InterDigital: A Well-Established Company In A Promising Industry With Very Little Downside Risk

As a value investor I tend to focus on smaller and lesser known companies that have excellent cashflows and little downside risk. When I find such a company and it also has shareholder friendly management, good prospects and a strong moat, I get really interested. InterDigital (IDCC) is such a company.

In the following article I will provide you with the reasons why I recently bought the stock.

Business

InterDigital develops and licenses mobile technologies that are used worldwide in a variety of devices, networks and services.

How does it make money?
InterDigital develops fundamental technology for wireless systems and then shares this technology with the industry in the standards process. The key here is that InterDigital is actively involved in defining the specifications for the technology and the successive generations of that technology – think for example 3G, 4G and the upcoming 5G – thereby ensuring that their technology will be used in devices based on these standards. They then license the technology to manufacturers of the devices. As such, InterDigital may be classified as an intellectual property company.

InterDigital holds a significant patent portfolio of over 20,000 patents. Fellow contributors Khursheed Brothers wrote an interesting article about the value of these patents which I encourage you to read.

What are its main clients?
In 2016 InterDigital signed a multi-year license agreement with Huawei, the largest Chinese handset manufacturer, as well as with Apple (AAPL). Together these two clients accounted for almost half of 2016 total revenues, Apple 25% and Huawei 23%. Other big clients include Samsung (OTC:SSNLF) 10% and Sony (SNE) <10%. InterDigital has half the smartphone market under license.

New initiatives
InterDigital is also involved in the fields of 5G and IoT but it’s more actively promoting its Smart City solutions. This is because there is not much visibility on revenue contribution from 5G and IoT, whereas Smart City solution are already yielding the first tangible successes. Smart City basically boils down to making cities and infrastructures in these cities more efficient by harmonizing devices, data and services. I will write more on this in a follow up.

In 2016 InterDigital joined the Avanci IoT licensing platform, alongside industry leaders like Qualcomm (QCOM), Ericsson (OTCPK:ERIXF) and KPN (OTCPK:KKPNY), among others, to be at the forefront of rapidly growing IoT solutions.

(source: 2016 annual report and corporate website)

Cash flow

In the first 9 months of 2017 the company generated a free cash flow of $71 million. In the first 9 months of last year this figure was $173 million, but these figures are not really comparable as in 2016 they recorded a large sum of past patent royalties, around $73 million more than in 2017. These past patent royalties make it harder to get a good hold on the financials, which may be one reason the stock is trading at low multiples.

In any case, the company generates vast sums of free cash flow, which, in the 5 years up to 2016, amounted to over $900 million. Comparing this with an average market cap (end of year) over the period yields to a free cash flow yield of around 9.4% which is very solid.

2012 2013 2014 2015 2016 Average
FCF ($MM) 130 154 177 61 387 182
MC ($MM) 1,687 1,188 1,953 1,737 3,133 1,939

(source: GuruFocus)

Because of the long-term agreements, the cash flow visibility is very high. In the 3Q earnings call, InterDigital announced it is already scheduled to collect $900 million in operarting cash flow through 2022 under existing fixed fee agreements. Per-unit revenues and new agreements only adding to this figure. For the first 9 months of 2017, total patent licensing royalties of $314 million were divided as follows: fixed fee $220 million or 70%, per-unit 12% and past patent 18%. Note that I used operating cash flow here instead of free cash flow, as management does not issue free cash flow estimates. The major difference between operating cash flow (30% higher) and free cash flow being dividends paid and share repurchases.

What does management do with all this cash generated?
Well, first of all InterDigital pays a quarterly dividend of $0.30, or a 1.64% annual yield at today’s stock price of around $73. The dividend will be raised to $0.35 for an annual yield of 1.91%, as announced on September 14.

What’s more is that the company is very active in repurchasing their own shares, aided by the high revenue visibility. In 2014 the company announced a share repurchase program of $300 million, which they increased by $100 in 2015 and another $100 this September. Of the total of $500 million there is $186 million left as of the day of the announcement on September 15, or around 7.7% of that day’s market cap. The company already reduced its share count from 55 million in 2004 to the current 34 million.

I really like the fact when a company is returning a lot of the cash to shareholders and not squandering it on all kinds of questionable acquisitions. InterDigital doesn’t do a lot of acquisitions and they are usually relatively small, such as the Hillcrest Labs acquisition in December 2016. Although the details of the Hillcrest acquisition were not disclosed, long term debt increased by only $7 million in the fourth quarter. It is worth a quick mention that Hillcrest is a logic acquisition as they are active in the field of sensors in consumer electronics and IoT devices, thereby enhancing InterDigital’s position in this fast-growing segment.

As of September 30, 2017, long term debt stands at $291 million which translates to a very healthy 15% of the total balance sheet. Taking into account the huge cash position of $967 million there is no net debt at all.

Industry

The wireless communications industry is growing rapidly and constantly adding new devices. IHS estimates that the IoT market will grow to an installed base of nearly 70 billion connected devices by 2025. Standards are shifting from voice-oriented services to multimedia services that exploit the higher speeds offered by newer technologies such as 4G and 5G.

(source: 2016 annual report)

Competitors

InterDigital does not compete in a traditional way, as other players do not have the same rights to the company’s proprietary inventions and technologies.
The company does however face competition from parties developing similar or other technologies, but because the company is so focused on collaborating with almost all relevant manufacturers in the industry and engages in long term relationships, this risk seems limited.

Moat

I think fellow contributor Nisala Weerasuriya, captures the moat nicely by mentioning:

Deep intellectual insight of the research and development team. A head-start in the space with high influence over regulations and standards. High operating margins that mitigate risks in litigation and provide cash flow for delayed technology incubation periods. The advanced and proprietary technology IDCC provides has no substitutes.

To this, I would like to add that the company has a firm position given its multi-year contracts with manufacturers.

All these benefits make it very unlikely that a new player would be able to change the economics in a major way.

The company is in business since 1972 and has a long history and focus on advanced R&D, resulting in its strong patent portfolio, which would take a competitor some time and effort to put at risk. For example, since 2000, the company has spent more than $1 billion on R&D.

Valuation

In the second half of 2016 the company generated a very high earnings per share figure which I prefer to smooth out a little bit. So, when I take the average annual earnings in 2012-2016 of $4.37 I arrive at a P/E of 16.7.

2012 2013 2014 2015 2016 Average
EPS ($MM) 6.26 0.92 2.62 3.27 8.78 4.37

(source: GuruFocus)

This is not very expensive for a company growing revenue at a 5y average annual rate of 15% and earnings at a rate of over 20%, but it gets even better. As 38% of the market cap consists of cash, we may substract this from the current share price and arrive at an adjusted P/E ratio of only 10.4.

As for the P/B ratio (3.07) and the P/S ratio (4.34) it’s nice when we can compare these with a peer group, but as there aren’t any comparable companies, there is not much to say about these ratios.

It may not be comparing apples to apples here, but to add some reference, Qualcomm is trading at P/B 3.06 and P/S 4.25, and a P/E (same calculation method) of 16.7 and a cash-adjusted P/E of 10.2. So quite similar multiples, but with the big difference that Qualcomm is growing revenues at 5%, and InterDigital is growing 3 times as fast. Also, IDCC’s market cap is only $2.5 billion compared to QCOM’s $94.1 billion, so there is room for further growth.

It is fair to take note that Qualcomm (QCOM) shares have popped 17% in the past few days on takeover talks from Broadcom (AVGO). This is somewhat inflating the multiples, but in my opinion, the current share price of Qualcomm now more reflects its true value.

Downside of the stock

InterDigital has around $28 per share in cash. As we have seen, management is not squandering cash, so it’s safe to assume that this is rock bottom for the medium term.

To this, we add some value for the patents. Patents hold a current book value of around $9 but are worth a lot more. The Khursheed Brothers estimate around $49 per share, but since we are determining downside risk, let’s be more conservative and use $29.

To complete this exercise, I take the sum of the other assets and substract total liabilities, which means we must substract $13 per share.

From this computation, I estimate InterDigital stock to be worth at the very minimum $28 + $29 – $13 = $ 44 for a downside risk of $29 per share. This downside does not take into account the $900 million in cash flows or $26 per share that are already virtually guaranteed. So, I think it’s safe to say that the downside from the current entry point is limited.

The upside however is probably significant, even without 5G and IoT.

The figures used are as of November 7.

What factors may put the valuation at risk?

The value of the patents may be lower than estimated, although I consider this risk to be small. The Khursheed Brothers are already conservative in their estimation of the value of the patent portfolio is excess of the stated book value. And just for the sake of computing the downside risk of the stock, I cut this excess value in half.

Further, there is some risk, as there always is, in future cash flows. As IDCC’s client portfolio is relatively concentrated, a default of one of those parties would put a dent in the income stream. Fortunately, the clients are well established names with healthy balance sheets. Also, the additional cash flows from new contracts and from per-unit revenues are not used in my calculation which increases the probability that the $900 million in cash flows will be realized.

(source: company presentation at Dougherty & Co. Conference, September 19, 2017). Note that management was more prudent in the 3Q earnings call with $900 million, the figure that I used in my calculation.

Opportunity

Before investing, I generally ask myself: “Why don’t I agree with the rest of the market?”. It should be clear that if an investor thinks what everybody else thinks, it is already priced in and there is no opportunity. To be able to recognize an opportunity, I must understand the consensus and explain why it’s wrong.

This is usually easier said than done and involves some guess work, but the following arguments may provide clues that the market is missing something:

Low market cap of 2.5 billion. As you go down the market cap spectrum, information tends to be less efficient. This is also why my sweet spot is between 0.5 and 5B market cap. Little analyst coverage. Only 5 analysts are actively following the company of which only 1 big name. Little coverage on Seeking Alpha and other media. It’s kind of a “boring” company to read about in terms of delivering “picks and shovels” technology. It is technology you cannot see or touch, and it is certainly not very sexy. The company is conservative is its guidance. For example, it is not actively speaking about the possibilities of 5G and IoT as far as earnings go. So, upside potential may not be fully recognized by the market. Significant value of the patent portfolio may not be broadly known. Future – basically guaranteed – cash flows do not seem to be given much appreciation. Volatility of past cash flows may make the company difficult to analyze on the surface and market participants may attribute more risk to the company than it deserves. Or it will not appear on their screen at all. Conclusion

In my opinion, InterDigital is a compelling buy, which is why I recently established a position at an average price of around $72 per share.

Reasons why I like the company as well as the current stock price include:

Shareholder friendly company. Very strong cash flow generation and visibility. Pristine balance sheet with no net debt. The stock price has dropped from a high of $102 in February 2017. Low P/E ratio compared to growth potential. Significant value of patent portfolio. Little competition and strong moat. Strong involvement in new developments in growing industry. High “staying power” Delivers “picks & shovels” to the industry, so it does not matter which manufacturer eventually “wins”. Not highly valued by the market.

Disclosure: I am/we are long IDCC.

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.

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