and maybe the change in the player there will be positive, with getting something, get it from you [ph].

Eugene Fox – Cardinal Capital Management

Thanks Bill.

Bill Merritt

Thank you.

Operator

There are no other questions in the queue at this time.

Patrick Van de Wille

Well, thank you very much Tiffany and thanks to everybody for joining us today. We look forward to our next conference call. Have a good day.

Operator

And that concludes today’s conference call. Thank you for your participation.

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