The most disappointing investment in the portfolio for 2013 was InterDigital (IDCC). This stock declined approximately 28% during the year, despite posting roughly 25% operating margins. Our thesis on IDCC is that the company should benefit from its wireless technology patents as more smartphones and mobile tablets are connected to the in ternet. IDCC creates wireless technology, applies for patents for the technology it creates, and then licenses its technology to manufacturers who produce the aforementioned products. In the past, Nokia, Samsung, Apple, LG, and many other manufacturers hav e licensed the company's technology to use in their products and paid IDCC royalties.
Typically, in the past, IDCC would receive royalty payments fixed for a certain period of time, for example four years, and then its customers would renew its license fo r another period of time and likely with some additional patents thrown into the agreement. However, as IDCC switched to receiving a royalty on a per unit sold basis and the number of smart phone units sold worldwide has exploded to the upside over the pas t couple of years, some of the company's traditional customers have chosen not to sign new license agreements and pay IDCC. The failure to pay, but still use IDCC's essential patents in the manufacturer's products has prompted IDCC to sue some of its large st customers.
Suing your customers is not an ideal business strategy, but one, unfortunately, that is all too commonly deployed in the technology industry. These lawsuits are not only expensive, but also can drag on for years as the suits wind their way t hrough both the International Trade Commission and the Federal Circuit. At the end of the day, IDCC has prevailed in prior lawsuits and won large judgments or settled with the likes of Nokia and Samsung. Most investors do not have the patience to withstand all of the ups and downs of the legal process. When there are temporary setbacks to IDCC's legal process, investors sell their stock, and this is what we believe largely transpired in 2013.
However, we do not view the prospects of a legal victory as the only means to the success of IDCC. In fact, the company can monetize its patent portfolio by selling non - core patents to other companies. For example, in 2012, Intel paid IDCC $375 million for a couple of hundred patents, out of a portfolio of over 20,000 patents. IDCC can also enter into joint venture agreements, such as the agreement signed with Sony in 2013, to generate value for shareholders. Instead of suing its potential licensees, IDCC can enter into binding arbitration with manufacturers.
Moreover, IDCC has not ruled out eventually developing products employing its patents, and then selling these products to its customers rather than licensing them the technology. Thus, there are multiple ways for IDCC to get paid for the value it creates, and it does not have to be a binary situation as some ill - informed investors might believe.
The one risk that we need to watch closely in the coming months and quarters is the political risk. There is some discussion is Washington about the merits of pate nts in our fast - changing, technologically - advanced society. Some people will argue that patents do not have as much value today as in the past. Their reasoning is that product life cycles are much faster today and new things are always being created to rep lace the older generation of products. However, perhaps the life cycle of products is shortening because there is payoff to those who create the technology in the first place. If inventors and scientists are not paid for the stuff they create, what is the incentive to create the new technology? Our view is that inventors, musicians, writers, and scientists should have their new ideas and products protected from being copied for a reasonable period of time, and get paid a royalty should someone or a company want to use their creation. However, we need to be cognizant that our opinion could be refuted in a political environment that has a different agenda. While the risk of a massive overhaul of our patent laws is small, we cannot fully discount it occurring.
Thus, we will be diligent in adding to our IDCC position and ask for an extra discount before buying more shares. The company's balance sheet remains exceptionally strong with about half of the company's market value consisting of its net cash position. The management team has also been very good stewards of shareholders capital, and the market for smart phones, tablets and other mobile devices connecting to the internet remains very robust.
From FPA Capital’s fourth quarter 2013 commentary.