September 20,2011

Interdigital (IDCC) is a patent holding company that put itself up for sale on July 18th of this year. Holding over 8,800 patents with thousands more applications awaiting approval, IDCC’s core strength revolves around the growing area of LTE/4G. While small, 4G is a growing share of the overall market and over the next 5 years is poised to overtake 3G as the dominant wireless standard. Expensive from a carrier perspective, consumers have shown a voracious appetite in using, and paying for, an increasing amount of data throughput. Carriers have increasingly discovered they can charge more as consumers accept the switch from all-you-can-eat data plans to those that cost more but provide a richer, more seamless service. So the question on the 4G/LTE front is not if but when the ‘tipping point’ occurs and 4G goes from being a minority segment to the dominating standard.

An investor deciding whether or not to be long IDCC stock needs to have some yardstick to value the company, and then compare the results to the current trading price to determine if taking the risk of being long IDCC is worth the eventual price. I would argue the best metric to value IDCC’s portfolio of IP would be to utilize a discounted cash flow analyst (DCF) – with the assumption that industry will eventually pay a set royalty rate per handset. Of course, charging and collecting are two different things entirely but to date IDCC has had success in getting the major handset manufacturers (Samsung & Apple) to pay royalties. Samsung’s agreement with IDCC runs out at the end of 2012 and Apple’s in 2014 at which point, assuming IDCC is still a standalone company, each would have to renegotiate payment terms (Apple currently does not have a 4G product on the market although it is widely rumored to be releasing one next year.  It currently pays royalties based upon IDCC’s older 2G & 3G patent portfolio).

The last comparable sale in the wireless patent space was the Nortel bankruptcy auction which yielded over $4b as Google went up against, and ultimately lost to, a consortium of wireless manufactures including Apple, Samsung & Research in Motion. The Nortel portfolio covered a wide range of over 6,000 patents and were mostly skewed towards existing 3G designs (114 were related to LTE, or Long Term Evolution, an acronym for 4G wireless technology).

Since LTE is an emerging market it’s extremely difficult to settle upon both the size and royalty rate that industry will support – necessary in order to generate an expected future cash flow. Multiple parties also own LTE patent portfolios, and therefore you need to come up with an estimated size of the overall LTE intellectual property and what IDCC’s percentage of it would reasonably allow it to collect in royalties.

The existing bidders for IDCC are most likely not buying IDCC for its current and future cash flow stream but rather to insulate themselves from future royalty payments – in essence prepaying (hopefully with a discount) future cash flows that would need to be paid to a standalone IDCC. This is why a consortium bid for IDCC is the most likely outcome, as multiple handset manufacturers’ could pool their future expected royalty payments and in theory, outbid any stand alone entity. Therefore, while an analysis of DCF is the best way in theory to gauge the value of IDCC in a sale, any consortium bidder would need a discount of its future payments in order for it to be worthwhile to ‘pay now’ (acquire IDCC) versus ‘paying later’ (litigating and settling down the road). One could argue that with global interest rates near zero that supposed discount is low, however, you could also argue that with corporations hoarding cash at record levels it requires a larger discount to incentivize corporations to pay upfront.

There is another value to an acquirer’s picking up IDCC; namely to make it difficult if not impossible for others to compete without paying punishing royalty rates – effectively neutralizing a future competitive threat. This was most likely the rationale between the bidding war between Google and the Apple-led consortium that lead to the $4b+ winning bid for Nortel.

So, to summarize, here is my cheat-sheet for analyzing the expected valuation of IDCC in the ongoing auction:

(a)    the size of the future 4G/LTE market
(b)    a reasonable percentage of the existing and future 4G/LTE IP held by IDCC
(c)    an expected discount to future payments a consortium bid would likely require
(d)    the value, if any, in utilizing IDCC’s portfolio to interfere with non-consortium manufacturers future products in making them financially non-competitive
(e)    a DCF analysis of the older, 2G & 3G portfolio
(f)    net cash position at closing

“Nuke John” an author on Seeking Alpha has penned what I believe to be the best published piece on DCF estimates for IDCC. While estimates vary, NJ makes a good case for assuming IDDC controls 20% of the 4G/LTE IP pie. I think a conservative estimate in market size is $75-100B in four years. Taking a 3% global royalty rate and assuming 20% market share gets you a $450m cash flow at the low end and $600m at the high end starting in year 4.

Now here’s the tricky part – what growth assumptions do you make for the cash flow, and when do you trail it off? To be conservative, I have modeled $450m in year 4 growing 5% a year stopping in year 11, and then decreasing by 50% for the next two years before going to zero. I have also modeled 150m a year for years 1-3 mirroring my expected value for the 2G & 3G portfolio.

DCF analyses require a discount rate on future cash flows. One could argue that in the current interest rate environment it should be between 5-6% but to be conservative I have modeled IDCC off an 8% valuation. The present value of the above cash flows at 8% equal $3.03 billion, which not coincidentally is not far from the current trading price of IDCC stock.

I throw in $530 million for the cash portion and assume zero value for the competitive disruption component of the portfolio and my NPV (net present value) of IDCC is $3.56 billion. At a fully diluted share count of approximately 46 million my DCF valuation gets me a price per share of $77.40.

Looking at the current stock price of $62, if I am right the market is primed to pay an IDCC investor a 25% rate of return for sitting in the stock through the conclusion of the auction. As a professional investor doing this for 15+ years that sounds about right to me given the risks inherent in owning IDCC. Another way to size up IDCC is to look at the call option prices and determine what odds the market is pricing in for my scenario. The October 65 calls are trading around $7. They would pay off $12.40 assuming a sale happens at my price and the market arbitrages the stock price without any financing risk (a good assumption in light of the current bidders for IDCC).

While I do not own a crystal ball I think you will agree there are a number of conservative assumptions baked into the above analysis. For one, I exclude any 4G/LTE payments outside of handsets (which is not what IDCC thinks its IP should command). Secondly 2G & 3G technology will be around for quite some time and it’s unreasonable to expect IDCC’s DCF to include only 3 years of payments for it. Lastly, the disruptive value of the IP is a wildcard that could easily push this auction past what a standard DCF analysis yields as fair value. Any one of these angles could add $10-$20 a share in a sale process with multiple bidders competing with each other.

Disclosure : I am Long Interdigital (IDCC) common stock

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