InterDigital (IDCC) develops fundamental wireless technologies that are at the core of mobile devices, networks, and services worldwide; and solves many of the most critical and complex technical challenges years ahead of market deployment. As the company explains, IDCC’s advanced solutions support more efficient wireless networks, a richer multimedia experience, and new mobile broadband capabilities.
This article discusses fundamental valuation, supported by InterDigital’s multi-year financial performance and the continuing rapid worldwide expansion in wireless communication.
The analytical inquiry focuses on the activities and financial attributes of the firm, market opportunity, and in the fundamental valuation itself. The metrics selected for discussion pertain to free cash flow, a driver in fundamental valuation.
This article presents the investment opportunity based on a conservatively estimated fundamental value significantly greater than the current price of the stock.
· Client Benefit
IDCC licenses its patents to producers of digital cellular products, and licenses or sells mobile broadband modem solutions to mobile device manufacturers, semiconductor companies, and others that manufacture or sell digital cellular products.
Indicative of the reach of IDCC are license agreements covering over 50% of all mobile devices sold worldwide, as of 12/09. Licensees include the most prominent manufacturers of such devices like Samsung (GM:SSNLF), LG (OTC:LGERF), Sharp (OTCPK:SHCAY), and NEC.
Client benefit derives from IDCC’s competence in developing digital wireless technologies. The company holds a portfolio of 3G and 4G technologies encompassing over 17,000 issued patents and applications. It employs some 200 engineers; 80% with advanced degrees.
Generally, patent license agreements entail payment consideration for sales made prior to the effective date of the license agreement and royalties or license fee payments on covered products that the licensee will sell or anticipates selling during the term of the agreement.
License agreements contain provisions which give IDCC the right to audit the licensees’ books and records to ensure compliance with the licensees’ reporting and payment obligations under the agreements. Inevitably, some audits reveal under-reporting or underpayment. In such cases, there is negotiation, and either resolution or a legal dispute.
There is inherent tension in the relationships between IDCC and unlicensed companies, particularly when these may be required to make significant payments for unlicensed past sales. Potentially contentious issues involve the essential nature of the patents, validity and applicability of patents, and patent pricing.
Resulting from this dynamic interaction between the two parties are revenues to IDCC as payment (from licensees) for technological benefit received, or expenses involving the negotiation, resolution, or litigation of such contentious issues.
· Economic Formula
Resources are devoted to two principal activities; technology development ($64.0 million, or 35% of operating expenses in FYE12/09); and patent administration and licensing ($56.1 million, or 31%), which include patent litigation and arbitration costs ($16.3 million in 2009, $34.0 million in 2008, and $38.6 million in 2007).
Research and development costs are largely expensed when incurred and not capitalized as assets on the balance sheet. Capitalized are only external costs, such as filing fees and associated attorney fees, incurred to obtain issued patents and patent license rights. Also expensed are costs associated with maintaining and defending patents subsequent to their issuance in the period incurred. The point: the book value of patents in the balance sheet ($127.5 million in Q 9/10) is hardly reflective of market opportunity (more below), or prospective free cash flow generation.
Technology development, and patent administration and arbitration, are linked and mutually supportive activities. Development of technology creates the intellectual value; patent administration is contract management, enforcement, arbitration; and litigation, the last resort in the defense of intellectual property rights.
Strong technology leadership guides effective contract and patent administration, which in turn supports legal defense. Disciplined administration and monitoring of contractual performance ensures timely and complete compensation, and provides the basis for remedial action. Effective litigation corrects contract breaches, enforces intellectual rights, and chills the use of legal action by observing licensed and unlicensed companies in the marketplace.
Such combination of technology and licensing activities result in very high return on invested capital (ROIC). The metrics below, for Q 9/10, show various components of ROIC and of free cash flow (FCF).
- EBIT (Operating Income) = $54.5 million
- NOPAT (Net Operating Prof. after Taxes) = EBIT (1–Tax Rate) = $35.4 million
- NOPAT Margin (NOPAT / Revenues) = 38%
- NOWC = Net Operating Working Capital = minus $521.9 million
- OLTA = Operating Long Term Assets = $271.7 million
- Operating Capital = NOWC + OLTA = minus $250.2 million
- ROIC (Return on Inv. Cap.) = NOPAT / Operating Capital = 35.4x4/-250.4 (annual.)
- FCF = Free Cash Flow = NOPAT - Operating Capital uses = $75.9 million
- Cash and Marketable Securities = $563.6 million.
Contributing to high ROIC is substantial NOPAT ($141.6 million; annualized quarterly NOPAT of $35.4 million) on negative operating capital (minus $250.2 million). Negative operating capital means that the company’s stakeholders, principally clients, provide financing which would have otherwise been provided by shareholders and/or debt holders.
In fact, clients originated sizable deferred revenues ($531.1 million in Q 9/10), which contributed to negative NOWC, and to negative operating capital. Deferred revenues stem from the difference in timing between cash received from clients in anticipation of revenue recognition. As it is, NOWC generates sufficient financing to cover OLTA and to significantly contribute to building significant surplus cash.
The point not to be lost in this discussion is that negative operating capital, or low capital use, signifies high capital efficiency. This strong financial attribute, along with a reasonable NOPAT, enables the firm to self-finance, even during periods of rapid revenue growth (without recurring to debt or to dilutive secondary equity financing). Also worth noting is the robust NOPAT margin, despite the fact that cash made up 62% of total assets in Q 9/10.
Implicit in the activities and financial attributes discussed is significant operational risk, measured by the volatility in revenues and in FCF (see table, below). The revenue stream is uneven due to gaps in timing between the addition of new, potentially sizeable contracts, and the expiration of maturing contracts, and due to the unpredictable recognition of revenues subject to dispute.
|InterDigital Table --Selected Metrics|
|(Amounts in millions of US$, unless otherwise noted)||FYE 12/06||FYE 12/07||FYE 12/08||FYE 12/09||4-Yr. Avg. (2007-09)|
|Revenue Growth (y-o-y)||195%||-51%||-2%||30%||43%|
|EBIT / Revenues||70%||10%||16%||38%||34%|
|EBIT Growth (y-o-y)||1868%||-93%||58%||212%||511%|
|Cash Flow from Ops.||314.81||152.73||85.81||320.69||218.51|
|CF f/Ops.Growth (y-o-y)||835%||-51%||-44%||274%||253%|
|Free Cash Flow||300.19||130.73||56.96||297.82||196.43|
|FCF / Revenues||62%||56%||25%||100%||61%|
|FCF Growth (y-o-y)||1249%||-56%||-56%||423%||390%|
|Cash (& Market.Secs.)||263.97||177.47||141.66||409.80|
|Cash Growth (y-o-y)||150%||-33%||-20%||189%||72%|
|# Shares Growth (y-o-y)||-2%||-12%||-7%||-4%||-6%|
|Q 9/09||Q 9/10||YTD 9/09||YTD 9/10||Change (y-o-y)|
|Cash Flow from Ops.||229.21||81.59||332.50||163.14||-51%|
|Free Cash Flow||224.32||75.93||314.74||146.68||-53%|
|Cash (& Market.Secs.)||429.72||563.58||429.72||563.58||31%|
FYE 12/09 P&L figures include $38.6 million in repositioning charges; $30.6 million non cash.
Concentration of revenues into relatively few clients also contributes to business risk. In 2009, 62% of revenues came from three clients: Samsung Electronics (33%), LG Electronics (19%), and NEC Corporation (10%).
Adding to volatility are difficult to predict patent litigation and arbitration costs, occasional arbitration and litigation contingencies (nil in 2009, a credit for $3.9 million in 2008, and a charge of $24.4 million in 2007), and infrequent repositioning charges due to the cessation of product development activities ($38.6 million in 2009 and nil in 2008 and 2007).
Difficult to assess, but important in value creation, is the perception of litigation as an avenue to pursue in the eyes of actual and potential clients. The broader industry perception regarding the combined strength of the firm’s intellectual property on one hand, and legal expertise and related track record, on the other hand, is of critical importance in leveraging InterDigital’s relationships with licensees and potential licensees. For the status of the Nokia/USITC/IDCC case, see here.
Mitigating volatility are capital efficiency, visibility from existing contracts (deferred revenues), increasing maturity of InterDigital as an organization with access to a growing portfolio of technology, and clients, prospects, and market opportunity (more below), absence of debt, and abundant cash on the balance sheet ($563.6 million as of 9/30/10).
· Management Effectiveness
Management allocates resources between two principal activities; development of technology, and patent administration and licensing (which include patent litigation and arbitration costs). In so doing, it has constructed a capital efficient business model with a robust ROIC.
A portfolio of 3G and 4G technologies, over 17,000 issued patents and applications, the intellectual capital provided by some 200 engineers, and a history of successful license agreements, provide credence to InterDigital’s leadership position in the development of digital wireless technology. To be sure, the engine of value creation in this business model is the development of technology, patent administration and licensing, which supports such value creation.
Management states that integral to strategy is the ability to develop advanced digital wireless technologies, and those that shape the future generations of wireless standards. Embedded in this effort is the contribution of ideas to accredited industrial and professional associations or governmental bodies regarding standards and specifications, and to allow for interoperability.
The strategy is explained here (.pdf) as the resolution of the bandwidth crunch by innovations that support data usage by means of bigger pipes (spectrum optimization; accelerate the evolution of cellular standards), better pipes (intelligent data delivery creates more efficient media distribution), more pipes (connectivity and mobility build networks of heterogeneous networks).
Signaling confidence in prospective performance is the initiation of a regular quarterly cash dividend of $0.10 per share on common stock, announced on 12/10. This measure augments the return of capital to shareholders via the $100.0 million stock repurchase program approved in 3/09 (during 2009, the company repurchased 1.0 million shares for $25.0 million. No additional repurchases were made through 10/29/10).
By all measures available: purpose, opportunity (more below), strategy, risk, and resources, they seem to be adequately balanced in the business model organized by management.
Mobile phone sales grew from approximately 278 million units in 1999 to over 1.2 billion units in 2010, and are expected to reach 1.5 billion units in 2013. The combination of a broad subscriber base, continued technological advancement and the growing dependence on the Internet, e-mail and other digital media sets the stage for continued growth in the sales of advanced wireless products and services over the next five years.
Shipments of 3G-enabled phones, which amounted to 450 million units in 2010 (or 35% of the market in 2010, are predicted to increase to 900 million in 2013 (or 60% of the market). Meanwhile, 4G-enabled shipments near 100 million units in 2013.
Within this industry context, as of December 2009, IDCC had entered into patent license agreements covering over one-half of all 3G mobile devices sold worldwide.
In addition to growth in handset devices (e.g. Apple (AAPL), RIM (RIMM), Samsung, LG, Nokia (NOK), others), there is projected growth in potential addressable markets such as network infrastructure (e.g. large carriers, manufacturers of cellular towers), and data services (e.g. Twitter, Google (GOOG), Nasdaq; consumer electronics, others).
The order of magnitude in the current and potential addressable markets is as follows:
Handsets: $180 billion in 2010; $266 billion in 2014
Infrastructure (Machine to Machine): $45 billion in 2010, $54 billion in 2014
Data Services: $850 billion in 2010, $1 trillion in 2014
Wireless Consumer Electronics: $3 billion in 2010, $16 billion in 2014.
The takeaway from these numbers is the sizeable opportunity for future growth, in handsets and in the other addressable markets noted. In other words, the magnitude of the potentially addressable market could be as large as six to seven times the size of the current addressable market.
While IDCC holds a significant industry position, the company is not dominant; competition in intellectual property rights is keen (see here). While ample opportunity does not, by itself, guarantee revenues or added shareholder value, InterDigital seems to be advantageously positioned to take advantage of such major market opportunity.
With such broad opportunities and comparatively limited company resources, sharp shooting becomes critical in the allocation of resources. Paraphrasing CFO McQuilkin (from the Q4 '09 earnings call transcript), the challenge lies in finding along the wireless value chain the place and party (terminal units, infrastructure, operators, consumer electronics) where IDCC technology creates the greatest benefit – either cost reduction, or operational efficiency; because the party who delivers the greatest value will respond by paying IDCC the highest value back.
The cash flow from of the portfolio of technologies determines in large measure the fundamental value of the firm. More specifically, the present value of future free cash flows (FCF) discounted at the firm’s cost of capital (WACC), is the estimated enterprise value of the IDCC.
Enterprise Value (Fundamental) = PV of future FCF discounted at the WACC
FCF = NOPAT – Net Investment in Operating Capital (during the period)
WACC = Cost of Equity (virtually IDCC has no debt)
Equity Value (Fundamental) = Enterprise Value + Surplus Cash - Debt
The estimated fundamental value of the stock is computed at $81.15/share, say $81.00/share. This value is based on $183.35 million in base annual FCF growing at a rate of 5% per year and discounted at a cost of capital (GM:WACC) of 11%. Base annual FCF of $183.35 million is computed by annualizing $146.68 million, FCF YTD 9/10.
A numerical comparison between the base annual FCF figure ($183.35 million) and $196.43 million, average FCF for the last four fiscal years, and against $297.82 million FCF generated in 2009 (table), suggests the reasonableness of the base annual FCF figure. In fact, it could be argued that the base annual FCF should be somewhat higher than $183.35 million, particularly in view of the much larger $314.74 million FCF YTD 6/09.
Likewise, the case could be made that the 5% annual rate of FCF growth is too small. Supporting a case for a larger rate of growth is 390%, the four year average FCF growth (table). Also supporting a higher growth rate is the size of the market opportunity, the leading position of IDCC in that market, and the high degree of capital efficiency, which enables the company to self-finance in a rapid growth scenario.
The fundamental value estimation is also depressed by high WACC. Growing FCF at 5% and discounting it at 11% can be considered too onerous to fundamental value. While business risk is on the medium-to-high side, the company’s industry position (quality of the intellectual property portfolio), the ability to self-finance growth, large surplus cash, and zero debt, are significant factors in mitigating risk and supporting a case for a lower estimated WACC (which would raise fundamental value).
The point of this discussion is that the base FCF, the driver of fundamental value, is modest, reasonable, and achievable. Likewise, the projected rate of FCF growth and the cost of capital are admittedly too conservative. Thus, the fundamental value, as estimated, represents solid value; it does not require a stretch performance by the company or any particular favorable litigation outcome to materialize.
Thus, the significant gap between the fundamental value of the stock ($81.00/share), conservatively estimated, and market price (about $50.00/share) represents an investment opportunity. Incidentally, 25% of the firm’s current equity price is in cash and marketable securities.
Strong technology leadership creates shareholder value, concurrent with significant business risk.
A high level of capital efficiency is embodied in InterDigital’s activities. Low use of operating capital enables rapid growth without the need of external financing. This rather permanent attribute contributes to a strong surplus cash position, no debt, and supports equity repurchase and the dividend program recently initiated.
The large magnitude of the market opportunity, the advantageous position of IDCC, and the potential large impact of major, new contracts, are such that only a small number of selective wins by the company can quickly translate in major shareholder benefit and investor gains, well above those implicit in the estimated fundamental value. The operating leverage embedded in the business model enables revenue upsurges to flow into substantial earnings.
Having said this, sudden changes in price (and volume) of the stock often accompany headline news with facts or opinions regarding contracts (begin, end, renew) and pending cases (dispositions, settlements). With this in mind, keeping an eye on the forest despite the trees, particularly in the face of negative opinion, ought to be the guiding light and the cautionary tale.
Beyond intermittent peaks and valleys inherent in the business, FCF and fundamental value are supported by enduring technical competence, long-lasting capital efficiency, and ample ongoing market opportunity.
InterDigital is in the right place at the right time - the time to ride the digital wave.
< Disclosure: I am long IDCC.