Introduction
InterDigital (IDCC, Financial) is a company focused on the creation and licensing of Intellectual Property (IP), mainly in the digital wireless space and video coding (compression) and transmission environments, but also covering other subjects like Internet of Things (IoT) and artificial intelligence (AI).
The bulk of the digital wireless business is dedicated to the creation of technologies used in wireless networks from 2G to 5G, the latter being the one on which the company is currently spending most of its efforts.
The company has a portfolio of around 28,000 patents and currently employs 290 highly-specialized engineers.
The business model: patent licensing
In order to create valuable Intellectual Property content, InterDigital's engineers must have deep skills in the corresponding area, be able to analyze what has been discovered in the past (especially by other companies or competitors) and try to figure out which is the direction new technologies will take in the future (even a distant future).
Once a new idea or technology has been formalized and subsequently analyzed and accepted by an internal committee, the legal department can start with a patent application procedure. A patent is a way to crystallize (and package) that knowledge and protect it.
But how does InterDigital make money exactly? Selling Intellectual Property is not like selling physical products, and it's also different from selling a service. The IP world has its own rules.
A patent can be monetized in many ways, but the most common one is patent licensing. That basically means making an agreement between the patent owner (the licensor) and the person or company that will use the patent (the licensee), which allows the latter to use the patented technology in products without breaking the patent laws.
The licensor gets usually paid with royalties applied on each single device (or software) sold by the licensee. For example, a smartphone producer could agree to pay InterDigital 3% on any single device which uses the specific licensed technology. Sometimes the patent owner can release an exclusive patent, meaning that no other company or person, except the licensee, is allowed to use the patented technology.
Being a patent owner myself, I fully understand the value of having highly skilled (and patent-producing) engineers in the company. In any technology company, there's normally very limited time to dedicate to IP production. I remember spending a lot of time speaking with law consultants specialized in translating your technical idea in a sort of legalese (needed by the patent application procedure). Embarking in a patent application process is only done when the cost-benefit ratio is really favorable.
But the value of generating new ideas and innovation cannot be understated. Companies operating in specific fields cannot compete with InterDigital on IP creation, as the latter is fully focused on it; they prefer to turn to patent licensing and pay royalties on their sold units. Apple (AAPL, Financial), Samsung (XKRX:005930, Financial) and Huawei, just to name a few, are all InterDigital's customers and chose exactly this approach. These tech companies will earn big profits even if they must pay royalties, so InterDigital's patents just become part of their value chain. Some of them have already been under license for more than 20 years.
The 5G and video coding businesses
InterDigital has been involved in wireless and visual technologies for over 40 years. Today, the knowledge continues to build up and compound over time.
Besides patent development, in order to expand its presence in other environments, InterDigital can also opt for bulk patent acquisitions. As an example, in 2018 the company acquired the patent licensing business of Technicolor (TCLRY) for $150 million. It included a portfolio of 18,000 patents and applications. The most interesting ones for InterDigital were the approximately 3,000 patents related to video coding, enabling it to expand in the digital video processing arena.
If we combine the digital wireless and video coding areas, it´s easy to understand that InterDigital has licensing access to billions of electronic products like mobile phones, laptops, TVs, etc. as most of them today use both technologies.
(Source: InterDigital Investor Presentation, Jan. 14, 2021)
Referring to the digital wireless business, InterDigital's patents currently constitute around 6% of all the patents categorized as 5G in the world. They also participate in the definition of the 5G standard: as a consequence, they have close relationships with all the companies operating in the field. This means that they exactly know where the product developments are headed to, and which are the newly introduced features, so they can direction their efforts in a way to optimize the final outcome.
The company is already projected to the future of digital wireless communication, and recently organized a symposium on 6G, with a special focus on sustainability and low-power technologies. Anticipating the future developments for companies like InterDigital is paramount: that's how you get to cover a specific area before the actual players start operating in it.
Financial outlook
InterDigital looks quite an healthy company. It has no net debt (with a cash-debt ratio of 2.53), while the trailing 12-month free cash flow margin is 32.20% (it has been higher in the past years). On the negative side, FCF and revenues have been on a decline in the last years, especially because of the expiration (at the end of 2018) of a license agreement with Huawei. The agreement was renewed in April 2020.
The company is quite generous in distributing its profits to shareholders:. In the last six years, it has bought back more than $600 million in shares, which is around 25% of the current capitalization. Dividends were raised three times in the last five years, and the current yield is 2%.
The company does not look cheap in terms of earnings-related ratios, with the GF value giving it a "fairly valued" ranking, but in the last quarters it generated strong revenue and FCF growth, especially related to eight new patent licenses signed over the last twelve months. Around 99% of revenues are recurring ones, highlighting the predictability of the business. Operating leverage is also positive as the growth in revenues is higher than the one of operating expenses.
FCF for the recent third quarter was $85 million, most of which is related to cash payments from existing patent license agreements, logged on the statements of cash flows as change in deferred revenues as they refer to to future periods (deferred revenues are present on both sides of the balance sheet, increase cash flow on the statement, but are logged on the income statement only when the product/service is actually delivered).
On the negative side, the company is continuously involved in patent litigations because of license infringements. Those related to litigations constitute a significant part of operating expenses (they are projected to be $5 million higher in Q4 2020 compared to Q3).
But the litigations trend seems to be improving. CEO Bill Merritt recently noted that 2020 saw great progress on the front of patent infringement recognition in the courts, with legal action siding more on the side of the patent holders:
"After years of being almost a lone wolf in the wilderness on some of these topics, we saw a significant number of judicial decisions that bought fairness, pragmatism, and realism to wireless licensing."
Product manufacturers all over the world will most probably continue to infringe patent licenses (or misuse them), but this is for sure good news for the company.
Conclusion
InterDigital is mainly involved in the creation and monetization of digital Wireless and Video coding Intellectual Property. The company has been on the forefront of technology developments for more than 40 years and is active in standardization activities, which involve all the big tech players.
The company's stock is also the FPA Capital Fund (Trades, Portfolio)'s portfolio top position. Here's a short summary of their investment thesis taken from the second-quarter commentary:
"We believe that the use of wireless connected devices will continue to grow and we want to invest in a company that supplies its technology to all the players. In essence, IDCC is a backdoor way to participate in the growth of mobile communications"
The current development of 5G technologies and the future development of 6G are the main catalysts an investor in InterDigital should look at for revenue, along with FCF growth. Closely monitoring the frequency and magnitude of the next signed licensing agreements will give further indications to assess the successful execution of the company's future plans.
Disclosure: The author does not currently hold shares of InterDigital (IDCC, Financial)
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nference, January 14, 2021
