Interdigital: Valuation Roadblocks

Thursday, January 31, 2008

My article on Sramana Mitra's site.

As I looked at the positives of QCOM acquiring IDCC, I threw a number between $35 and $45 as a possible sale price. This price was based on a mix of historic data projection, IDCC’s current stock price and the perceived value to QCOM. I revisited the topic recently to do a more thorough valuation analysis which I will present over the next few articles.

As with my QCOM valuation, I have chosen the path of an event-based discounted cash flow analysis since it allows me to superpose the company’s position in the industry’s future. Further, the lucid picture steers clear of multiples based on the peer group in the technology sector. The valuation for companies like QCOM and IDCC which thrive on intellectual property licensing cannot be fair if it is based just on peer comparison.

This being said, the valuation of IDCC has been a challenge due to a variety of factors –

  • Percentage of IDCC-licensed handsets is unclear: The company claims that 30-35% of 3G handsets have IDCC licenses currently. I do not see this number as sacrosanct. So, it is difficult to linearly predict their growing customer base.
  • Lumpsum fees versus per-unit royalty: IDCC reports that 60% of its revenue comes from 3G handset sales. It is unclear if lumpsum payments made for 3G licenses like in the case of LG fit into this category. I am going with the assumption that it is.
  • Royalty rates are not linear as is the case with QCOM: IDCC seeks a per-unit royalty subject to a cap. This makes it difficult to map royalty as a percentage of the handset ASP. Based on the revenue share data and the 3G market share IDCC claims, the per-unit royalty is a little over $2 currently. But with larger volumes to be shipped in the years to come, this number will certainly come down.
  • The legal uncertainties: Due to the volatile nature of the IP business, it is very difficult to predict when the licenses will materialize. This in turn determines the company’s market share. This also makes the company’ primary growth driver – 3G boom – more unpredictable.
  • Chipset business: IDCC’s ASIC business is a new kid on the block and its success is yet proven through major customer wins. IDCC has however completed successful performance trials and has to now draw the carrier and handset vendors’ attention to its solutions to obtain design wins. These design wins will in turn give us more concrete market share data on the company.
  • Secondary growth: As I have always maintained, with a flatter patent play in OFDMA, the growth rates will be stinted with just the current model. The company will have to transition its ASIC division into a staple revenue source. Any design win will not only give it a good push right now, but also serve as the platform for the company’s secondary growth beyond 2012 when the OFDMA technologies will slowly start to make inroads.
  • Expenses: The current operating expenses as a percentage of the revenue are not indicative of the long-term picture. The CAGR of the operating expense is equally misguiding. IDCC is pushing a lot of money and resources into its R&D program, primarily to develop its 2G/3G ASIC. I think that while the R&D expenses, SG&A and its sales and marketing costs will grow at about 17% to expand its engineering team, its IP related fees should flatten out. I anticipate a net 15% increase in its year-on-year operating expenses.

In the sequel, I will briefly go over some of my assumptions and rationale and later take a look into my valuation.

2 comments:

Eight Reasons Qualcomm will Acquire InterDigital in 2007

1. Massive dollars are at stake. Qualcomm (Q) is in the process of building a wireless technology licensing juggernaut. If successful, Q’s annual royalty revenue will more than triple over the next five to eight years (from $2.75B – or $10 on 275M phones, to $10B – or $10 on 1B phones) as 3G WCDMA replaces 2G GSM. The acquisition of InterDig’s IPR will help justify and maintain the $10 per phone royalty rate for all 3G standards.

2. The current dispute between Q and Nokia over their licensing agreement that expires in April is an immediate threat to Q’s ability to collect the standard 5% royalty for all flavors of 3G. Specifically, Nokia claims (among other things) Q’s WCDMA IPR simply doesn’t justify a 5% royalty rate especially considering the major contributions to the WCDMA standard by Nokia and others. Battle lines have been drawn and there are no hints of a settlement. I suspect that Nokia would strongly support Q’s acquisition of InterDigital – eliminating the only other major non-manufacturing licensing entity. To the extent Q is being asked to make rate concessions, the acquisition by Q of InterDigital could reestablish and reinforce Q’s rationale for a 5% rate for all 3G standards. From a recent article: Jacobs waved off comments by Ericsson (ERICb.ST) CEO Carl-Henric Svanberg, who told Reuters on Monday he was more optimistic that he and other vendors could agree with Qualcomm on lowering royalties -- which Jacobs said was "one avenue" under consideration.

3. Qualcomm is beset by royalty rate challenges, not only from major OEMs, but also from at least three foreign government agencies, including the European Union’s European Commission, Japan’s Fair Trade Commission and South Korea’s Fair Trade Commission. Each of these foreign trade watchdogs is investigating or threatening to investigate the fairness of Q’s licensing policies, particularly regarding WCDMA. To quote a reporter, “Qualcomm is standing in a hornets nest”. By acquiring InterDigital, Q would immediately and substantially enhance its WCDMA IPR portfolio providing valuable ammunition in these investigations. In a report recently released by Q, the top four WCDMA IPR holders by number of patents declared essential to ETSI are: Ericsson 163, InterDigital 136, Qualcomm 105, and, Nokia 53. After acquiring InterDigital, the list would read: Qualcomm 241, Ericsson 163 and Nokia 53. Clearly, adding InterDigital’s IPR to Q’s creates a WCDMA powerhouse second to none.

4. An emerging licensing issue for Q is the development of TD-SCDMA in China, the world’s largest market for cell phones. China is expected to grant operator licenses early this year for 3G with strong support for their “home grown” standard, TD-SCDMA. Although it’s not yet a front burner issue – no TD-SCDMA products are being sold – TD-SCDMA licensing could become another huge royalty source for Q. Q may hold foundational TD-SCDMA IPR; but acquiring InterDigital’s substantial portfolio of TDD related IPR would bring Q to the forefront in TD-SCDMA development. A recent report showed InterDigital number one in TD-SCDMA patents. Another emerging issue for Qualcomm is the WIMAX standard (often called 4G) being implemented in parts of Europe, by Sprint (with Nokia) in the USA and by multiple operators in South Korea, where it is called WIBRO. WIMAX/WIBRO, developed by Intel, Samsung and others, uses a TDD Duplexing scheme – where InterDigital holds foundational patents. Also, InterDigital has proven its WIBRO prowess in the recent SK agreement described below in reason number 6. Here’s an excerpt from a recent article:
Jacobs (Q’s CEO) suggested if it became necessary the company may make an acquisition in the field of WiMax - a technology Qualcomm has previously branded as inferior to 3G. While its stance on WiMax remains the same - "it doesn't work very well in the mobile environment", according to Jacobs - the Qualcomm head said if operators ask the company to support WiMax, it will do so. He said: "If it turns out to be a popular technology and if operators want us to support it, we will do." In that case Qualcomm will consider acquisition, partnership or internal development as strategies. InterDigital is also the world leader in WCDMA TDD development, based on their recently completed development agreement with Nokia. WCDMA TDD, while not yet commercially deployed, has the potential for world wide usage.

5. Qualcomm’s foundational cdma patents are aging and many will revert to the public domain over the next ten years. Q’s main focus over the last many years has been its proprietary 3G standard, cdma2000. On the other hand, InterDigital has focused intently since 1999 on developing standards compliant WCDMA (FDD and TDD). InterDigital’s fresh WCDMA patent portfolio would complement and supplement Qualcomm’s groundbreaking cdma work.

6. Recent InterDigital accomplishments illuminate their bleeding edge technology. InterDigital has announced a WCDMA HSDPA chip that they claim is faster than others currently on the market. Qualcomm is the primary supplier of these chips today – perhaps Q could benefit from InterDigital’s more advanced receiver design. InterDigital also recently announced a WiBro (Korea’s WiMax) engineering development agreement with South Korean operator, SK, proving InterDigital’s prominence and prowess in converging wireless standards. These accomplishments might meld nicely with Q’s own technologies.

7. There seem to be subtle hints from both companies that something is brewing (so to speak). For example, in recent published papers explaining and justifying their licensing practices, Q has been emphasizing their strategic acquisitions of companies with complementary technology (EG. Flarion and SnapTrack). Also, Q refers to preventing “royalty stacking” by acquiring and passing along IPR rights. Further, Q published the aforementioned WCDMA patent analysis (see reason number 3) showing InterDigital ahead of Qualcomm in number of patents claimed to be essential to the standard, a bit odd coming from a company trying to justify a 5% royalty rate (the Q analysis does go on to claim their patents are more valuable because they are cited more often by other patents). Q has also amassed cash reserves of about $10B prompting some Wall Street observers to speculate the they are looking to a large acquisition to bolster prospects.
From InterDigital’s perspective, the series of huge stock buybacks could be interpreted to say: we’re not going to use our cash hoard to support future development (even though we are on the bleeding edge of a high growth technology), nor will we use these funds for growth through acquisitions (even though we discussed those opportunities in 2004 and 2005): instead, we will buy back our shares (even at near six year high prices) because that will most benefit our shareholders (and option holders and RSU holders) in the event of a buyout.
Another InterDigital mystery that might be explained by this pending buyout theory is the complete lack of new licenses signed over the last year. In 2004 InterDigital signed new or expanded agreements with six manufacturers. In 2005, there were four new licenses. In 2006, with WCDMA blossoming, just LG signed at the beginning of the year. Why the twelve month pause? InterDigital tells us it is “terms”; but, maybe it results from ongoing discussions with Qualcomm who might think new licenses are not needed and would only confuse the acquisition agreement.
The last hint comes from the stock market: Qualcomm is underperforming and InterDigital is outperforming. Speculation might be: Qualcomm has a problem, InterDigital has the answer.

8. The economics are compelling from all sides. The potential reward to Qualcomm is the cementing of 5% royalties for all 3G standards which translates to ~$7.75B increase in royalty income over the next few years. Using a commonly accepted revenue multiplier of 10 (times revenue, not earnings), these future royalties are worth ~$77.5B in market cap, or more than double Q’s current market cap. If that’s the case, what might Q pay to acquire InterDigital to help fend off the nasty hornets? I’m thinking about $10B (about $200 per IDCC share after buybacks) for four reasons: 1) using the same 10x revenue multiplier as above, InterDigital would be worth ~$10B if, as anticipated, royalty revenues reach $1B ($1 times 1B units), and, 2) InterDigital recently updated their poison pill to activate at $200 per share, or ~$10B market value (interestingly, InterDigital lowered the trigger price from $225 to $200 – not allowing much leeway over the next ten years), 3) $10B seems like a reasonable price for Q to pay to help guarantee additional future cash flows of $7.75B per year, and, 4) Q’s cash reserves recently grew to about $10B, making an acquisition of that size very reasonable. The big problem many IDCC holders see in this discussion is the logic of acquiring a company whose stock is at $34 per share for, say, $200 per share – premiums like that just don’t happen in the market. But this time it’s different – the consequences are overwhelming – Q may be willing to pay a substantial but reasonable price for the support they need to bolster their future royalty income. And, a $10B acquisition shouldn’t hurt Q at all – any dilution from a stock based acquisition could quickly be offset by an increase in Q’s stock price once the ramifications of the acquisition were understood (in other words, like any other good agreement, I’m guessing both stock prices would increase after the acquisition is announced).

Bottom line: I suspect Q will acquire InterDigital in a (mostly) stock deal worth up to $10B probably in the March to June timeframe, coinciding with intensifying Nokia negotiations and increased foreign agency scrutiny.

Disclosure and warning: I am an InterDigital share and LEAP holder with a very poor record of reading tea leaves (vbg).

Anonymous said...
January 31, 2008 at 1:40 PM  

The content and the stats on this article seem dated, seemingly written early last year. (Q's 2007 royalty revenues to speculation of a WiMAX acquisition which subsequently happened). Nonetheless, there are certain aspects that resonate what I have mentioned in my earlier articles. I do still think that $10 billion is at the higher end.

I do not agree with certain other points made here. For example, QCOM still has substantial WCDMA/HSDPA IP contrary to the belief that all its IP is predominantly in CDMA2000 and EV-DO.

I would also appreciate it if you reference the source of this article.

Vijay Nagarajan said...
January 31, 2008 at 2:15 PM  

Post a Comment