Is InterDigital’s Patent Portfolio Undervalued?

InterDigital is a company that designs and develops digital wireless technologies for use in cellular and wireless IEEE 802 related products and networks. They also develop solutions for improving bandwidth availability and network capacity, wireless security, and seamless connectivity and mobility across networks and devices. Their primary source of revenue is from licensing their patents to equipment producers. IDCC currently holds approximately 7,000 worldwide patents and has a further 10,000 patent applications in process. Their customers include mobile device manufacturers, semiconductor companies, and other equipment producers. Products in which their patented technology can be found include mobile devices such as cellular phones, wireless personal digital assistants, notebook computers, datacards, base stations and other wireless equipment, and components and modules for wireless devices. InterDigital’s strategy is to develop technology that they believe will be essential for current and next generation mobile communications and to license that technology to manufacturers and network operators.

The market currently values IDCC at approximately $1,080M. IDCC currently has Cash and Short-Term investments worth $214M and $268M respectively. IDCC is also party to certain licensing agreements that pay them a fixed sum over a set amount of time. The unpaid portion of these contracts is placed on the balance sheet in accounts receivable. IDCC currently has approximately $148M in revenue from licensing agreements that it has yet to receive. The majority of the payments are owed by Samsung, and there is no reason to believe Samsung will not make the final payments as promised.  This means that IDCC has cash, short-term investments, and cash it can be reasonably assured to collect of about $631M or $14.35 per share. Subtracting that figure from IDCC’s market cap of $1080M means that the market is currently valuing IDCC’s primary asset, its patent portfolio, at a little less than $500M.

Valuing the Patent Portfolio

There is no widely accepted method of valuing a patent portfolio. Indeed, various measures exist. These methods usually fall within one of three broad and loosely defined categories: Cost approaches, Market approaches, and Income approaches.

Cost Approaches and Market Approaches

Cost and Market approaches are the most simplistic measures. Cost approaches look at what the carrying value of the patents are on the balance sheet or how much it cost the company to develop the patent, or how much it would cost another company to develop similar technology. The Cost methods do not take into account any revenue earned by the patents. Furthermore, it would be impossible to estimate how much a company would have to spend to develop technology similar to IDCC’s 17,000 strong patent portfolio. Market approaches uses the stock market, or other readily observed market price to value the patent portfolio. Since we are examining the issue of whether or not the stock market is acknowledging the full value of IDCC’s patent portfolio, using the market’s estimation of the portfolio’s worth is pointless.

Income Approach

The best method then is to use an Income approach. The Income approach looks at what income the patent portfolio has generated or is expected to generate in the future. Since all of IDCC’s revenue comes from licensing its patents, we do not need to break out the revenue and costs from any other business units. For this method, we use a discounted cash flow model. For the discount rate I’ve chosen to use 12%. This rate implies that an investor in IDCC would demand about the same level of return (or perhaps slightly higher) as the U.S. stock market as a whole. Since IDCC and many other competitors are publicly traded in the U.S. stock market, I believe this discount rate is appropriate. If IDCC was a smaller private early-stage company, a higher discount rate would be demanded.  IDCC’s cash flow is very erratic. Cash tends to come in large chunks as various communications companies sign royalty agreements. We should look at cash flow as an average over time, such as five to ten years. Let’s examine two different scenarios, one bearish and one bullish.

The Bear

In a no-growth, bearish scenario, let’s assume that IDCC’s patent portfolio revenues will be the same in the next 10 years as they have been in the past 10 years. Over the past 10 years, IDCC has produced an average of $88M per year in free cash flow from its patent portfolio. So let’s assume that over the next 10 years cash flow will be about the same. By plugging the $88M a year figure and the 12% discount rate into the net present value equation, we get a value of about $500M or about what the market is implying. In this case we can assume that IDCC is likely fully valued at around $25 a share.

The Bull

In the bullish scenario, let’s assume that the patent portfolio revenue will continue to grow over the next 10 years due to the increased need for technology to address the challenges of a growing global communication market. To represent this we will look at IDCC’s average revenue from the previous five years, which has shown strong growth. Over the most recent five years, the more profitable time period, IDCC has produced $181M per year in free cash flow on average. Using the $181M per year figure over the next 10 years and a discount rate of 12%, we get a value of about $1020M. This comes out to a whopping $24 per share. Adding in the $14.35 in cash and receivables, we get a fair value estimate of $38.35 per share.

So which of these scenarios is closest to what the future might be? Let’s take a look at the trends in the global mobile device market and communications market.

Global Handset Market

After several quarters of falling sales, the global handset market has rebounded and posted positive growth in the fourth quarter of 2009 and again in the first quarter of 2010, according to Strategy Analytics and the IDC. Consumers also tend to view handsets as semi-disposable items, and if they have the available income they will replace items with newer models. Although IDCC customers are primarily large telecom clients, the true end users of its technology, mobile subscribers, represent a growing global market. This makes country and regional economic issues less important. IDCC should benefit as long as there is subscriber growth in some areas that is enough to offset weakness in others, be it emerging markets leading the way or a rebound in developed markets.

Network Traffic Growth

According to ABI Research, total global mobile traffic was approximately 2,500 petabytes in 2009. This figure is expected to grow to almost 20,000 petabytes by 2014 driven primarily by increases in web, internet, and video traffic. The strain of increased traffic is already beginning to show on many networks.

Overall Addressable Market Outlook

Overall the entire global market in addressable devices (i.e., devices attached to a communications network) and the supporting infrastructure is expected to reach $1.5 trillion dollars in 2014, up from the $1.3 trillion dollar estimate of the current market in 2010, according to ABI Research. Given the current global economic situation, it may be prudent to assume slower than expected growth. But the turnaround in the handset market shows that there is growth potential there and it should continue. The economic situation worldwide may not get better quickly, but it is unlikely to get significantly worse.

Competitors

Taking all these trends into account, it seems fairly likely that there will be growth in the mobile communications market. The next question is how much of this potential growth will IDCC capture. IDCC competes with larger network technology companies such as Qualcomm, telecom companies such as Verizon, and the handset makers themselves such as Samsung. All of these competitors have much larger financial and human resources. However, historically developing technology has not been a capital intensive process (as opposed to implementing that technology). IDCC has thus far competed successfully against competitors with greater financial resources.

Conclusion

Valuing patent portfolios is an inexact science. Should the discount rate be lower than 12%? Higher? What cash flow assumptions should be used? The examples in this article are a bit crude in their assumptions. The best way to judge the attractiveness of this investment would be to demand a very high margin of safety. That is, make sure that your estimation of the value of the patent portfolio is much greater than the market’s value of it. That way even if you make a few miscalculations, you should still realize a sufficient return.

Disclosure: No positions at the time of publication.