10-Q: INTERDIGITAL COMMUNICATIONS CORP
(EDGAR Online via COMTEX) -- Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
OVERVIEW
The following discussion should be read in conjunction with the unaudited, condensed consolidated financial statements and notes thereto contained elsewhere in this document, in addition to InterDigital Communications Corporation's (collectively with its subsidiaries referred to as InterDigital, the Company, we, us and our) Annual Report on Form 10-K for the fiscal year ended December 31, 2004 (2004 Form 10-K) as filed with the Securities and Exchange Commission (SEC) on March 31, 2005, other reports filed with the SEC, and the "Statement Pursuant to the Private Securities Reform Act of 1995" below. Please refer to the Glossary of Terms located after the Table of Contents for a list and detailed description of the various technical, industry and other defined terms that are used in this Form 10-Q for the quarter ended March 31, 2005 (Form 10-Q).
General Dynamics
In December 2004, we entered into an agreement with General Dynamics Decision Systems, Inc. (General Dynamics), to serve as a subcontractor on the Mobile User Objective System (MUOS) program for the U.S. military. MUOS is an advanced tactical terrestrial and satellite communications system utilizing 3G commercial cellular technology to provide significantly improved high data rate and assured communications for U.S. warfighters.
The Software License Agreement requires us to deliver to General Dynamics standards-compliant WCDMA modem technology, originating from the technology we developed under our agreement with Infineon Technologies AG, for incorporation into handheld terminals. Under the agreement, we expect to receive $18.5 million for delivery of, and a limited license in, our commercial technology solution for use within the government's MUOS and Joint Tactical Radio System programs. Maintenance and product training are also covered by this amount. The agreement also includes options that are exercisable by General Dynamics at various times through March 2006 for additional deliverables valued at up to $4.0 million. We anticipate that a majority of our MUOS program deliverables and related payments will occur in 2005, excluding the exercise of options for additional deliverables. We will provide maintenance and support to General Dynamics for three years following delivery of the technology. In addition to the deliverables specifically identified in the agreement, we have agreed to provide additional future services as requested by General Dynamics. The contract may be terminated for convenience if the U.S. Government terminates, for convenience, that portion of the MUOS program that includes General Dynamics.
We are accounting for the delivery of and limited license in our commercial technology platform under the Software License Agreement using the percentage-of-completion method. This portion of the agreement is valued at $16.5 million. From the inception of the contract through March 31, 2005, we recognized approximately $4.9 million in revenue, including approximately $4.7 million in first quarter 2005. At March 31, 2005 and December 31, 2004, our accounts receivable included unbilled amounts of approximately $1.7 million and $0.1 million, respectively. At March 31, 2005, our other current assets included approximately $1.2 million of related costs which we deferred in accordance with our application of the percentage-of-completion method.
In first quarter 2005, we completed the first milestones under the agreement and received $1.2 million in related payments.
Subsequent to our delivery of our commercial technology platform, we will provide General Dynamics with support for a period of three years. This portion of the contract is valued at $2 million and revenue related to this portion will be recognized evenly over the period of support.
Acquisition of Patents
In first quarter 2005, we acquired, for a purchase price of approximately $8.0 million, selected patents, intellectual property blocks and related assets from an unrelated third party, the function of which are aimed at improving the range, throughput and reliability of wireless LAN and other wireless technology systems. The purchase price was allocated almost entirely to patent assets with a nominal amount being allocated to other assets, driving a 26% increase in the net book value of our patents at March 31, 2005 as compared to December 31, 2004. Based on our assessment in connection with the asset acquisition these patents will be amortized over their expected useful lives of approximately 15 years.
Stock Repurchase
In October 2004, our Board of Directors authorized the repurchase of one million shares of the Company's common stock (Repurchase Program). In March 2005, the Board of Directors expanded the Repurchase Program by an additional one million shares to a total of two million shares. We began activity under the Repurchase Program early in first quarter 2005 and repurchased a total of 500,000 shares in the quarter at a cost of approximately $9.0 million. We repurchased the remaining 1.5 million shares under the Repurchase Program early in second quarter 2005 at a cost of approximately $25.1 million.
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CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our significant accounting policies are described in Note 1 of the Notes to Consolidated Financial Statements included in our 2004 Form 10-K. A discussion of our critical accounting policies, and the related estimates, are included in Management's Discussion and Analysis of Financial Condition and Results of Operations in our 2004 Form 10-K. There have been no material changes in our existing accounting policies or estimates from the disclosures included in our 2004 Form 10-K.
In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123 (revised 2004), Share-Based Payment. SFAS No. 123(R) requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. The cost will be measured based on the fair value of the instruments issued. SFAS No. 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. SFAS No. 123(R) replaces SFAS No. 123 and supersedes APB Opinion No. 25. As originally issued in 1995, SFAS No. 123 established as preferable the fair-value-based method of accounting for share-based payment transactions with employees. However, that Statement permitted entities the option of continuing to apply the guidance in APB Opinion No. 25, as long as the footnotes to financial statements disclosed what net income would have been had the preferable fair-value-based method been used. In April 2005, the SEC delayed the effective date of SFAS 123(R) for public companies to annual periods beginning after June 15, 2005. We plan to adopt SFAS 123(R) on January 1, 2006 using the modified-prospective method. We are currently evaluating the effect SFAS No. 123(R) will have on our results.
FINANCIAL POSITION, LIQUIDITY AND CAPITAL REQUIREMENTS
We generated positive cash flow from operating activities of $16.7 million in first quarter 2005 compared to $16.1 million in first quarter 2004. The positive operating cash flow in first quarter 2005 arose principally from receipts of approximately $48.0 million from patent licensing agreements. This included approximately $27.9 million from Sony Ericsson, the majority of which represents a new prepayment under our 2003 patent license agreement, $9.5 million from Sharp Corporation (Sharp) related to our 2G and 3G patent license agreements, $8.1 million from NEC Corporation of Japan (NEC) associated with our 3G patent license agreement and approximately $2.5 million from other licensees related to their respective patent license agreements. These receipts were partially offset by cash operating expenses (operating expenses less depreciation of fixed assets, amortization of intangible assets and non-cash compensation) of $30.9 million and changes in working capital during first quarter 2005. The positive operating cash flow in first quarter 2004 arose principally from net receipts of approximately $42.7 million from patent licensing agreements. This included approximately $13.0 million from Ericsson and approximately $11.6 million from Sony Ericsson under their respective 2003 patent license agreements, $10.0 million from Sharp related to our 3G patent license agreement, $4.6 million from NEC associated with our 3G patent license agreement, and $3.5 million from other licensees related to their respective patent license agreements. These receipts were partially offset by cash operating expenses of $21.8 million (operating expenses less depreciation of fixed assets, amortization of intangible assets and non-cash compensation) and changes in working capital during first quarter 2004.
Net cash used for investing activities in first quarter 2005 was $10.6 million compared to $17.6 million in first quarter 2004. Our net sales of short-term marketable securities in first quarter 2005 were $3.3 million compared to net purchases of $14.5 million in first quarter 2004. This change resulted from cash requirements of approximately $9.0 million and $8.0 million, respectively, in first quarter 2005 to finance both our Repurchase Program and an acquisition of patents from a third party. Our investment in hardware and software of $2.1 million during first quarter 2005 represents an increase of approximately $1.5 million compared to first quarter 2004 and consists of investments necessary to support our engineering information systems network. Our pace of investment associated with patent filings increased $1.3 million to $3.8 million in first quarter 2005 compared to first quarter 2004, reflecting continuation of the growth in our development of intellectual property that we have experienced in recent years. As discussed in the overview above, we also invested approximately $8.0 million to acquire patents and intellectual property that compliment our current development initiatives.
A use of approximately $9.0 million related to our Repurchase Program drove our $7.8 million use of cash by financing activities for first quarter 2005. In first quarter 2004, our financing activities generated cash of approximately $6.4 million, primarily from proceeds resulting from stock option exercises and employee stock purchase plan activity.
As of March 31, 2005, we had $126.5 million of cash, cash equivalents and short-term investments, compared to $131.8 million as of December 31, 2004. Our working capital, adjusted to exclude cash, cash equivalents, short-term investments, current deferred tax assets, current maturities of debt and current deferred revenue, decreased to $(2.5) million at March 31, 2005 from $(1.9) million at December 31, 2004.
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As noted above, in early second quarter 2005, we repurchased the remaining 1.5 million shares authorized under our Repurchase Program at a cost of approximately $25.1 million. In addition, we received a new royalty prepayment of approximately $5.5 million from a current licensee. We are capable of supporting our operating requirements for the near future, through cash and short-term investments on hand, as well as other internally generated funds, primarily from 2G and 3G patent licensing royalties. We do not expect that any resolution of our dispute with Federal Insurance Company (See, "Item 1. Legal Proceedings-Federal") will prevent us from supporting our operating requirements for the near future. Although we do not, at present, anticipate any need for additional financing through either bank facilities or the sale of debt or equity securities, we may seek to establish a bank facility to provide us with additional flexibility in managing our business.
As of December 31, 2004, we had federal net operating loss (NOL) credit carryforwards of approximately $110 million. Our obligation to pay foreign source withholding taxes to Japan on the collection of Japanese sourced royalties ceased effective July 1, 2004. We will continue to pay local and state income taxes, and alternative minimum taxes (AMT) when applicable. We do not expect to pay federal income tax (other than AMT) until these federal NOL credit carryforwards are fully utilized.
RESULTS OF OPERATIONS
First Quarter 2005 Compared to First Quarter 2004
Revenues
Revenues of $35.5 million for first quarter 2005 increased $2.5 million or 8% over first quarter 2004 revenues of $33.0 million. This increase was primarily due to the recognition of $4.7 million of revenue from our software license agreement with General Dynamics which was offset, in part, by a $1.6 million decrease in recurring patent license royalty revenue.
Recurring patent license royalty revenue in first quarter 2005 of $30.8 million decreased 5% from first quarter 2004. The decrease in recurring patent license royalty revenue was primarily driven by a $5.1 million decrease in royalties from NEC as the level of NEC's first quarter 2004 royalties were affected positively by 3G handset shipments that were delayed from calendar fourth quarter 2003 to calendar first quarter 2004 upon NEC's resolution of software and interoperability issues (Note: Until third quarter 2004, we recognized per-unit royalty revenue in the period in which our licencees' underlying sales occurred. Currently, we recognize such revenue in the period in which we receive the related royalty reports from our licensees). First quarter 2005 recurring patent license royalty revenues from Sharp and Sony Ericsson increased by $2.3 million and $0.1 million, respectively, from first quarter 2004. NEC (32%), Sharp (27%) and Sony Ericsson (12%) collectively contributed 71% of our total revenue in first quarter 2005.
We did not record any royalty revenue in first quarter 2005 associated with a licensee that did not submit its royalty report covering fourth quarter 2004 sales until early second quarter 2005. As a result, in second quarter 2005 we will recognize approximately $1.1 million of royalty revenue associated with this licensee's fourth quarter 2004 sales, in addition to any amounts this licensee reports during the balance of second quarter 2005 associated with its first quarter 2005 sales.
Operating Expenses
Operating expenses increased 46% to $36.3 million in first quarter 2005 from $24.9 million in first quarter 2004. The key drivers of this increase were legal fees associated with outstanding arbitrations and litigations, and personnel costs related to a long-term compensation program. First quarter 2005 legal fees increased approximately $5.5 million over first quarter 2004. In second quarter 2004, we introduced new compensation initiatives that substantially replaced our previous widespread use of stock options as an incentive tool. These initiatives include a cash incentive award tied to long-term company performance and restricted stock units. We recognized approximately $3.9 million of expense in first quarter 2005 related to these initiatives. 2005 represents both the final year of the initial measurement period (April 2004 through December 2005) and the first year of a new three year measurement period (January 2005 through December 2007) under this long-term compensation program. As a result of this overlap, the rate of expense we are experiencing related to these initiatives in 2005 is greater than the rate incurred in the last three quarters of 2004 and the rate we expect to incur in 2006.
Development expenses in first quarter 2005 increased 25% to $16.2 million from $12.9 million in first quarter 2004. This increase was due primarily to a $2.2 million increase in personnel costs and a $1.0 million increase in outsourced services and operations expense. Our increased levels of expense related to outsourced services and operations resulting from work associated with our HSDPA platform development.
Sales and marketing expenses of $2.3 million in first quarter 2005 increased 41% from first quarter 2004 as a result of higher personnel costs of $0.5 million and trade show costs.
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General and administrative expenses in first quarter 2005 increased 22% to $6.6 million from $5.4 million in first quarter 2004, primarily driven by an increase of approximately $0.8 million in personnel costs.
Patents administration and licensing expenses of approximately $11.2 million in first quarter 2005 represent a 125% increase over first quarter 2004 expense levels of approximately $5.0 million. Our patent enforcement costs increased approximately $5.1 million as a result of our respective arbitrations and litigations with Nokia, Samsung and Lucent. Increases in personnel contributed another $0.5 million to the overall increase.
Interest and Net Investment Income and Interest Expense
Interest and net investment income of $0.8 million in first quarter 2005 increased $0.4 million compared to $0.4 million in first quarter 2004 due to higher rates of return on our investments in 2005.
Income Taxes
Our income tax provision decreased from $2.7 million in first quarter 2004 to $0.9 million in first quarter 2005. The income tax provision for both periods consisted primarily of withholding taxes associated with patent licensing royalties from Japan. The decrease in our foreign source withholding tax expense in first quarter 2005 compared to first quarter 2004 resulted from a July 2004 tax treaty between the U.S. and Japan that eliminated the foreign source withholding tax requirements between those countries, provided certain conditions are met.
Expected Trends
We expect to provide updated guidance on second quarter 2005 revenue after we receive and review the majority of our per-unit royalty reports. Based on a preliminary report received from NEC, we anticipate that royalties from NEC will improve 15% to 18% over first quarter 2005 levels. In addition, we expect to benefit from the recognition of approximately $1.1 million of royalties from a licensee that submitted a royalty report after the most recent quarter-end covering fourth quarter 2004 sales. We currently estimate that revenue associated with the work for General Dynamics may exceed that of first quarter 2005 as activity levels remain high. Subject to the level of expenses associated with current arbitrations and litigations, we expect second quarter ongoing operating expense levels to be similar to first quarter 2005. We also project that our book tax rate for second quarter will approximate 34% to 38%, plus an amount for deferred foreign source withholding tax expense, which is, in part, dependent on the level of per-unit royalties.
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STATEMENT PURSUANT TO THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
This Quarterly Report on Form 10-Q (Form 10-Q), including "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 2, contains forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, reflecting, among other things, the Company's beliefs, plans and expectations as to: (i) the timing of deliverables and associated revenue under our contract with General Dynamics and any related additional services; (ii) the effect of our January 1, 2006 adoption of SFAS 123(R) on our financial results; (iii) the impact of any resolution of our dispute with Federal on our ability to meet our near term operating requirements; (iv) our lack of need to seek additional financing; (v) our future federal income tax obligations, our estimated book tax rate and foreign source withholding tax expense for second quarter 2005, and our expected utilization of our federal NOL credit carryforwards; (vi) the rate at which we expect to incur expense associated with our long-term compensation program into 2006; (vii) our plan to update our guidance for second quarter 2005 revenues, and anticipated revenue in second quarter 2005, including royalty revenues from NEC; (viii) our projected second quarter over first quarter 2005 operating expense levels; (ix) the relevance of issues of patent invalidity or infringement on the arbitrable royalty dispute in the Nokia Arbitration and the anticipated timing of the ICC's decision; and (x) our second quarter 2005 revenue. Words such as "expect," "anticipate," "may," "will," "plan," "future," "could," "seek," "project," "potential," "continue to," "believe," "intend," or similar expressions are intended to identify such forward-looking statements.
Although forward-looking statements in this Form 10-Q reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by the Company. Consequently, forward-looking statements are subject to risks and uncertainties. We caution readers that actual results and outcomes could differ materially from those expressed in or anticipated by such forward-looking statements. You should not place undue reliance on these forward-looking statements, which are only as of the date of this Form 10-Q. In addition to the associated risks and uncertainties identified in this Form 10-Q as well as other information contained herein, each of the following factors should be considered in evaluating our business and prospects.
The timing of deliverables and associated payments under our contract with General Dynamics and any related additional services may be impacted by: (i) our ability to satisfactorily meet milestones; (ii) changes in delivery schedules; or (iii) an exercise of termination by convenience on the part of the U.S. Government.
The effect of our January 1, 2006 adoption of SFAS 123(R) on our financial results may significantly increase our compensation costs relating to share-based payment transactions depending on: (i) the valuation method used; and (ii) the amount of outstanding share-based compensation arrangements the Company has at such time.
Our ability to support our operating requirements in the near future, our expectations that second quarter 2005 operating expenses will be consistent with first quarter 2005 levels, and our belief that any resolution of our dispute with Federal would not affect our operating requirements for the near future may be affected by the factors listed herein, as well as our cash flow and our recurring royalties which are dependent on: (i) the market share and performance of our primary licensees in realizing our projections for sales of covered products; (ii) the economy and sales trends in the wireless market; (iii) our ability to expand our customer, partner and licensing relationships; (iv) whether new licensees or existing licensees make past payments for royalties due or pre-payments against future royalties; (v) our ability to successfully prosecute, enforce and protect our patents and other intellectual property rights; (vi) unanticipated changes in the schedule or costs associated with the Nokia and Samsung arbitrations and Lucent litigation; and (vii) expenses associated with our long-term compensation program. Further, our failure to generate sufficient cash flows over the long-term, based on the factors listed herein and those set forth in our 2004 Form 10-K, could adversely impact operating requirements and our current lack of need to seek additional financing.
Our expected utilization of our federal NOL credit carryforwards are dependent on: (i) changes in the market share and the performance of our primary licensees in selling their products; (ii) the market acceptance of our technology products; (iii) our ability to effectively manage costs; (iv) the costs and outcome of ongoing litigation/arbitration; (v) our ability to identify and effectively implement effective tax planning strategies; (vi) changes to existing federal tax regulations; and (vii) our ability to enter into new or expand existing patent license agreements. Our future federal income tax obligations, our estimated book tax rate and our foreign source withholding tax expense for second quarter 2005 may be affected by: (i) changes in federal and/or state tax regulations; (ii) changes to international tax treaties and federal tax regulations; (iii) the amount of per-unit royalties paid by new and existing licensees; (iv) the cost of litigation; and (v) our level of continued self-funding in technology development activities.
The rate at which we expect to incur expense associated with our long-term compensation program in 2006 may be impacted by significant changes in personnel eligible to participate in the program or changes in the terms of the program.
Our plan to update guidance as to second quarter 2005 revenues is dependent upon our timely receipt of a majority of our licensees' per-unit royalty reports during second quarter 2005. Anticipated increased royalty revenue from NEC in second quarter over first quarter 2005 may be effected by the accuracy of preliminary reports received by NEC and NEC's continued ability to realize projected sales for covered products.
Our expected second quarter 2005 revenues may be impacted by: (i) a delay in the receipt of quarterly royalty reports from our licensees; (ii) our ability to record the receipt of $1.1 million in royalty revenue from a licensee reporting fourth quarter 2004 sales; and (iii) the potential additions of new patent license agreements or other revenue streams.
The relevance of issues of patent validity or infringement to the arbitrable royalty dispute in the Nokia Arbitration may be affected by the Nokia Tribunal's: (i) interpretation of the applicability of the Ericsson and Sony Ericsson patent license agreements on the royalty obligations of Nokia; (ii) a finding in favor of such claims; or (iii) any future legal proceedings concerning the same patents and claims. The anticipated timing of the ICC's decision could be impacted by unanticipated delays or changes in the meeting schedule of the ICC.
Factors affecting one forward-looking statement may affect other forward-looking statements. We undertake no duty to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise.
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(c) 1995-2005 Cybernet Data Systems, Inc. All Rights Reserved
Received by Edgar Online May 09, 2005
CIK Code: 0000354913Accession Number: 0001193125-05-100546
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