InterDigital, Inc. (NASDAQ:IDCC) Q3 2018 Results Conference Call November 1, 2018 10:00 AM ET
Patrick Van de Wille - CCO
Bill Merritt - President and CEO
Kai Öistämö - COO
Rich Brezski - CFO
Charlie Anderson - Dougherty & Company
Scott Searle - ROTH Capital Partners LLC
Good day, and welcome to the InterDigital's Third Quarter 2018 Earnings Conference Call. Today's call is being recorded.
At this time, I would like to turn the conference over to Patrick Van de Wille. Sir, please go ahead.
Patrick Van de Wille
Thanks very much. Good morning, everyone and welcome to InterDigital's third quarter 2018 earnings conference call. With me this morning are Bill Merritt, our President and CEO, Kai Öistämö, our COO and Rich Brezski, our CFO. Consistent with last quarter's call, we will offer some insights about the quarter and the Company, and then open the call up for questions.
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 and the third quarter Form 10-Q published this morning. As well as those details in our Annual Report on Form 10-K for the year ended December 31, 2017 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 and non-GAAP net income. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our first quarter 2018 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 Q3, 2018.
With that taken care of, I'll turn the call over to Bill.
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 solid quarter. Rich will go into the number in more detail in his remarks, in particular covering some of the accounting around our Technicolor acquisition. I’m going to keep my remarks fairly brief, covering the Technicolor integration, our efforts in China and the recent management addition.
So to start with Technicolor, we're working through the integration of the team and the two patent portfolios. To-date that has progress extremely well, it's not surprising given the level of business alignment between the two organizations. We remain on target to get back to our 2017 cost levels using the metrics that Rich laid out earlier this year. Perhaps more important, we are currently engaged with our core licensing customers, and are including Technicolor video coding assets in those discussions. As expected, the assets of that have very positive dimension to discussions, and we remain confident that our combined patent portfolios will drive strong value for our licensing business.
We’re also engage with a new set of customers in the digital TV and set top box space. The more we drive down the path, the more we are intrigued by it and its growth potential. As far as the Technicolor relationship Interdigital lab has also begun to engage with the Technicolor research and development team. We’re extremely pleased again at how well the teams operate together and the opportunities for research they're uncovering, it's like we always thought, there is magic at the intersection of wireless and video.
Moving on to China, we continue to be highly engaged with the major players in that market. The meetings are occurring at a frequent pace and we've had a large and continued presence in China for much of the summer and into the fall. That level of engagement is bearing fruits. It has also made us think about the level of permanent presence in China that may make sense for us given the continuing importance of that region to our ongoing business. Which brings me to the last topic, mainly managing addition at the company we announced a few weeks back; in a nutshell, both are directed at the items I just spoke about.
With the Technicolor acquisition under our belt, Interdigital, while still running fundamentally the same type of R&D back licensing business, it's simply running a much larger one today. Indeed our business has evolved dramatically over the last three to four years with broader research efforts, more geographies, more tools to work with and a larger set of customers with whom to engage. We’re also highly sensitive to new licensing environment, which I believe requires extraordinary knowledge of your customers. Those changes in our business drove my thinking in terms of how we should restructure the management team. Starting with Kai, our new COO, I can think of no one better able to handle the new opportunities for the Company and the new environment we live in.
Having run the largest divisions in Nokia and also having had a good visibility into their patent licensing business, it brings specific skills we need to oversee our customer facing groups, mainly our R&D, licensing, product and business development teams. He has done all of this before. Also having been intimately involved with the handset business, he has uniquely positioned to understand the customers' needs, our needs and drive our customer engagement accordingly. I also know Kia very well, both at Nokia and as a board member in Interdigital. He is a great catch, a great talent, a great fit and we expect great things out of him and have no doubt he will deliver.
Just so as additional important capacity at the Company as we engage more deeply in China to more deeply generate with our customers. The environment in China is changing rapidly and navigating that changing environment is nothing that Jeff is extraordinary capable of doing. At Qualcomm he managed one of the strongest and trickiest pivots ever as Qualcomm moves from something of an outsider with its IS 95 and CDMA 2000 market position that become the world's leading supplier of WCDMA and LTE chips and valued by its customers. I was in the industry back then and I recall that transition very well. I also recall how much Jeff contributed to its success.
Jeff was also our board member here for eight years, so I know him very well. I was thrilled that both he and Kai still have a role in company positions and how much we could grow. It's not the usual career path for executives to come-off the board to take on long-term management roles with the company at a company that is doing so well. But these two gentlemen has made me believe, believing like me that we can take the company even further and we are already seeing the benefits of that transition.
With that, let me turn the call over to Rich.
Thanks Bill. We are happy to report another strong quarter of financial results. For most part, I'll let the results speak for themselves and focus instead on a few areas you may have questions on; mainly the impact of the Technicolor acquisition on our financial results; two opposing non-operating items we recognized in the third quarter; and capital allocation.
When we first announced our binding offer to acquire Technicolor’s patent licensing business last March, I noted that we expected the acquisition would, in the short-term, add some expense with a modest revenue impact. This proves to be true in the third quarter, which included two full months with the acquired Technicolor business. Over that time, the acquired Technicolor business contributed about $2 million of revenue and about $12 million of operating expenses, including $5 million of onetime cost, $3 million of amortization and $4 million of recurring cash operating expense. In addition it contributed $2 million of capitalized prosecution costs.
Now, let me unpack those numbers a bit. The revenue number is based on the very modest revenue stream we acquired. The strategic rationale for the transaction is that the Technicolor patent assets will enhance the value of our core handset licensing business by driving higher recurring revenue, reducing the time to get deals done and/or eliminating the cost of litigation. As Bill mentioned, the early returns from our engagements with customers certainly support that strategic rationale.
As I noted the recurring cash investments for the period is comprised of $4 million of operating expense and $2 million of capitalized prosecution. So all the equal, our recurring net investment before realizing additional synergies was about $2 million per month. This tells me the following; for a headline price of $150 million, we ensured valuable patent assets that we are confident will drive strong value in our core handset licensing business, as well as driving new licensing business in consumer electronics; and given the numbers above and our commitment to return our expense levels to those of 2017 overtime, the cost to maintain that asset is negligible. That is just fantastic. Let me expand a bit on our commitment to return our cost back to 2017 levels as I've described in prior calls.
When we announce the acquisition last March, we noted that Technicolor’s portfolio included more than 21,000 patents and applications. Between that March announcement and the July close, we identified opportunities to reduce the size of the portfolio being acquired by almost 15% to approximately 18,000 patents and applications, while at the same time, working to prune cost from our owned existing portfolio and overall cost structure. In fact, even with the acquisitions' $12 million contribution to our operating expense in the two months first close, our 2018 year-to-date operating expense, excluding depreciation and amortization, is less than the prior year.
We are continuing our efforts post close with an expectation that the end result will be a portfolio that is larger than either of the individual portfolios and with the best attributes of both. In addition, we are encouraged by the opportunity to integrate the acquired team, thereby increasing the proportion of our portfolio that is filed and prosecuted with less expensive in-house resources. These factors make us highly confident that we will reach our cost target.
Remaining on the transaction for a moment, we detailed the accounting for the acquisition in note nine to the financial statements in our third quarter Form 10-Q, which we filed this morning. I will note that in addition the patent assets of approximately $150 million, we recorded a number of other assets and liabilities related to the acquisition. These include a contingent consideration liability and a long-term debt obligation. Each of which represent the estimated fair value of a portion of the revenue share obligation we're required to make to our partners as a result of the acquisition.
In addition, we recognize an estimated transaction-related receivable. All of these amounts are based on long-term estimates, each of which includes a number of assumptions. As our estimates change, we will run adjustments to the fair value of those amounts through the P&L, and we will clearly disclose such adjustments if they're material. The remaining portion of our revenue share obligation is not reported upfront on the balance sheet and instead will be reported as an expense in the same period we recognize the related revenue. At this point, I will remind everyone that all revenue-sharing obligations are net of estimated costs and limited to the new consumer electronics market. We have no revenue-sharing obligations related to the wireless terminal unit and infrastructure markets, which historically have made up the vast majority of our revenue.
With that, I will move on to two non-operating items of note in the quarter. First, we reported an asset implement of $8.4 million, almost entirely related to the liquidation of a single investment. Second, we recorded a tax benefit of approximately $15 million, primarily related to an anticipated refunds on amended returns. This is a net one-time benefit that doesn’t change our outlook for 14% to 15% rate over time. Though, I'll remind everyone that our estimated long-term tax rate is before giving effect to timing differences, resulting from our foreign derived intangible income deductions. Such timing deductions have been favorable this year, driving a negative effective rate even without giving consideration to the one-time tax benefit.
Finally, a few words on capital allocation. We returned almost $75 million of capital to our shareholders through share buybacks from the start of the third quarter through yesterday. This is the latest reflection of our commitment to return excess capital to our shareholders.
I will now turn it back to Patrick.
Patrick Van de Wille
Thanks Rich. Now, I would like to turn it to the newest member of our executive team, Kai Öistämö who is with us today. Kai joined us after a 23-year career at Nokia, culminating in his role as Executive Vice President and Chief Development Officer, followed by role of executive partner to private equity firm, Siris Capital. I would encourage listeners to see our press release dated October 11th, or our Web site for a full bio. Kia, thanks for joining us today.
Patrick Van de Wille
You spent almost exactly four years on the Board of Directors joining in 2014, and before that in our company -- well, obviously, in your role at Nokia. What are your impressions of InterDigital over that time?
As always, very impressed by the performance of the company and especially the people inside of the company. And I view the company as being somebody who is there, at the same time, very thoughtful but getting results, getting things done, which is not a very common combination.
Patrick Van de Wille
What do you see as your key role at InterDigital as COO?
I think it's getting closer to our customers, bringing what -- how do that customers think, what are the relatively importance of different things and eventually, leading into how do we strike deals that are really win-win between them and us.
Patrick Van de Wille
What excites you about joining the Company at this time?
Well, we are in a very sound financial state. We've begun just a very transformational deal on the video side and I feel the future is full of opportunities and that makes me very exciting. At the same time, having met now more and more people inside to the company, I know it really is a privilege to work with such talented folks.
Patrick Van de Wille
Well, Kai, fantastic. Thanks for joining us today. Katy, with that, I would be happy to open the call up for questions.
[Operator Instructions] Our first question comes from Eric Wold with B. Riley.
So a few questions around Technicolor, I know you see that's license discussions you are having with some of their prospected customers, I guess some existing customers. I guess, one, with the handset discussions that you've been having with the unsigned OEMs prior to adding Technicolor. Now, that you bring Technicolor into the mix of discussions. Do those companies tend to understand the importance of Technicolor to their products and its value, or is this almost essentially restart discussions around new set of paths, and help me get over the understanding of those and the value, just likely to shorten I guess or lengthen discussions from this point?
So, on that question, Technicolor -- one of the things we really liked about Technicolor. It was just very well known brands in video and also the very well known -- half of portfolio that they have. And if you go back to various vide coding standards there has always been a prominent figure in all of those video standards. So there is actually very little education you have to do with the customer regarding the Technicolor portfolio or the Technicolor research capabilities. So you really move very quickly to a discussion of how much it worth versus what majorities of it. So again, that was one of the things that really attracted us to the assets to begin with.
And then the current licensees -- now going back to and talking about Technicolor. Are there any, in handsets, partners you had in place or do you have agreements in Technicolor or -- currently or in the past, or is it all brand new from this point?
There's a mix. So that we would have I'd say three types of customers, right. One would be, one where there's no license on the Technicolor side and there's actually no license or agreements. So you have basically a fresh licensing opportunity. You have ones where Technicolor had licensing for a period of time and so you have to wait for that, those licenses are up but there is very limited amount of that. And then there is once that gets captured under ours to a degree. So you have a mix but between the unlicensed folks and the folks that there's a clear lane that’s a huge amount of opportunity for us at the current time.
And just final question, can you give us any sense around where you are with the discussions on the Huawei renewal? I know you signed essentially two years ago and that was a longer deal technically. Now that Technicolor could be sort of in the mix. How would you characterize those discussions given that they come up for expiration pretty soon?
So, I think overall in China, we have as I said in the prepared remarks, a broad level of engagement and much different level of engagement than I have seen here previously, meetings occur more frequently the longer meeting -- they're more comprehensive in the sense that there's discussions not only around licensing but the research and development opportunity. So obviously, with companies like Huawei or Oppo or others, these are very, very high value license discussion. So they -- both sides move carefully in those discussions. But I think not only as these companies our own growth, from the wireless perspective but also now the addition of Technicolor on top of that has desecrated a different type of dialog that I really appreciate. And I can -- personally though the difference been what they used to feel like and what they'll like now. So we're pushing them forward and we continue to be confident that we’re going to get the agreements done on the right terms at the right time.
[Operator Instructions] Our next question will come from Charlie Anderson with Dougherty & Company.
Bill, I wonder if you could give us elaborate a little bit your comments around China, look into potentially have more resource on the ground there. What's behind that? And then on a related subject just geopolitical situation, to what degree is it helping or hurting matters in some of these discussions? And then I have got a follow up.
Again, I think as I mentioned, China is obviously getting very important in our business ecosystem for a long period of time. And the way we historically engage with China is we go over there with teams and come back then what we noticed is that it will be much more effective for us to be on the ground over there in a more permanent way. So the things that we would think about and are thinking about is you have people from a business development role that are on the ground in China. You have people from an R&D perspective that are on the ground in China. And either are conducting R&D or maybe just shifting the licensing team in the technical aspect of that discussion -- of those discussions.
We have opportunities to engage universities in China. We did our recent tour with one of the new -- Hagley Museum in Delaware around patent models. And so how much the community is embracing innovation and invention, as well as the monetization of innovation. So, I think there is a really good opportunity for the company to engage on those various topics in China. Much like we did in the United States, I think our regular interaction with the government is an important component of our strategy. So that they know us better and understand how we operate.
So, there is a lot of different engagements that we are planning to do those most effectively, we need to have the presence in China. I don’t think it's becomes -- these large scale presence since I thought of that. But a nice size presence over there that gives us a constant touch points with the customer, I think will be really beneficial and I think ultimately will be really helpful in driving deals sooner and a better value and developing much closer relationships with the customer.
And then follow-up for Rich just on operating expenses, maybe just coincident with that if you guys do expand to some degree in the China. You do that when the -- in the envelope of your plans on keeping around those 2017 levels long-term and do really allocate? And then in terms of the extra Technicolor expenses, can we just -- about a full quarter of what you saw in Q3 or -- I know there -- so it was the one-timer in there. But aside from the one timer this Q4 looks like Q3 but for a full quarter?
So with regards to the first question. Yes, our goal here is as is typically the case, we want to try and stick initiatives within the envelope of the current cost profile. With respect to the Technicolor acquisition, we're absolutely confident that we're on track to meet our synergies targets. As evidenced as I've mentioned in the script by some of the reductions in the portfolio on both sides that we've already taken and was more to come.
With respect to China, we're looking at that investment and certainly there's cost there. But again, the idea is to fit it within the overall envelope, which is more or less been our practice here. As far as the looking at the third quarter for Technicolor, as I noted, it did include two months not three. And it also was, at the end of the summer when some of the activity was a little bit lower. So we're in the process of going through our budget and updated forecast. I think the offsetting -- maybe some of the reasons that might have been light in that period is the fact that that's before additional synergies. And some of those synergies, even some of the ones that we've already taken, take a little time to bleed in.
For example, as you abandon patent assets that you no longer feel has value that that's not a cost savings day one, it's not until the next annuity payments might we due, which would be six months, 12 months or sometimes even longer. So we will be looking at that and considering that in connection with our upcoming guidance.
Thank you. Our next question comes from Scott Searle with ROTH Capital.
Rich, just to follow-up on some of the cost fronts related Technicolor patent administration costs, specifically was quite a bit higher. Is that the normalized level to start from before you start working down assuming three months of contribution rather than two months? Or are there any elevated costs that are going in there? You talked about $2 million capitalized prosecution cost. I am just trying to normalize that. And directionally, what we should be thinking about? Going into the fourth quarter, I know, there is some seasonal issues on that front. And then just to clarify, on the $5.4 million onetime transaction cost. Is that in SG&A? And then I had a follow-up or two.
So the $5 million of integration cost are spread across -- there's certainly a lot of integration in the patent side, so that's an element of the cost there. And I should mention that as we are working to achieve the cost savings, there are integration costs that we will continue to expand. So although that’s a one-time element, we'll probably see some additional one-time integration costs in the next quarter. The capitalized prosecution, there we have a policy that has been long standing at the company. It’s a little bit different than what you see -- there is other licensing companies, so it's actually conservative preferential.
So at times, we consider changing but the accounting rules don't let you change from a preferable policy to a non-preferable policy. And that has capitalized cost the external costs and incremental cost of prosecuting filing your patent.
So we have had an internal team that's been relatively small. Technicolor was the opposite. They had relatively small external resources with comparatively large internal resources. So, as we look to bring that group in that results in a shift between capitalized prosecution and internal prosecution. That being said, there was an element of that about $2 million of additional CapEx related to that acquired business. So, as we move forward in time, we see that -- our internal prosecution is going to be certainly much shorter than it was before, that will help generate some of cost savings, but it also shifts things between those two items. And that’s why I think an important metric for us is looking at expenses exclusive of depreciation and amortization but then adding in the CapEx, because at the end of the day, it's across either way.
And Rich to follow up as well on the royalties front, the normalizing for ASC 606. It seemed there was a bigger change than usual in the per unit royalties. I was wondering if there was anything to clarify on that front. Usually, it's your one large fixed customer contract. And then from a high level, Bill, what do you see and what are the thoughts as it relates to IoT and engagement on that front? I know you're going through a voluntary but there is in term of seeing some of that revenue recognition starting to ramp up. And I am curious as to the level of engagement on 5G and whether or not that's helping you to get to the table with some of the Chinese? Thank you.
So regarding the per unit, the two things that come to mind there are, you do have more variability and even seasonality in per unit, because that's reported as the sales occur. It’s a small portion of the overall revenue base. But if you look just at that line, I mean, you will see some variability there. In addition, under the new rules we're estimating -- for instance when we book third quarter, that’s our estimate of the royalties that will be reported to us in the coming weeks related to third quarter sales. Third quarter we did a similar estimate in second quarter and then third quarter includes the true up for second quarter as well. So there are things that impact that. I think if you look quarter-to-quarter, you may see some volatility but that should be smoothed out over time.
So on IoT, so -- and separate Avanti, which is doing the licensing at cash inside for us and then the Middleware play, which is an internal effort at the company. So, Avanti, if you look at the license for us in Avanti, they've gotten up to substantial scale in Avanti now. So I think they are in a position now where they have very, very powerful offer to the automotive manufacture that really is becoming one stop shop for the automotive manufactures. So, I think that’s a really good development over last number of months. I think they also as they've chatted before needed to work through a market that traditionally hadn't that license at that level and come up with a structure that accommodated some of the historical structures there. And I think they've done a good job on that.
So, I think they are extremely well positioned now. They've got a couple of agreements under the belt. And so hopefully we will see acceleration from them on the licensing side from where they are sitting today. So we still have a lot of confidence in that group and they've got, from a personnel standpoint, they've got tremendous capability within that group. So I know the people personally and I think they are just fantastic.
So in terms of 5G, there is two components there in terms of helping on licensing side. Obviously, our involvement in 5G in fact that we're continuing to have a very prominent role there and many of the agreements we're negotiating now with the cover 5G deployments, it certainly helps on the negotiation side. So it speaks to the perpetuity of our value. The other piece that was there is continues to be a tremendous amount of 5G innovation opportunity that we can share and in fact that perspective licensees. So like we did with Sony building with them a 5G portfolio by doing research together that research opportunity exists with us and other of our unlicensed customers that can be really valuable to them in building patent positions, which they can use to defense.
And so it's -- and it's something that we are highly credible in both telling to customers. So, 5G is I think very, very powerful, not only as a long-term value driver or for the business but also a tool that we've been using licensed discussions to bring additional value to our customers.
Bill, is that entering into the discussion with Chinese OEMs or still too early on that discussion?
It's definitely part of the discussion with them.
Thank you. At this time, I am showing no further questions in the queue. I would now like to turn it back over to Patrick for closing remarks.
Patrick Van de Wille
Well, thank you very much, Katy. Thanks to everybody for joining us this quarter. I would request that you keep an eye out for some announcements relating to our Investor Day, which is going to be December 10th in New York. So, we should be putting out some communications around that very soon and some of you will be receiving invitations as well. Thanks for joining us this quarter. See you in three months.
Thank you, ladies and gentlemen. This concludes today's teleconference. You may now disconnect.