InterDigital: An 'Under the Radar' Opportunity in Wireless Technology

Includes: IDCC, SWIR
by: James Levy
Founded in 1972 and public since 1981, InterDigital (NASDAQ:IDCC) practically invented wireless technology. Through nearly four decades, this company has not only survived but thrived by reinventing itself numerous times, while always maintaining its central focus on wireless technologies. Currently, InterDigital is very profitable, with high margins and growing recurrent income streams. Though widely respected among wireless insiders and the technological cognoscenti, InterDigital is not well known as an investment. The share has very limited research coverage by only four second tier firms, and can clearly be classified as an "under the radar" investment opportunity
One reason for the neglectful attitude of investment analysts toward InterDigital is that the company´s business model differs radically from what is typical for wireless technology companies. InterDigital essentially has only one product line, and that product is patents. InterDigital currently holds over 3,000 US and foreign patents related to wireless technology, enhancing bandwidth availability and network capacity, wireless security, seamless connectivity, as well as mobility across networks and devices. These issued patents expire at different times between now and 2030. However, InterDigital´s patent library is not a wasting asset, as the company's top notch engineers and patent lawyers are not asleep at the switch. The company’s research engineers continue to innovate at an outstanding rate, and InterDigital has a further 9,000 patent applications in process right now.
Why produce patents? To license the technology protected by these patents to mobile device manufacturers, semiconductor companies and equipment producers that manufacture, use, and sell digital cellular products. Is this a viable business strategy? Well, as of December 2009, InterDigital had entered into patent license agreements covering over one-half of 3G mobile devices sold. The company states that its goal is to derive revenue from every 3G mobile device sold worldwide, either in the form of patent licensing revenues, technology solutions-related revenues or a combination of both. (For example, one InterDigital Licensee is Sierra Wireless, recently featured in my article, ¨Sierra Wireless: Micro Cap Value Plus Growth¨ on Seeking Alpha.)
Under the leadership of a new Chairman of the Board, InterDigital is making significant progress toward achieving this goal. In March of this year the company announced a worldwide royalty bearing patent license agreement with Casio Hitachi Mobile Comunications, as well as with Enfora Inc to cover the sale of Machine-to-Machine (M2M) modules, M2M devices, and PC cards designed to operate in accordance with 2G and/or 3G cellular standards. The M2M module market is expected to quadruple between now and 2015, and InterDigital now has under license more than half of the suppliers of these devices. The company states that they are actively developing self healing and smart energy protocols to enable large arrays of sensors in a network scenario, a crucial application for the full development of the boundless possibilities of M2M.
In my view, InterDigital is a midcap growth company at the center of what is likely to be one of the fastest growing sectors in the coming years. However, the share is priced at valuations which Ben Graham could love. InterDigital trades at 15 times current earnings and only 10 times next year´s estimates. The company has over 9 dollars of cash per share on its balance sheet, no debt, and a price to free cash flow ratio under 5. With only 300 employees and revenues of over 300 million per year, InterDigital has a gross margin of nearly 95%, one of the highest of any public company, and operating margins of over 38%. The company surprised positively in the past two quarterly earning announcements, and recently raised revenue guidance for the first quarter. These results will be released on April 28th.
One of the challenges facing the company is what to do with its increasing cash hoard. InterDigital does not pay a dividend, though it has been actively repurchasing shares over the past several years. Total shares outstanding have declined from 54 million in 2005 to only 43 million today. Some shareholders are calling for the company to institute a generous regular dividend in order to attract new investors and reward shareholders who do not want to sell shares to realize capital gains.
Apart from the earnings announcement on April 28th, another possible catalyst to short term gains in InterDigital is the very high short ratio of over 13% of outstanding shares. As the company continues to sign new licensees, and the global market for wireless products and M2M modules expands, the short holders themselves may well provide the impetus to further gains in the share as they scurry to cover their positions, particularly if earnings guidance is raised again at the earnings release on April 28th or if a dividend is implemented. Over the past five years InterDigital has increased earnings at an average pace of nearly 25% per year, and the outlook for the future is sufficiently bright to believe that this large short position is not sustainable.
Given the positive outlook for the share, I was concerned to find not only no insider buying since 2007, but also steady insider selling during these years. However, as was pointed out to me by several helpful participants (special thanks to Data Rox and JimLur) at the useful and friendly Investorshub message board for InterDigital, this is not uncommon in technology companies where the execution of stock options is considered a normal part of overall compensation. In the particular case of InterDigital, many of the insiders’ sales were planned sales in 401-K accounts, often forced by executive stock option expiration deadlines. For example, on March 29th of this year the CEO of IDCC sold 20,000 shares at $27.95. However, these shares were options which he had purchased at $25.25, and he sold on the expiration date at the last possible moment before his options would have become worthless. This sale and many other similar insider sales of IDCC cannot fairly be interpreted as indicating a lack of faith in the continuing long term performance of the share in the future. In light of this observation, I do not believe that insider selling is a valid warning sign in the particular case of InterDigital.
This is an unusual company in many ways, and for this reason it is difficult to classify. It is often included in the communications equipment sub-industry, though InterDigital produces no equipment whatsoever. Its product is intellectual capital, and other than research engineers the key employees are patent lawyers to negotiate patent agreements and mediate disputes, as well as accountants who verify that licensees are paying in full as per their contracts. One consequence of the singularity of the business model of InterDigital is the fact that performance of the share has almost no correlation to that of the technology sector as a whole, and has a very low beta of just over 0.5 in relation to the S&P 500. Though the shares are very volatile, the average daily volume moves over $10 million value in shares per day, more than sufficient for most individual investors and small institutions.
InterDigital is a pure "seeking alpha" play for those who believe that management will succeed in their quest to continue generating increasing amounts of cash from their intellectual property factory at the heart of the wireless revolution. I believe that at the current price this share offers a unique opportunity for value and growth investors to participate in the expansion of the 3G, 4G and Machine-to-Machine sectors in the coming years.
Disclosure: Long IDCC common shares

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