The Street went into heat last week to celebrate the inauguration of the first NYSE listed hedge fund manager, Fortress Group (NYSE:FIG). The 67.6% rise on the initial day of trading indicates that either benevolence is breaking out at Goldman and Lehman, or perhaps more likely, irrational exuberance is breaking out among the great unwashed.
Don't get me wrong; Fortress is an outstanding hedge fund manager. There is abundant intellectual capital, after all it has managed to attract $30 billion in assets. FIG describes its business in the prospectus as follows:
We are an intellectual capital business. The management of alternative assets is a highly specialized undertaking that demands talent, skill, and experience.
Of course, I was completely thunderstruck by this revelation. Seems to me that I had read a quote recently in the International Herald Tribune (12/12/2006) about hedge fund performance:
"This year is the third straight year that the global equity markets and long-only managers outperformed hedge funds."- Christy Wood, senior investment officer for global equities, CALPERS.
Fearing the law of large numbers, the bane of every investment manager's existence, I thought that perhaps a $30 billion hedge fund may find itself in this law's cross-hairs.
Grabbing an Eveready battery version of Diogenes lantern, and some 10-K wizardry, I set out on my quest for sentient beings outside of the hedge fund world, especially the mega-fund world.
Here's what I found!
InterDigital Communications Corporation (NASDAQ:IDCC) designs, develops, and licenses digital wireless technologies which are incorporated into wireless equipment, and mobile handsets.
The bulk of the company’s revenues are generated through licensing its intellectual property, primarily to original equipment manufacturers (OEMs) of 2G, 2.5G, and 3G mobile handsets and infrastructure. In fact, its inventions and technology are embedded in every 2G, 2.5G and 3G device. The company has been involved in wireless for three decades (who knew?) and created some of the widely used TDMA and CDMA technologies for which it receives licensing revenues as well. Our friends at FIG have been at it since 1998, almost one decade.
The company continues to develop new technologies as it spends some 14% of revenues on R and D. The company is currently involved in developing standards for 3G, Next Generation Networks [NGN], and IEEE 802.11x technologies, among others. In the meantime, it holds some 6000 patents. That's a tremendous amount of intellectual property. Little wonder that this business, based in King of Prussia, PA, has generated over $1 billion in license fees over its history.
Licensing is enormously profitable with near 100% gross margins. The revenue is essentially a pure cash flow stream. Not unlike a successful hedge fund operation.
The company is brain-intensive, not labor or capital intensive. It employs 315 people including 202 engineers of which 71% have advanced degrees, among them, 30 PhDs.
What are the negatives? This is one of the most litigious industries that I can think of. Every major handset maker seems to have been involved in some large dispute with licensors such as Qualcomm (NASDAQ:QCOM) or IDCC. Nokia (NYSE:NOK) and QCOM have a 3G licensing agreement that ends this April...there has been at least a year of dispute regarding renewal. IDCC is in a legal dispute with Samsung involving some $175-$200 million in back fees relating to 2G technology. Lawyers have generally done very well by this industry, perhaps third only to the pillage of the tobacco or asbestos industries. Think of lawsuits between Research in Motion (RIMM) and NPD, Samsung and Ericsson (NASDAQ:ERIC), Broadcom (BRCM) and Qualcomm, etc, etc. Despite the unceasing legal battles, the effect of most disputes is to delay rather than invalidate the revenue stream.
There is a strong chance that IDCC will sign agreements with all major handset manufacturers of 3G equipment over the next couple of years. Fees tend to average somewhere around $1.00 per handset easily resulting in several hundred million dollars in licensing fees over time. I suspect that the industry is taking a bit of a wait and see attitude pending the outcome of Nokia/ Qualcomm's renewal.
The company is a strong cash flow generator. In the last four quarters, IDCC has generated $322.5 million in free cash flow as compared to its revenues of $426 million, a FCF margin of 70%! Based on its enterprise value of $1.51 billion, this is a FCF yield of 21%. Though it does not pay a dividend, the company has been an active buyer of its stock. It recently expanded its buyback program from $200 million to $350 million. Since 2003, the company has bought back about 18% of its fully diluted shares.
The hedge fund business is known to be enormously profitable. In 2005, the last complete reporting year for FIG, the business earned net income of $192.7 million on a revenue base of $1.005 billion. This translates into a net margin of about 19%. To be fair, let's add in another $444.57 million in deferred incentive fees. Hence, the net margin of FIG is a whopping 63%.
Let's look at IDCC's profitability. Not that shabby. For 2005, on $163 million in revenues, the company made net income of $55 million or about 34% net margin. But compared to an S&P 500 net margin of 9.13%, it looks terrific.
Valuation differences are scary. FIG trades at an EV/EBIT of 57.8 times based on TTM EBIT. Interdigital trades at an EV/EBIT of 4.86 times.
Investors can be mesmerized by the audacious profitability and powerhouse intellectual capital of a hedge fund. Remember the law of large numbers...it serves to undermine most fonts of knowledge. Intellectual capital can be found in many less conspicuous places. The hedge fund industry has no monopoly on smarts.
IDCC has not only the library of patents to provide licencing revenues into the future, its profitability ranks amongst the highest in technology. Qualcomm at 32% is almost there but is considerably more expensive (at 22 times EBIT) than IDCC.
Disclaimer: I, my family, or clients have a current position in IDCC, NOK and QCOM. No positions are held in any of the other securities mentioned.