InterDigital, A Case For A Turnaround

Summary

• The 2017 was a year of revenue contraction, with only the LG agreement signed at the end of the year.
• Management was able to control its costs and expenses and delivered strong profitability and cash flow as well.
• Despite the inconsistencies in revenues, the company has grown an average of 20% year over year.

InterDigital, Inc. (NASDAQ:IDCC) presented its results for the fourth quarter of 2017 and seems that the numbers have generated opposite reactions in the market and also some mixed movements in the price of the shares after the release. Revenues for the period were $205.3 million, which means a decrease of 25% from the same period last year, although it represents an increase of 111% from the previous quarter. For the whole year, the 2017 delivered a total of $512 million in revenue, falling a 22% from the 2016.

While these somewhat inconsistent results are nothing new for the company, this is kind of problem in which executives are trying to amend for some time but that until now, they have not yet been able to achieve. Overall, InterDigital looks to be performing well at the eyes of the CEO Bill Merritt, who has described the quarter and the full year as "very strong" since the operational costs have been controlled, the profitability is really healthy, and the cash flow is stable.

Source: Data extracted from filings.

There is a simple reason why the company has reported these ups and downs over the past 10 years, and it's inherent to the revenue source. In fact, InterDigital is running over cycles of two years, where in one year the company reports exceptional revenue growth while in the next one falls short, although on average, revenue has grown at 20% year over year in the past eight years.

By taking a closer look at the revenue source, is easy to spot what is causing these jumps from quarter to quarter. On one hand, we can see that the patent license agreements from InterDigital are structured mostly on a royalty-bearing basis, and others are structured on a paid-up basis or a combination thereof. Regardless of the type of agreement, these patent-based revenues are accounted as recurring revenues, whether in a form of fixed-fee royalties or per-unit royalties.

As shown from the table below, the recurring revenue has represented a reliable source of income for the company and in some quarters, accounts for almost the total revenue received by the company, working as a lifesaver in tough years.

Source: Data extracted from 10-Q and 10-K reports from the SEC.

In addition to these fees, the licensee typically agrees to make a payment before the effective date of the license agreement that is accounted as past patent royalties. These kinds of payments are strictly dependent on the ability to sign new agreements or renewing old ones, and therefore, causing irregular results from quarter to quarter and ups and downs from year to year.

In 2016, the extraordinary revenue growth was driven by past patent royalties from Huawei and Apple (AAPL), signed in the third and fourth quarter respectively, while in the 2017, only the renewal of the LG agreement was reported in the fourth quarter, bringing the total revenue down by $132.9 million compared to the last year.

Looking forward, for 2018, InterDigital is expected that the patent license agreement from Huawei expires at the end of the year, leading to a most likely renewal by the fourth quarter. We have to take in mind that the current agreement between the companies includes a cooperation component to research and develop technologies and that these kinds of agreements are shown to be easier to renew, as the CEO pointed back when the deal was signed.

Also, as a reminder, the current agreement between InterDigital and Huawei signed in 2016 covers only 3G and 4G technology for mobile terminal devices, leaving aside the 5G technology for now.

The next year will be a disruptive year for the diffusion and scale of 5G technology from mobile service providers. Analyst suggests that investments in CAPEX will accelerate by 2019 as the cycle approach to an expansion stage. The adoption of 5G will be more significant as more and more providers shift to this technology, giving confidence to manufacturers of mobile devices to include 5G terminals to its products.

Source: Extracted from the following article. Figure 1: "Mobile 5G technology adoption, optimal investment cycle, and technology hype life-cycle".

In the meantime, the only agreement signed with InterDigital that includes 5G terminal unit products is from LG, while the ones signed from Apple and Samsung include 3G, 4G and future generation cellular and wireless-enabled products.

Until now, InterDigital hasn't received any recurring revenue from its 5G patents, but this could change quickly as the 2018 may lay the foundations for manufacturers to incorporate this technology to its devices. Remember that recurring revenues coming from a new stream could easily lift overall valuation for the company.

Valuations

The 2016 was an exceptional year for the company in which revenue grew 52% and the share price soar a 55%. On the contrary, the last 2017 came as a year of low performance, with returns contracting each quarter and a price per share falling a 16% at a time when the market reported a 19.5% surge and seems that almost all companies experienced increases in their market value. Moreover, in the past 5 years, the share price hasn't matched the returns of the market since the company has seen a 61% increase while the S&P has delivered a 77% in the same period.

The poor performance in price, in addition to a double digit return rate, suggests that InterDigital is undervalued at current levels, especially after compared to the industry mean and its peer's ratios. Additionally, the analyst estimates for the company were restated after the fourth quarter release, with 2 buy recommendations versus 2 holds, and an average price target of $88.00, meaning a 21% upside potential.

Source: Data extracted from 10-K filings from the SEC.

Furthermore, by taking a closer look at returns, we can find that the ROE and ROIC haven't changed much in the past 5 years, and the remarkable return seen in 2016 was quickly restored to similar levels of past years. The ROE breakdown shows that the return is sustained by a combination of a high EBIT margin and a healthy leverage level. This speaks about the ability of the management to achieve nearly flat operating expenses even in times of exceptional growth, and the commitment of the company to maintain a similar operating leverage over the years.

Also, like the EBIT margin and the ROE, valuations have pulled back from the highs of 2016 to the same levels seen at the end of 2014 and part of 2015.

IDCC Price to Book Value data by YCharts

Overall, the market looks to be valuing the company in the same way it was 3 years ago. While is it true that 5G patents have not delivered any value yet, the second half of 2018 and the next year could be disruptive for the adoption of this technology and can easily boost the recurring revenues in the middle term.

In the long term, the internet of things (IoT) continues to be a promising new market for the company. Although this technology is currently at an early stage, the executives are optimist about its potential to unlock new business capabilities by 2030.

By taking all this in mind and by reviewing the effect about past patent royalties explained above, InterDigital could be in the turnaround category of companies which have the potential for a significant gain in the medium-term.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This article represents the opinion of the author as of the date of its publication. The information set forth does not constitute a recommendation to buy or sell any security. This article is based upon information reasonably available to the author and obtained from sources the author believes to be reliable. Investors are encouraged to conduct their own due diligence.