Smartphone Patent War – click to enlarge | Credit: Jennifer Daniels
An Overview of InterDigital (IDCC)InterDigital develops, licenses and sells wireless technology patents. Patents in its portfolio include WiFi, 2G, 3G and 4G and for the techies, you can view their entire US patent listings.
InterDigital owns about 19k patents and since they specialize in the wireless space, there are all sorts of theories and calls for a company like Samsung or other handset manufacturers to buy them out to get the advantage in the patent war. See the image above to see what a mess it is.
Ever since Apple bought Nortell’s portfolio and Google bought Motorola, the value and war on patent acquisitions has surged and created its own industry. A company like RPX Corp now has a strong and solid business defending companies against patent trolls.
The type of business model that did not exist 5 years ago.
The InterDigital StoryBack in 2012, InterDigital went out to shop itself. Since then, the focus on InterDigital has always been for a buyout and discussing the value of its patents. Unfortunately, that type of investment thesis is just hope for a quick short-term gain. I’ve never purchased a stock hoping it will get bought out. That’s the last thing I’m thinking about.
If the business has a valid product or service, generates cash and is cheap, it tends to get bought out. No point in trying to predict it.
The only investor I’ve come across having an excellent record of picking buyout stocks is Cheap Stocks. But that’s a different topic. Getting back to InterDigital.
What about its business?
If you go through all the InterDigital articles on seekingalpha, you’ll notice a pattern. Everything is written about the value of its patents.
So let’s take a different look at the company. A fundamental look, because the patents are just products and there is a business to analyze behind those patents.
The Good StuffThe business model of licensing and collecting royalties is highly profitable. InterDigital’s gross margins range from 75% to the 90%. A company that comes to mind is Dolby (DLB), who also licenses their technology with gross margins in the 90% range consistently.
In 2012 the sale of a block of patents to Intel for $375m boosted revenue by 120% compared to 2011. This increase in revenue makes the SG&A and R&D expense small at 5.6% and 10.2% for 2012 compared to 10.4% and 21% in 2011 respectively but the absolute expense is in line with prior years.
I like to see companies buying back shares, but only at the right time. It’s a turnoff to see companies announce a buyback when the stock price is hitting the roof. Thankfully, InterDigital has bought during the decline.
Look in the cash statement of the Stock Analyzer and the 2012 net issuance of stock shows -$150m. No additional shares were bought back this year. I expect EV/EBITDA to be around 6-8x for 2013 and that’s still cheap, so InterDigital should look into buying more shares and returning value to shareholders.
Plenty of cash and no short-term debt. They took on long-term debt in 2011 and it is continuing to increase in small amounts. The amount of cash they hold and FCF the business generates can easily pay it back.
Quick tip: Use FCF to Debt to calculate whether a company has enough FCF to cover its debt. On the Stock Analyzer the values are located in the “DCF Valuation” section.
Basic Balance Sheet Ratios
FCF Easily Covers Debt | FCF/Debt Ratio in the DCF Valuation Section
Although the balance sheet is strong, it shouldn’t be glossed over because the value of the patents fall under “intangibles” on standardized financial statements. The latest value of the patents in the report comes out to $192.5m.
The Bad StuffCost of goods sold is sky rocketing. Developing new patents in a fast changing industry isn’t easy or cheap. It’s not like Peerless Systems, where they can milk a few licenses for years on end. In the wireless space, technologies change so quickly that InterDigital has to be constantly developing. That all adds up.
When you look at the SEC filings, half of the 10Q/10K is dedicated to litigations.
- InterDigital has patents
- Other companies use it or implement similar methods without paying
- InterDigital sues them
- InterDigital collects money
If you use the Stock Analyzer, there are lots of yellow and red flags in the quality section. The accruals and the Beneish Manipulation Score are the worst offenders. However, keep it in context.
InterDigital has a lot of deferred revenue, intangible assets, long term license agreements, makes one time patent sales, and collects money from lawsuits. This is not common in most businesses and is why the accruals and Beneish Scores flash warning signals.
Valuation of InterDigitalOne important point to note is that the patent sale to Intel took place in Q3 of 2012. Right now, that quarter is still a part of the TTM number.
Unless InterDigital is able to replicate the same type of sale, the TTM figure is going to make the numbers look cheaper than it really is.
Here’s what I mean.
InterDigital TTM Numbers make it Look Cheap
The quick and easy way is to view and compare against the 2010 and 2011 numbers which I see as being closer to what the results will show at the end of the year.
Because InterDigital has irregular one time sales, occasional losses on the income statement and cash flow statement, it isn’t as easy to value as I thought. To get around this, I opted to use the EBIT multiple valuation based on a normalized EBIT multiple of 8x. See below.
IDCC EBIT Multiples Scenario
At the current price below $36, there isn’t much of a margin of safety.
The other point I want to include is that the patents are worth more.
Before the sale to Intel was announced, the value of the patents on the balance sheet was listed at $138m in 2011. However, only a portion of that was sold for $375m in 2012. So it’s easy to bet that the value today is much higher. A company in need of the patents will definitely pay a premium for it.
For accounting purposes, I’m sure the value of the patents are being amortized which is lowering the value on the books.
Here’s my wild assumption of the day.
Double the value of the patents and add the extra value to the final fair value.
This will add another $4.70 per share.
Is this a crude calculation? Yes.
Is this incorrect? Probably.
The point is to get an idea of cheapness, not to see whether I can win a math competition. What is the premium that I have to add before InterDigital looks cheap? Doubling it is a good enough start.
Applying this thought, my fair value formula comes out to
Stock price = Fundamentals + Premium of patents
The original range is $30 to $54. Add the premium and I get a fair value range of $35 to $59.
Not tempting enough for me.