Hilliard Lyons IDCC Research Report Published @ 3:54pm EST on Friday (6/13)
Although the report is 10 pages, I posted pages 1-3 (summary investment thesis) below.
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InterDigital, Inc.
Tom Carpenter, CFA
Senior Technology Analyst
Rating: Buy
June 13, 2008
Important Legal Issues Could Soon become Clear. Reiterate Buy.
•InterDigital has three important legal issues that could significantly impact its share price over the next two months. Two of the maters relate to Samsung 2G and 3G, while a third ruling concerns a possible 3G license with industry heavyweight Nokia. If InterDigital is successful in these three issues, it could collect its $180 million to $200 million 2G arbitration win from Samsung, and more important, pave the way for 3G licenses with mobile phone industry market share leaders Nokia and Samsung, who combined, represent approximately 55% market share.
•The most important legal issue, in our view, is InterDigital appealing a ruling that allows Nokia to go to arbitration over a 3G patent dispute. On August 8, 2007, InterDigital filed a 3G patent infringement complaint at the International Trade Commission (ITC) alleging that Nokia infringes four of InterDigital’s patents. Nokia claims its has special rights to IDCC’s patents due to a 2G and 3G agreement Nokia and InterDigital signed in February 1999 (expired in 2006) whereby the companies jointly developed 3G Time Division Duplexing. InterDigital disagrees. An administrative law judge at the ITC, who specializes in patent disputes, denied Nokia’s request for arbitration. Nokia found a sympathetic forum, and federal Judge Deborah Batts ruled that Nokia could take InterDigital to arbitration, and put InterDigital’s 3G complaint at the ITC on hold.
•In our view, there are three points of concern with Judge Batts’ ruling: 1) It appears to violate collateral estoppel, which prohibits relitigating an issue once a court had decided an issue as to fact or law, and 2) Whether a federal judge has jurisdiction over the ITC. Usually, the Federal Circuit Court of Appeals is the federal venue for ITC matters, and 3) Whether she overstepped her bounds by injuncting an ITC case. The Second Circuit Court of Appeals is hearing IDCC’s appeal on June 17, 2008. Based on three questions the court asked Nokia to answer on June 13, 2008, it appears the court has reservations about Judge Batts’ ruling. See Exhibit III for the questions. We believe the Second Circuit will rule in InterDigital’s favor by the end of July 2008. If the Second Circuit rules in InterDigital’s favor, InterDigital’s 3G complaint against Nokia at the ITC will restart in several months. If the Second Circuit upholds Judge Batts’ ruling, then Nokia can likely delay an ITC restart for at least one year.
•The International Trade Commission has scheduled an evidentiary hearing for InterDigital’s 3G patent infringement complaint against Samsung July 8-14, 2008. Unless there is a speedy ruling by the Second Circuit in InterDigital’s favor in its appeal of Judge Batts’ ruling that could possibly allow the Nokia and Samsung cases to be re-consolidated, we expect the InterDigital/Samsung evidentiary hearing to proceed as scheduled. We believe the evidentiary hearing will be insightful, as attendees likely will be able to tell which of the five patents, if any, the administrative law judge’s staff believes Samsung’s 3G handsets infringe upon. The administrative law judge is scheduled to rule November 25, 2008 whether Samsung infringes on any of InterDigital’s patents in the case. If infringement is found, the ruling will also contain a remedy, which could include an import ban into the U.S. on any Samsung 3G phones that infringe on IDCC’s patents. A final ruling by the ITC is scheduled for March 25, 2009.
•We believe the International Court of Arbitration could (finally) rule the first week of July on InterDigital’s and Samsung’s 2G arbitration. The International Court of Arbitration ruled in September 2006 that Samsung owes InterDigital approximately $180 million to $200 million (including interest) for 2G sales covering 2002-2006. Samsung appealed a U.S. federal judge’s confirmation of the award, and posted a $167 million bond for the years 2002-2005, with 2006’s amount yet to be decided. Samsung also filed something similar to an appeal at the International Court of Arbitration, and we believe a ruling on Samsung’s appeal is imminent. Hopefully, a ruling by the International Court of Arbitration will put the matter to rest, and InterDigital and Samsung can use the 2G money as a bargaining chip in their 3G licensing negotiations. Whether or not the International Court of Arbitration confirms the original ruling or gives Samsung a discount on what it owes IDCC for 2G, we believe Samsung will owe InterDigital well north of $100,000,000.
•InterDigital released an 8-K on March 24, 2008 indicating that it and Nokia were in settlement talks and had made substantial progress. Unfortunately, no 3G agreement between the parties has been announced, and we believe Judge Batts’ ruling gave Nokia additional hope that it might be able to stall/delay paying InterDigital for 3G for another year or two, thus sidetracking negotiations. A ruling in InterDigital’s favor by the Second Circuit Court of Appeals could help jump start 3G licensing talks, as Nokia would be forced back to the ITC, where a loss to InterDigital could mean a 3G import ban in the U.S., a market where Nokia’s market share is over 30 percentage points below its global share. Nokia is introducing up to twelve phones in the U.S. in 2008, and would like to at least double its U.S. market share.
•IDCC’s Slim Chip and other products appear to be meeting acceptance in the marketplace. In February, InterDigital announced it licensed its 3G modem technology to a leading Asian fables semiconductor company. The unnamed company will incorporate IDCC’s modem intellectual property, baseband design, and protocol stack software into the company’s dual mode chips. We anticipate revenue from this win in 2H08. We expect additional modem and chip licenses in 2008 that could enable InterDigital to grow its product revenue significantly in 2009. In 2009, we believe InterDigital will launch the next generation of its chip family, and in addition to its current modem and data card capabilities, the 2009 chip will be geared toward smart phones. If Slim Chip gains new customers, and Infineon ships its 3G chips in bulk to Samsung, Apple, and others, we estimate IDCC’s product revenue could approach $15 million to $20 million in 2009.
•This is the year for InterDigital’s management to deliver 3G licensing wins with major manufacturers. After IDCC’s groundbreaking five-year combined 2G and 3G deal with LG Electronics in January 2006, management repeatedly spoke of licensing momentum on conference calls during the remainder of 2006. We believe the firm has had serious negotiations with Nokia, Samsung, and Sony Ericsson since the LG Electronics agreement, but has been unable to agree on a licensing rate. This led InterDigital to file a 3G patent infringement complaint against Samsung in March 2007; and one against Nokia in August 2007. At Nokia’s request, the cases were consolidated. From legal filings, it appears Nokia and Samsung are trying the kitchen sink defense. On one hand, they claim they don’t infringe on InterDigital’s patent, then in another argument, claim they are willing to license, but that IDCC hasn’t been willing to license under fair, reasonable, and not discriminatory terms (FRAND). Our legal sources indicate Nokia’s and Samsung’s FRAND argument is an attempt to avoid a potential U.S. import ban if they are found to infringe on InterDigital’s patents. We believe InterDigital is seeking $0.50 to $1.00 per handset from Nokia and Samsung (less than 1% of the selling price of a handset), while Nokia is likely offering much less than that. We estimate Qualcomm’s current average royalty rate to be approximately $8 per handset. It is ironic considering that in a patent infringement litigation Nokia filed against Vitelcom in 2004, Nokia’s expert Erik Stasik noted that, “Bundled royalty rates for GSM essential patents owned by a single patent holder are between 2.5% and 5% assessed on the net sales price of the infringing products.”
•InterDigital’s cash position is a strong $5.07 per share, and could rise significantly by the end of 2008 if it collects its 2G award from Samsung and signs 3G licensing agreements with major mobile phone manufacturers. The firm had $240 million of cash on its balance sheet at the end of 1Q08, and if IDCC collects money owed from Samsung, the firm could have $400 million to $500 million in cash (or almost one-half of its market capitalization), depending on how much of the approximately $50 million remaining (through May 4, 2008) share repurchase authority it uses. We would like to see the firm expand it share repurchase plan by another $50 million to $100 million by the end of the summer.
•InterDigital’s strong cash and patent position could make it a takeout candidate. If the firm finalizes 3G license agreements with industry heavyweights, the agreements could bring in over $1 billion dollars over the next five years - See Exhibits I and II. Add this to InterDigital’s cash position once it collects its 2G award from Samsung, and InterDigital could be attractive to private equity firms (even in today’s markets). If the ITC finds that Samsung and Nokia infringed on InterDigital’s patents, then this, coupled with the UK judge’s ruling about IDCC’s essential patent, could make InterDigital enticing to someone like Qualcomm, which may want to bolster its already strong patent position as it battles Nokia over 3G royalty rates. Perhaps if Qualcomm purchases InterDigital, and the top cell phone manufacturers don’t have to pay InterDigital approximately $1 per phone, the manufacturers might be more inclined to accept QCOM’s standard royalty rate.
•We believe IDCC can sign licensing agreements with two of the remaining top four manufacturers in the next year. A 3G agreement with industry heavyweights Nokia and Samsung could also occur in late 2008 or 1H09. We estimate IDCC’s earnings per share can range from $2.00 to $3.50 when it signs the leading manufacturers. To derive our price target, we are choosing the low end of that range, $2.00 to be conservative. Applying an 18x multiple to that yields $36. We believe our target multiple is reasonable given the 22x multiple for the Nasdaq Composite for 2008 and competitor Qualcomm’s 23x multiple for 2008. Given uncertainty of the timing of 3G licensees with the remaining major manufacturers, we believe it is prudent that IDCC receive a discount in our target multiple valuation. In our view, investors with an above average risk tolerance looking for a pure play investment that leverages the growth of the 3G wireless market should consider InterDigital.
