InterDigital's (IDCC) CEO Bill Merritt on Q2 2016 Results - Earnings Call Transcript

| About: InterDigital, Inc. (IDCC)
This article is now exclusive for PRO subscribers.

InterDigital, Inc. (NASDAQ:IDCC) Q2 2016 Earnings Conference Call August 2, 2016 10:00 AM ET

Executives

Patrick Van de Wille - IR

Bill Merritt - President and CEO

Rich Brezski - CFO

Analysts

James Berkley - Barclays

Eric Wold - B. Reily

Matthew Galinko - Sidoti

Jessica McHugh - Dougherty & Company

Operator

Good day, and welcome to the InterDigital Second Quarter 2016 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 to everyone, and welcome to InterDigital’s second quarter 2016 earnings conference call. With me this morning are Bill Merritt, our President and CEO; and Rich Brezski, our CFO. Consistent with last quarter's call, we will offer some highlights about the quarter and the company and then open the call up for questions.

Before we begin the call, I would like to acknowledge that a mistake was made to the dial-in information in the collection posted. The original number was looked at 1-888-768-6569 and the correct number was 1-800-768-6569. I would like to apologize to those who had trouble dialing in and thank those who waited while we delayed the start for their patience.

Before we begin our remarks, I need to remind you that in this call, we will make forward-looking statements regarding our current beliefs, plans and expectations, which are not guarantees of 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.

These risks and uncertainties include those set forth in our earnings release published this morning, as well as those detailed in our Annual Report on Form 10-K for the year ended December 31, 2015 and from time-to-time in our other filings with the Securities and Exchange Commission. These forward-looking statements are made only as of the date hereof, and except as 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.

In addition, today's presentation may contain references to non-GAAP financial measures, such as free cash flow, pro forma operating expenses and non-GAAP net income. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are including our second quarter 2016 financial metrics tracker, which can be accessed on our homepage, www.interdigital.com, by clicking on the link on the left side of the homepage that says, Financial Metrics Tracker for Q1 2016.

With that taken care of, I will turn the call over to Bill.

Bill Merritt

Good morning, everyone. Thank you for joining us on the call today.

As you saw in the press release this morning, the company delivered another very solid quarter. While revenue was down sequentially, that was anticipated and we selected more than the seasonal nature of certain phone sales.

Seasonality aside, our royalty platforms remained strong at approximately $400 million annually with our goal to get to $500 million to $600 million built firmly in our sight.

We sought to take more steps to control our cost, particularly around passes with the result being a substantially profit in the quarter and a known modest contribution for future periods.

Let’s go into the numbers in more detail and remarks. I wanted to spend just a couple of minutes today talking about 5G and the opportunity it represents for the company. 5G represent a very significant change in terms of the network capability our engineers are being yet to invent. In previous generation, the goal was typically to drive a single service global speech for example or capabilities higher throughput.

In 5G our engineers are being active designer system that can deliver three very different types of service classes, each with a variety of service types within them. These services classes have vastly different technology leads in terms of latency, reliability and throughput among others.

The results for consumers will be amazing. The challenge for our engineers to design such a system will be daunting. But the combination of those two, hard technical challenges being solved to deliver remarkable new services, presents a great opportunity -- great growth opportunity for us as a company.

Drilling down a little deeper, the three service platforms for 5G are enhanced local broadband, massive machine type communications and ultra reliable mission-critical communications. Let me talk about each one of those service classes in terms of the challenges presented and how those challenges present opportunity for our business.

Enhance mobile broadband will greatly enhance current services for mobile users, throughput will be greatly increased as will the reliability and efficiency, equally important users will see a uniform experience across a variety of conditions whether they are at home, travelling on a fast moving train or at a crowded stadium.

Users will also experience new services like Tactile Internet, virtual reality and ultra-high definition video streaming. These new services will also result in changes in how we think about hardware. Those as we know that will continue to proliferate but still will other devices to support these new services.

The technical challenges to deliver these services are severe and will push our engineering skills to new heights. For example, a key technology in delivering these services is millimeter wave technology. The demanding services like ultra-high definition video will drive the need for new spectrum. The spectrum ranges used to date are getting harder come by. However, there is an abundance of spectrum at much higher frequencies.

Five years ago many believe that using frequencies above 60-gigahertz was impossible, because of the limited range and penetration of signals operating in this range. We and others have proven that to be fully -- to be incorrect and our pioneering work in the space will be an important capability among others we will leverage in the 5G standardization effort.

From a business perspective, the first 5G service class can be viewed as a growth factor for our current licensing business. Like the Gs that have come before, 5G will drive higher unit sales of current devices, create new device classes and increase the selling prices of devices as capability expands exponentially.

As long as we're successfully again at having our technology solutions incorporated into the 5G standards and we have every reason to believe we will be able to drive our core licensing business.

The second 5G service class massive machine type communication is a new set of services that you may also known as IOT. This part of the 5G standardization effort is critical to the ability to connect the 10s of billions of devices that is a vision of IOT, essentially connecting anything that has the ability to produce data and then collecting, analyzing and cross power making data continuing to start environments to enhance current services, but more importantly drive whole new services in the industry.

Like the first service FLAC, the technology is necessary to make this thing a reality are daunting. Connected devices will need to be very low cost and operate at incredibly low power. Connection management will need to be robust, but also efficient as millions of new connections will be deployed every day. Security will have to re-through from the ground up as 10s of billions of points of network vulnerability will be created.

Once again InterDigital has been a leader in driving these key technology needs. Over seven years ago we began our work on the on eM2M platform that will serve as a critical component in future IOT deployments.

Our vision was simple that to efficiently connect up the billions and billions of discrete data sending devices, needed a common standardized method of managing those connections. That vision was spot on and the one M2M standard for which we are one of the key architects is now emerging as the world's leading standardized solution for IoT deployments.

Also important was our work of what we are call our wot.io platform. Here we saw the need for our horizontal service platform to stand across a different vertical market or sub-verticals within a market to allow data to be aggregated in share, driving new services that will depend on data from separate industry silos.

Again our vision was correct. These innovation opportunities have cleared new value driver for the company, which is our licensing of the wot.io and oneMPOWER software solutions as well as our broad portfolio of patents related to this new service class. As we have mentioned before we will provide some additional color on the size and economy of that opportunity at our Investor Day in September of this year.

The third service class Ultra-Reliable Mission Critical Communication is the most revolutionary of the service classes and they will present some of the most difficult technical challenges. This service class will support things like autonomous vehicles, remote healthcare and [managers].

Among other challenges is the extreme reliability and incredible speed at which signals must be moved to support these types of services.

Once again, we have done some very fine early research on these critical technologies, whether they are global edge computing, device to device communications and the like and that early research gives us a leg up in terms of the standardization process. With success in this area we can open up an even broader opportunity of licensing for our technologies.

In sum, 5G is part of an evolutionary technology that will simply sustain our business. It is a revolutionary change in wireless network that can not only drive our core business but open up new licensing businesses to our company and drive even higher value.

Our challenge is just to be a key 5G innovator. That is a challenge we welcome as we come in great position to do again.

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

Rich Brezski

Thanks Bill. In my comments today, I’ll cover our second quarter revenue, operating expense, tax provision and cash flow including how each relates to the current state of our business. We reported revenue in line with our guidance. As we expected, the seasonal drop in second quarter revenue was a bit larger than we experienced last year.

There were no changes in our customer base between the first and second quarters of 2016. Instead this drop was driven by lower per unit royalties from Taiwanese licensees including Pegatron.

It’s worth noting that Pegatron made strong contributions to our first quarter revenue and through six months, our revenue from Pegatron is down just 4% from the prior year. Furthermore, we have yet to recognize any revenue from Huawei despite receiving payments in the quarter related to our arbitration result and related license agreement.

The precise terms of the ultimate license agreement remain to be finalized, but we remain optimistic that we can include revenue from Huawei in our third quarter results. Having said that, I’ll remind everyone that our four most concern in any license negotiation is the value of the license not the timing of it.

Our GAAP operating expense dropped $6.6 million from the first quarter. This was driven by a small reduction in pro forma operating expense as well as first quarter charges to adjust compensation accruals and typical seasonal items.

Second quarter pro forma operating expense of $33.5 million marked our lowest level for that metric in nearly 2.5 years. This reflects our ongoing commitment to maintaining a relatively flat level of operating expense in comparison to the significant increases and our recurring revenue that we achieved today and hope to continue.

Moving on to taxes, I am very pleased to report that we recognize a significant tax benefit in the quarter. During second quarter we concluded a tax study that resulted in us amending several years of tax returns to capture deductions that have more clearly become available to us through recent interpretations.

As a result of these deductions, we recognize the discreet one-time net benefit of $23.1 million related to prior years. In addition, we now expect our ongoing effective tax rate for 2016 to be about two percentage points lower than the first quarter of this year or little more than 33%.

That said, if we are successful in driving increased pre-tax profit, our effective tax rate could rise from this expectation as a contribution of similar deduction would be dilutive in the future.

Finally, our business continues to be cash rich. We collected a $200 million customer advance during the quarter and have classified it within our short-term deferred revenue. Typically, short term deferred revenue represent the amount of deferred revenue we expect to amortize in the next 12 months from fixed fee agreements.

At June 30, 2016, it also includes the customer advance because we have not yet reached a fixed or determinable price for the related license. Without a fixed or determinable price, we cannot break out the short term and long term components of revenue related to this advance. So we’re reporting the full amount in short term deferred revenue.

Putting aside the revenue recognition, the receipt of this cash advance contributed to a cash and short term investment balance of $814 million as of June 30, 2016. For our cash rich business like ours, use of cash is always a matter of particular attention and we will continue to work diligently to balance investment in the business with returning capital to shareholders.

With that, I’ll turn the call back over to Patrick.

Patrick Van de Wille

Thank you very much, Rich. Carolina we'll now open to -- open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And will go ahead and take our first question from James Berkley with Barclays. Your line is open.

James Berkley

Hi guys. Congrats on the quarter. Thanks for taking my question. Just really quick, on the deferred revenue jump, any thoughts on the timing of when that will ultimately be recognized, I think you said more like third quarter is a possibility and then just restrictions on using that cash before it’s recognized. Are there any there or could you use that for buybacks or anything else if you wanted to?

Bill Merritt

So the payments are non-refundable and without restriction. But beyond that, as I commented before, as it relates to Huawei we have an expectation of recognizing revenue in the third quarter. That’s probably as much as I can say at this point.

James Berkley

Okay. And then I’m not sure how much you'll be able to say on this one as well, but I was going for the 10-K. I notice you guys agreed to settle with Sharp negating the need for a July hearing, what you are previously anticipating. Just any detail you can provide on that would be helpful as well?

Bill Merritt

I’m sorry James. Could you repeat that?

James Berkley

Just the -- I was going through the 10-K. I noticed you agreed to settle with Sharp. Your were previously scheduled for a July hearing with them and just any detail you can provide on that -- that change.

Bill Merritt

There is nothing that we can provide at this point. And I apologize, I just want to clarify an earlier remark that as the payments we received relate to an arbitration award that still has some level of appeal pending, there is always that possibility, but notwithstanding that we view them as unrestricted.

James Berkley

Okay. So you would be comfortable using that cash, I mean you.

Bill Merritt

Yes.

James Berkley

Okay. Great. I’ll turn back to queue, thanks.

Bill Merritt

Okay.

Operator

And will go ahead and take our next question from Eric Wold with B. Reily. Your line is open.

Eric Wold

Thank you. Good morning. On the -- couple of questions, on the amount added into deferred revenue from the Huawei arbitration any way you can frame for us how much of that is related to past infringement versus how much is in there to be recognized for future recurring revenue or future fixed e-payments?

Bill Merritt

Yeah Eric, unfortunately there is nothing more we can add at this point. Certainly once we begin to recognize revenue as is always the case we'll be clear in terms of past and future to the extent there’s amounts material.

Eric Wold

Okay. And then, I know you’re still working on the recognition around Huawei, how should we think about the opportunities around a larger relationship such that, what would be the most beneficial for InterDigital beyond just a simple royalty agreement? What would be the most -- a better scenario that you would hope for?

Bill Merritt

If you look at Huawei is obviously very large participant in the mobile space. There is a lot of faith that they hear and a lot of days we would like to work with them. So in terms of ways that we can think contract terms that will be more beneficial to both parties, one is a longer term because they give longer bit of stability to both sides.

And the second is research cooperation, which we've done with a number of parties and allows the companies to get to know each other better. We've used other things in the past in terms of patent transfers between the companies because it’s also a way to build relationships between the companies.

So there is a wide -- nice thing about Huawei is there is a wide range of things that you can do and it's one of the reasons we've taken this time to work with them on what we hope is a stronger, more comprehensive relationship because we ultimately think that it's more beneficial for them and also more beneficial for us.

Eric Wold

And then just last question and if I go through the Qs and Ks and go through a time line, but just maybe assuming this Huawei situation gets resolved in Q3 or you come to new agreement on the relationship and revenue recognition terms.

What is the next sort of discussion point for other handset manufacturers on the calendar to look forward to and how would this Huawei relationship potentially impact those discussions?

Bill Merritt

I think the biggest impact and there is already some impact already, but I think the biggest impact is one because of recognized revenue and people can kind of back into if they're able to do pretty readily the rough royalty that Huawei is paying.

They now know their competitive position and that's really one of the biggest challenges and people don’t know what their competitor maybe paying. So I think that bit of information will be very helpful in terms of discussions that are ongoing due to the fact they're paying that's already out there, but that continues to be helpful.

It's also -- if we're able to construct a broader relationship, that also helps in terms of encouraging others to do the same. So it's been very successful with companies like Sony and other companies in building those broader relationships if they can find a way to do that again in some way, then I think that will also provide some tools for these other negotiations both with companies inside China, but I'd say it would apply equally to company's outside China as well.

Eric Wold

Helpful. Thank you, guys.

Bill Merritt

Okay. Thanks.

Operator

[Operator Instructions] We'll go ahead and take our next question from Matthew Galinko with Sidoti. Your line is open.

Matthew Galinko

Hey, guys. Thanks for taking my questions. First one, just on -- you seem reasonably confident that you'll be able to conclude terms with Huawei in the third quarter, but I'm just curious how should we think about the risk that slips out of the third quarter?

Bill Merritt

Look as we said in the press release we believe that's going to be the result. There is always that risk of things slide out, but I would also say it's largely within our control. The arbitration -- it's had a license agreement that was binding as part of it and we could simply rely upon that if we wanted to, but we see the opportunity again to construct a different relationship within them if the parties have the clarity that the arbitration provided.

If we think we're going to get that we would -- we'll patently work for that. If we felt like that was not going to happen then we can certainly default back to the initial agreement, but at this point as we said in the release, we're confident that in the third quarter we could wrap this up.

Rich Brezski

Yes, so definitely it would only slip if we felt it was worthwhile to allow us to slip. But we have some control over it and we made the statement that we expect them for the quarter because that's when we expect it.

Matthew Galinko

Great. And then you spend a fair amount of time on 5G, so I was hoping you could -- and talking about I guess how it's more significant evolution than previous cycles. So can you talk a little bit about how long lived you kind of expect 5G to be used in terms of -- in terms of a wireless standard and how long should we expect to be waiting until the following one if we look longer term I guess?

Bill Merritt

Yes, so, one of the things with 5G is it's going to roll out in phases but as a result of that I think it has it will occupy more time perhaps than the other Gs which tend to come out in one fell swoop or two.

This one will begin to roll out in the late part of this decade 2017, 2018 we'll start to see components of it. But other pieces will come in 2020, 2021. I think as a result I think the capability that gets build into 5G, one, it will be out there for a long time than it's hard to say when a 6G effort would begin, but my guess is the 5G effort innovation takes a decade to run before or taken into 6G.

And that’s fine because there is just so much work to be done in 5G, I think the common misperception is that it's just an upgrade of the network in some small way, it is a radical change in the network. So I think, that amount of time is probably the appropriate amount of time in terms of what have to be done and the capabilities it will provide.

Matthew Galinko

Got it and then I was hoping lastly if you could just provide any update on progress in terms of enforcing patent rights in China?

Bill Merritt

So we continue to have discussions ongoing with all the unlicensed manufactures over there and again back to the commentary before I think the Huawei result will be helpful there. We've had other things going on in China in terms of some patent and validation proceedings and acts that the company has done very well on those proceeding in terms of protecting its portfolio there,

I think generally the licensing environment in China is relatively stable right now, I think with the result of what we went through in the regulatory front there. I just felt was ultimately fine results with the company and the other regulatory efforts there, you have a pretty clear regime you have to follow over there.

So I think at this point, it's just a matter of us being very patient and creative and if need be using enforcement of the tool, but we've seen this over the last couple of years, we tending to really view enforcement as the last resort. We think other ways of getting license at the time are better ways to pursue the business and we'll continue to do that both inside and outside of China.

Matthew Galinko

Great. Thank you.

Operator

And we’ll go ahead and take our final question from Jessica McHugh with Dougherty & Company. Your line is open.

Jessica McHugh

Hi there. Thanks for taking my questions, looking at your OpEx specifically development mine was done year-over-year and sequentially, could you just talk about what influenced that and is it sustainable done at this level?

Bill Merritt

Yeah, so there is a couple of things. One is our compensate depending on what your period of comparison is, development is where we have our largest base of headcount. So anytime we adjust our compensation accruals that we'll have that will influence that period.

The other thing is we have reduced spend this year in some of the commercial initiatives, that doesn’t mean we’re not spending in those areas. We just as you cycled through different levels of development that made off late up or down.

So, I would say that as we have all of operating expense we seek to invest the lowest level that’s going to provide the highest return. So, in terms of sustainability, I wouldn’t say it's going to continue at this level versus the levels it was at last year. It will all depend on the return that we see based on the investments available to us.

Jessica McHugh

Okay, thanks and then back to 5G, you mentioned time period of 2020 to 2021, but in terms of licensing deals, is that something that you're already talking to potential licensees about and could we see that earlier?

Bill Merritt

So in some of the discussions that are ongoing, 5G will come up right because if you think about a constant licensing agreement that expands five and 10 years, then those folks who don’t want to get coverage for 5G since certainly product that we deployed during that period.

So, I think we could start to see agreements that include 5G as a one of our latest technologies. I think the other thing that’s important is our participation in 5G and our continued success in having technology adopted in it.

It's always a very soft benefit back to the licensing programs because they continue to see the company invest in technologies and be successful in having its technology adopted and its portfolio of patents to go up and that’s -- those all are doing very good facts that you bring into licensed discussions.

Jessica McHugh

Okay. Thank you.

Bill Merritt

Thanks.

Operator

And we have no further questions at this time. I’d like to turn the program over back to you.

Patrick Van de Wille

Okay. Thank you very much, Caroline. Before we finish the call, I would like to encourage listeners to access our financial metrics tracker. Once again it's available on the homepage following the link on the left side of the page or on the Investors page using the drop down menu under Financial Information.

Thanks everyone for joining us today. See you at the Investor Day.

Operator

And this concludes today's program. Thank you for your participation. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!