Price Target $30-$36 Insider / Institutional Ownership 2%/60%
Company Description: InterDigital designs and develops technology content and systems
solutions for advanced digital wireless communications applications. The company licenses 2G
and 3G technology to wireless communications firms. Please see p. 8 for a Wireless Glossary.
• InterDigital delivered solid 3Q08 results. Revenue of $55.1 million and GAAP EPS of $0.20
compared to $56.5 million and EPS of $0.18 in 3Q07. InterDigital benefitted from a $2.7 million
offset to legal expenses in the quarter from a resolution to a 3G dispute in the United Kingdom with
Nokia (Nokia had filed suit against IDCC). Recurring patent license revenue was $51.6 million,
product revenue was $2.2 million (up from $0.8 million last year), and audits of licensees for past
underreporting of payments brought in $1.3 million. LG at 27% of revenue, Sharp at 16%, and NEC
at 13% were 10% or more customers. We believe Research in Motion and HTC were 5% or more
customers.
• Management also announced it is exploring options for its SlimChip modem and data card
business. Over the past few months, leading semiconductor manufacturers have announced
competing products, making it an uphill battle for InterDigital where scale is a necessity for profits.
We are in favor of a divestiture, as the business has required $25 million to $30 million of yearly
development expense, and has had only a limited revenue contribution.
• CEO Bill Merritt indicated high level discussions are ongoing between InterDigital and
Samsung regarding a 3G settlement. We believe this is par for the course, with a significant legal
ruling due over the next month. With Samsung also owing InterDigital approximately $180 million
for 2G sales, the parties appear to have trade offs at the negotiating table in order to achieve a deal.
• The International Trade Commission (ITC) is scheduled to rule on November 25, 2008 in
InterDigital’s patent infringement case against Samsung. Judge Paul Luckern will rule, absent
a settlement, whether Samsung infringes on five of InterDigital’s 3G patents. The five patents
encompass sixteen claims. Samsung has raised multiple defenses in the case including: 1)
InterDigital’s patents are invalid, 2) Samsung doesn’t infringe on the patents, and 3) Even if the
patents are valid, and Samsung infringes, Samsung has an implied license through InterDigital’s
declaration of the patents as essential through the European Telecommunications Standards Institute
(ETSI), and InterDigital has to offer the patents at fair, reasonable, and nondiscriminatory terms
(FRAND). We believe the latter defense is a case of Samsung throwing a claim against a wall and seeing what sticks, but the staff attorney in the case appears to side with Samsung on argument #3
However, we believe Judge Luckern’s decision will come down to validity and infringement. Why
get excited about InterDigital? If it wins, and signs Samsung and Nokia to a modest 3G royalty rate
of $0.50 per phone, we believe the firm’s earnings power could be $2.00 to $3.50 in 2009. See
Exhibits I and II for our calculations.
• Slowing worldwide mobile phone shipments and shrinking margins may lengthen negotiations
between InterDigital and the four main unlicensed manufacturers, Nokia, Samsung, Motorola,
and Sony Ericsson. Samsung and Nokia could be prodded by 3G infringement cases at the ITC, but
the leading mobile phone manufacturers are not rushing to take a 3G license with InterDigital as it
would impact already declining margins. Samsung and Nokia have been able to prolong court cases
and arbitration for years with appeal after appeal. Nokia and Samsung may be attempting to stall to
get InterDigital to accept pennies on the dollar, but IDCC’s $188 million war chest ($4.10/ share)
gives it flexibility to negotiate a favorable agreement.
• Absent a settlement, the ruling on November 25, 2008 looks like a bimodal outcome – either
really good for InterDigital or really bad. We believe these are the two most likely scenarios: 1)
Judge Luckern rules that Samsung infringes on InterDigital’s patents, and as a remedy, orders an
import ban on Samsung’s infringing 3G handsets into the U.S. or 2) Judge Luckern rules that either
InterDigital’s five patents are invalid, or that Samsung does not infringe on InterDigital’s patents.
Under scenario 1, we believe Samsung would likely sign a 3G license with InterDigital in the $0.50 to
$0.75 per phone area. This rate translates into approximately $300 million to $400 million for
InterDigital over the next five years. Scenario 2, however, is very pessimistic for InterDigital as
investors could question the worth of its patents, and in a worst-case scenario, existing licenses could
clamor for a discount in license renewal discussions. Under Scenario 2, we believe the share price
could fall to the $8-$12 range if InterDigital’s 3G patent portfolio becomes suspect. We believe this
is an extreme view, as the ITC case only entails five of InterDigital’s over 1,000 3G patents (not
including thousands of worldwide patent applications). However, if InterDigital can’t select five
patents that are valid, and infringed by Samsung, our view is that management will have a credibility
problem.
• If Judge Luckern rules in favor of InterDigital, but does not order a 3G handset ban on
Samsung, then InterDigital and Samsung likely restart their Delaware litigation. This outcome
has only a small probability, in our view, but we list it as a possibility as it preserves the status quo
(litigation) for the next twelve months.
• Samsung continues to appeal InterDigital’s attempt to collect its $180 million to $200 million 2G
arbitration award from September 2006. InterDigital and Samsung went to arbitration over a 2G
royalty dispute, and an arbitration panel unanimously ruled in InterDigital’s favor in September 2006
for $134 million, covering Samsung’s 2002-2006 sales. Arbitration is supposed to be binding, but
Samsung requested a second arbitration panel, which ruled in InterDigital’s favor. The panel ruled
that Samsung owes InterDigital $153 million (includes interest) for 2002-2005, and the panel may
rule on the 2006 amount in the coming months. We believe Samsung owes IDCC $180 million to
$200 million for 2002-2006 handset royalties. Although the award is outstanding, it could provide a
bargaining chip in 3G licensing discussions. Absent a resolution as part of a combined 2G/3G
settlement, Samsung could prolong IDCC collecting its 2G award until late 1Q09 or early 2Q09
through appeals in the United States courts.
• We believe InterDigital’s 3G patent infringement case against Samsung recently had final
arguments. Judge Luckern of the ITC completed an evidentiary hearing in mid-July, and has been
reviewing claims construction and post-hearing briefs. Judge Luckern is scheduled to rule November
25, 2008 whether Samsung infringes on IDCC’s five patents in the case. If he finds a violation, he
can also recommend remedies, one of which could be an import ban into the United States for
Samsung’s 3G phones that infringe on InterDigital’s patents. It appears that the staff attorney in the
case is siding with Samsung on some of the issues and InterDigital on others, but recommending against an import ban. The staff attorney’s opinion has merit, but Judge Luckern is a patent judge
with over 45 years experience as a patent examiner, patent lawyer and patent judge. With his wealth
of knowledge, we are confident Judge Luckern will rely heavily on his own experience (the staff
attorney was appointed to his position in early 2008) in formulating an opinion. Judge Luckern has a
technical background - beginning his work career as a chemist at Eastman Kodak, and also having
worked on Nokia/Qualcomm ITC cases - and is well qualified to decide the core patent validity and
patent infringement issues in the case.
• The ITC scheduled an evidentiary hearing for May 26-29, 2009, in InterDigital’s 3G patent
infringement complaint against Nokia. The case was put on hold in late March 2008 after Judge
Batts’ ruling that allowed Nokia to go to arbitration and injunct the ITC process. Judge Batts’ ruling
was overturned by the Second Circuit Court of Appeals in late July 2008, enabling the process at the
ITC to be restarted. When InterDigital filed the patent infringement complaint in August 2007, there
were four patents at issue. We expect a ruling by the presiding ITC judge in late 2009 or early 2010.
• Nokia and Qualcomm’s 3G and 4G settlement could provide a framework for InterDigital and
Nokia/Samsung to agree upon a 3G royalty rate. There are many confidential terms in the
Nokia/Qualcomm settlement, but it appears that the blended 3G royalty rate that Nokia is paying
Qualcomm is approximately 2%, or a little over $4 per phone at today’s average selling price per 3G
handset. We believe InterDigital is asking Nokia for $0.50 to $0.75 per phone, and Samsung for
$0.75 to $1.00 per phone. Although a modest rate, it would mean hundreds of millions of dollars of
royalty revenue to InterDigital over a five-year period, which is a common length of InterDigital
licenses. The licenses then renew for another five years, and so on. Please see Exhibits I and II for
the impact licensing agreements with Nokia, Samsung, and Sony Ericsson on IDCC’s financials.
• InterDigital will benefit from Apple’s 3G iPhone and Google’s new G1 phone. Apple is licensed
for 2G and 3G, although financial terms are not public. Additionally, InterDigital may receive a
royalty from its technology and licensing relationship with Infineon, a chip provider to Apple.
According to InterDigital’s management, it receives a royalty every time Infineon sells a 3G chip.
We estimate the royalty at $0.25 to $0.40 per chip. An important point to remember is that
InterDigital recognizes licensing revenue (whether handset or chip) with a one quarter lag, so
InterDigital would likely only recognize a nominal amount of revenue from Apple’s 3G shipments in
InterDigital’s 3Q08. The larger revenue contribution will be in 4Q08. Google’s G1 phone is
manufactured by High Tech Computer Corporation (HTC), an InterDigital licensee. Our
understanding is that InterDigital receives a royalty every time HTC manufactures a phone. We
expect Google’s handset shipments to significantly increase over the next two years.
• It is time 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 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. From legal filings, it appears Nokia and Samsung are trying the kitchen sink defense.
On one hand, they claim the patents are invalid. In the next argument, they claim even if the patents
are valid, that they don’t infringe on InterDigital’s patents. And finally, they claim they are willing to
license, but that IDCC hasn’t been willing to license under fair, reasonable, and not discriminatory
terms. 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). Once InterDigital finalized licensing deals with the majors,
an added bonus is that a large percentage of its legal fees will disappear – we estimate this would add
$0.50 or more to earnings.
• InterDigital’s cash position is a strong $4.10 per share, and could rise significantly over the next
six months if it collects its 2G award from Samsung and signs 3G licensing agreements with
major mobile phone manufacturers. The firm had $188 million of cash on its balance sheet at the end of 3Q08, and if IDCC collects its money owed from Samsung, the firm could have over $400
million in cash (or 40% of its market capitalization). InterDigital has repurchased 8.1 million shares
using its $100 million buyback plan launched in 4Q07. Although the firm could expand its share
repurchase plan once it collects its 2G monies owed from Samsung and/or finalizes 3G agreements
with Nokia and Samsung, we believe it is more likely the firm either starts a modest dividend in the
future, or uses its war chest for technology and patent acquisitions.
• We reiterate our Neutral rating. We are positive on InterDigital’s ability to sign 3G licensing
agreements with Samsung and Nokia, only uncertain as to the timing given Nokia and Samsung’s
willingness to use any and all legal means to stall over the past five years. 3G agreements with
industry heavyweights Nokia and Samsung could add hundreds of millions of dollars of licensing
revenue to InterDigital over a five year period, and lead us to project InterDigital’s earnings power at
$2.00 to $3.50 per share once it signs the leading manufacturers. We believe a reasonable price target
is 15x-18x the low end of the earnings, or $30-$36 per share. The target multiple may appear high
given that the forward multiple for the NASDAQ Composite is 13x, but a normalized NASDAQ
multiple is 15x-20x. Why don’t we have a Buy rating on the shares if our price target is $30-$36?
We don’t believe a traditional Buy rating is warranted for investors given what we believe is an
“either/or” outcome. However, for investors where options are suitable, we highlight several
strategies where one might profit from what we believe will be extreme volatility in the share price
once the ITC rules on November 25, 2009.
INVESTMENT THESIS
InterDigital is one of the leading wireless patent firms with approximately 3,000 2G and 3G patents, and
thousands of 3G and 4G patent applications worldwide. The firm has licensing agreements with
manufacturers such as LG Electronics, Apple, Research in Motion, Sharp, NEC, and Panasonic. It also
has a licensing and product relationship with chipset manufacturer, Infineon. One of the reasons to get
excited about InterDigital is that if/when it resolves its 3G royalty issues with Nokia and Samsung, we
estimate the firm’s earnings power, even at a modest $0.50 per phone for 3G products, could be $2.00 to
$3.50 per share in 2009. As 3G shipments increase their percentage of worldwide handset shipments in
the coming years, InterDigital’s earnings power at $0.50 per phone could rise to $5.00 per share, in our
view.
As industry-wide litigation has increased the past few years (see Nokia/Qualcomm, Sony
Ericsson/Samsung, and Qualcomm/Broadcom), it has become more challenging for InterDigital to secure
licensing agreements with top manufacturers. The firm signed a combined 2G/3G agreement with LG
Electronics in January 2006, a 2G/3G agreement with Apple in September 2007, and upgraded Research
in Motion to a 3G license in October 2007. However, securing 3G agreements with industry
heavyweights Nokia, Samsung, Sony Ericsson has proved daunting. InterDigital alleges that it: 1) Has
essential patents in 3G, 2) Has declared as such with ETSI, and 3) Believes these patents are incorporated
into the (International Telecommunications Union (ITU) 3G standards. Therefore, according to
InterDigital, all mobile phone manufacturers and data card manufactures that build 3G phones need a
license with InterDigital.
After Nokia and Samsung dragged their heels on 3G licensing negotiation, InterDigital filed 3G patent
infringement complaints at the International Trade Commission. If Nokia and Samsung are found to
infringe on InterDigital’s patents, one of the remedies the ITC can order is a ban on entry into the U.S. on
infringing phones. The key for InterDigital is to obtain an infringement ruling and ban on Nokia and
Samsung’s 3G handsets into the U.S. A ban would make Samsung and Nokia more willing to sign a 3G
licensing agreement with InterDigital, in our view. We estimate Samsung will ship approximately 25
million to 30 million 3G handsets (includes CDMA 2000) into the U.S. in 2008, and Nokia five million to
eight million. The number of 3G handsets each company ships should increase significantly in 2009 and
2010. While Nokia’s numbers are small given the firm’s worldwide totals, increasing its U.S. presence is a cornerstone of Nokia’s strategy. The firm knows it has fallen significantly behind Apple and Research
in Motion in the U.S., and needs to catch up in the important U.S. corporate market.
See Exhibit I and II for our estimates of InterDigital’s potential revenue and EPS if it signs licensing
agreements with the remaining top manufacturers. Note that if the firm signs 3G agreements with Nokia
and Samsung, it receives an added bonus – a large percentage of its litigation expense will disappear, and
add $0.50 or more to earnings, by our estimates.
WAYS TO INVEST/TRADE ON NOVEMBER 25, 2008 RULING
If there is a ruling on November 25, 2008, it could produce a large swing in InterDigital’s share price.
We estimate there is a 60%-70% chance Judge Luckern will rule that at least one of InterDigital’s patents
are valid and that Samsung infringes upon the patent. If an import ban on Samsung’s infringing 3G
handsets is also part of the ruling, Samsung will likely ink a 3G license with InterDigital given Samsung’s
large number of U.S. phone shipments. This could mean $300 million to $400 of million of revenue for
InterDigital (assuming a modest $0.50 to $0.75 royalty rate) over the next five years, and send
InterDigital’s share price $5-$10 higher, in our view.
An adverse ruling by Judge Luckern means that: 1) The patents are not valid, or 2) Samsung’s handsets
do not infringe on the patents, or 3) There is an implied license or FRAND argument that InterDigital is
not meeting. This could make investors question the value of InterDigital’s patents. In our view, this
could send InterDigital’s share price down to the $8-$12 range. The lower end of that range represents
InterDigital’s current cash balance plus the Samsung 2G award (not yet collected).
Here are our thoughts on handicapping the November 25, 2008 ruling:
�� 60%-70% chance Judge Luckern rules that at least one of InterDigital’s patents are valid, and that
Samsung infringes. A 3G import ban on Samsung’s infringing handsets is part of the ruling.
�� 25%-30% chance Judge Luckern rules that the patents are not valid, Samsung does not infringe,
or believes the implied license/FRAND argument, and lets Samsung off the hook at the ITC.
�� 5%-10% chance that Judge Luckern tells the companies to resolve the royalty rate in a Delaware
court.
The dispersion in expected outcomes and potential volatility creates opportunity, in our view. Many of
these cases tend to settle at the last minute, almost on the proverbial “courthouse steps.” See the
Ericsson/Qualcomm case from 1999 and the recent Qualcomm/Nokia agreement. Below are some of the
ways we believe investors could attempt to profit from the ruling on November 25, 2008, which could
cause a $5-$10 price swing in InterDigital’s share price following the ruling:
1. Sometime between now and mid-November, an investor could buy a December straddle (buy a
call option and buy a put), attempting to profit on a potentially big swing in InterDigital’s share
price. With this strategy, it doesn’t matter which side prevails in the ruling or which way the
share price moves, only that the share price makes a significant move.
2. Purchase a December call option. This could be preferable compared to owning the shares
outright, as the most at risk is the call option premium.
3. Buy shares outright between now and mid-November, and hold the shares until November 23rd
or 24th. An investor would hope for a settlement before November 25th. This is a risky purchase
given: 1) Downside potential and 2) The fact that Samsung (along with Nokia) has always
attempted to prolong discussions rather than settle them.
We note that our rating on InterDigital is Neutral. Option trading my not be appropriate for all
investors, and investors must meet certain requirements before trading options.
Exhibit I: Nokia, Samsung, and Sony Ericsson Estimated Sales and Royalties to IDCC
AI
