InterDigital Inc

NASDAQ:IDCC

Earnings Call Transcript 2018-Q1

[Operator]

Good day and welcome to the InterDigital's First Quarter 2018 Earnings Call. Today's conference is being recorded.

At this time, I will like to turn the conference over to Patrick Van de Wille. Please go ahead.

[Patrick Van de Wille, CCO]

Thanks very much, Alicia. Good morning, everyone and welcome to InterDigital's first quarter 2018 earnings conference call. With me this morning are Bill Merritt, our President and CEO and Rich Brezski, our CFO. Consistent with last quarter's call, we will offer some insights about the quarter and the company and then open the call up for questions.

Before we begin our remarks, I need to remind you that in this call, we will make forward-looking statements regarding our current beliefs, plans and expectations, which are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results and events to differ materially from results and events contemplated by such forward-looking statements.

These risks and uncertainties include those set forth in our earnings release and quarterly report on Form 10-Q, published this morning as well as those details in our Annual Report on Form 10-K for the year ended December 31, 2017 and from time-to-time and our other filings with the Securities and Exchange Commission. These forward-looking statements are made only as of the date hereof and except as required by law, we undertake no obligation to update or revise any of them whether as a result of new information, future events or otherwise.

In addition, today's presentation may contain references to non-GAAP financial measures, such as free cash flow, pro forma operating expenses and non-GAAP net income. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our first quarter 2018 financial metrics tracker, which can be accessed on our homepage, www.interdigital.com, by clicking on the link on the left side of the homepage that says, Financial Metrics Tracker for Q1, 2018.

With that taken care of, I'll turn the call over to Bill.

[Bill Merritt, President and CEO]

Good morning everyone. Thank you for joining us on the call today. As you saw in the press release this morning, the company delivered another very strong quarter both financially and strategically. Rich will go into the numbers in more details in his remarks including providing some added color around the impact of the new accounting standards and tax law. I want to do a quick review of the first quarter from a revenue and cost perspective before touching on the Technicolor transaction and then interesting events going on with respect to China.

The first quarter revenue for the company was just over $87 million which reflects the impact of the new accounting standard ASC 606. Under the prior accounting standards first quarter revenue would have been $105 million. The overall level of revenue was solid and also included a variety of new contributions including new release of LG and Kyocera and a contribution by the Signal Trust which are licensed to get large InterDigital patent portfolio related to cellular infrastructure.

The expense side was also very encouraging with a 5% year-over-year reduction in operating expenses. As I will talk about it a bit later after a transition period our goal with the Technicolor transaction is to maintain our cost of 2017 levels allowing the added revenue from the transaction to easily and directly drive profit. In the first quarter we began to take the steps internally to reduce our cost essentially making room for the Technicolor assets. We continue to carefully manage our patent portfolio, we've reduced our headcount modestly and we sold our [indiscernible] commercial initiative. We will have some additional work to do, but we are well on the path to delivering on the goal of maintaining our expenses flat notwithstanding the acquisition.

Moving on to the Technicolor transaction itself, let me first remind everyone of our growth strategy which is pretty simple. Focus on growing the value of our core terminal unit licensing business. To do that, we need to continue to develop critical wireless technologies which we are doing very well, but also develop and acquire deep new competencies in other pervasive technologies that are also critical to our handset customers.

Lastly, we need to do all of this while respecting our cost structure and operating leverage. The Technicolor deal is a long drive down the fairway of that strategy, the acquisition brings together leading patent licensing businesses in the increasingly complementary areas of mobile technology and video technology creating a R&D-based intellectual property and licensing leader. Both companies have a long history of driving innovation through R&D. Technicolor is recognized as a world leader in the area of video and has developed important technologies across the media and entertainment industries.

Technicolor's current portfolio includes more than 21,000 patents and applications across a broad range of technologies including over 2,500 worldwide video coding patents and applications. The patents we acquire will greatly complement InterDigital's large portfolio of patent assets that cover wireless, video and other technologies. The combined research backed patent portfolio represents one of the strongest most diverse in the technology industry.

The benefit of this broader portfolio will drive significant shareholder value. The added video portfolio will immediately contribute to InterDigital's core handset licensing program. The benefits of which we keep entirely. The acquisition also opens up InterDigital to an entirely new consumer electronic device market such as set-top-boxes and streaming devices. The revenue from that portion net of estimated operating expense will be shared with Technicolor but with InterDigital getting the majority stake. All this will be backed by long term research like our wireless business today.

As part of the agreement, Technicolor's research and innovation unit and InterDigital Lab will cooperate in R&D in the areas of next generation video codec and other key video technologies with InterDigital owning 100% of the resulting patents. InterDigital itself is [indiscernible] in video technologies almost a decade with a particular focus on ATVC standards, 360 degree video and other key video technologies. This R&D collaboration between the two companies will bring here the efforts of hundreds of engineers in locations spanning the globe. For InterDigital customers, the expanded technology footprint and research capabilities means greater value and a broader range of technologies that can form the basis of partnership, collaboration and a deeper more productive relationship.

Lastly Technicolor's global team of licensing professionals, patent managers and support staff will join InterDigital and work with InterDigital's existing team to license the expanded portfolio and to develop opportunities to build new business with existing licensing clients. We're extraordinarily excited about this opportunity and are hard at work to close the deal with a current targeted close in mid-2018. Over the next two months, we plan to develop metrics to allow you to assess how the integration is proceeding and the value we see in the transaction.

As things stand, based upon a careful analysis of historical licensing rates and video and the strength of the portfolio. We think that the Technicolor video coding assets could eventually add roughly 10% to the revenue base of our core terminal unit licensing business. And again, that's separate from the additional revenue in the consumer electronics space.

Using 2017 recurring revenue as a basis, that 10% increase combined with our new lower tax rate would result in a roughly 50% increase in profitability. We're planning an Investor Day for the third quarter 2018 where we will talk not only about that opportunity but also update you on the consumer electronics opportunity as well as our IoT initiatives. But at first view, the anticipated impact of this transaction on our core business alone is very, very compelling.

Separately, we've been asked by investors about the impact of the various developments taking place between the U.S. and China over trade. As you all probably know, the China and the U.S. has made various statements and the U.S. has also banned companies from supplying technology and part of our -- from the U.S. to ZTE in particular, the latter the result of ZTE's violation of their product [settlement] agreement. Starting with the latter, we do not believe that prohibition would extend to our ability to sign ZTE to a license under our standard essential patents.

It does impact our ability to engage in some of the cooperative elements that we sometime include in our license agreements like joint or funded R&D. That does affect our flexibility to a degree, but not so much that we think it has a material impact on getting the deal done. We continue to have conversations with ZTE and expect those to continue as the companies look to resolve the open licensing matter. We also think that it remains in ZTE's interest to demonstrate to the U.S. Government and others that they respect the intellectual property rights and other international laws.

On the broader trade issues the information we have in [DC] alliance with what you've probably heard in this press, mainly that while the rhetoric continues with the tariffs and other restrictions the two countries remain engaged in a dialog to reach an amicable resolution. And with the renewed focused on the strategic importance of intellectual property and China evolving into a nation that truly values intellectual property, one is hopeful that the appropriate resolution will be arrived at with the center piece being the valuing and protecting of innovation.

With that, let me turn the call over to Rich who has a fair amount to cover on the revenue accounting and tax side.

[Rich Brezski, CFO]

Thanks, Bill. As Bill indicated there are few optics that lend themselves to additional discussion this quarter. My comments today will focus on three matters, one the new revenue recognition standard, two the positive impact of the recent US tax reform measures, and three our pending acquisition of the Technicolor patent licensing business.

Let's start with our January 1st, adoption of ASC 606. As we discussed before the new revenue recognition standard is a sweeping change that impacts nearly all companies across all industries and is the result of the joint efforts of FASB and the IASC. While licensing companies receiving fixed payments or prepayments the critical question is whether technology developed and/or patents issued over the life of the agreement are inextricably linked to technology and/or patents delivered at the inception of the agreement.

For InterDigital, this is most often the case which lessens the long-term impact of the rule change. However, we did have some unique circumstances that led to a few agreements where this was not the case. As a result, our adoption of ASC 606, results in us losing the ability to recognize an estimated $90 million of revenue in 2018 that we would have otherwise recognized under the old accounting rules.

The most important point, I would like to drive home, is that this is no reflection of the ongoing success or health of our business or cash flows. This is purely a revenue recognition matter driven by new accounting standards. This quarter, our financial statements reflect the impact of the new accounting standards. We've adopted the standard using the modified retrospective method which does not restate prior periods but rather runs the cumulative effect of the adoption through retained earnings as a beginning balance sheet adjustment.

As a result, any comparison between first quarter 2018 results and first quarter 2017 results is really comparing apples and oranges. Fortunately, FASB and IASC recognize this and require us to prepare a footnote that presents our 2018 results as if we continue to recognize revenue under the old standard. In order to serve our investors and all users of our financial statements, we have taken advantage of that rule and centered the discussion of our year-over-year results not around accounting changes, but rather around the changes to our business.

Cutting through it all, an apples-to-apples comparison of recurring revenue shows that it was a relatively flat year-over-year. New agreements, including our fourth quarter 2017 patent license agreement with LG have more or less offset the expiration of a few smaller patent license agreements and a longstanding technology solutions agreement. This puts us in a great position to grow our recurring revenue base in 2018 by signing new patent license agreements. And Bill also mentioned what we see as a potential 10% impact on our core licensing business from our pending acquisition of Technicolor's patent licensing business. And as before we include the potential impact of our IoT efforts and our consumer electronic and licensing.

Moving on to tax reform. Let me start by acknowledging that prior to tax reform, we paid very near the U.S. Federal statutory rate of 35%. As a result, any federal tax reform was likely to help us become at least a little more competitive with our foreign counterparts. That is certainly proving true.

Let's start with our views on our long term tax rate. We see our long term rate at least through 2026 as being in the range of 14% to 15%. There are a number of factors that could cause that rate to vary from year-to-year and they mostly relate to the way timing differences and the sources of payments drive the impact of the deduction related to foreign derived intangible income or FDII. It is also worth noting that our views around this long term rate are based on the law as it is currently written and will eventually be clarified by more detailed IRS regulations.

Having said that, our first quarter tax provision is actually a tax benefit. This is understandably not intuitive, at least it wasn't for me. We did see tax benefits from stock compensation in the small -- and the sale of a small commercial initiative in the quarter. But the major benefit is actually driven by the combination of our adoption of ASC 606 and tax reform. In a nutshell there is a significant amount of revenue that we expect to be eligible for the FDII deduction but that is not recognized as revenue under 606 in 2018, which magnifies the FDII benefit through the current year.

Given that the impact of 606 is concentrated in 2018, our current forecast is for the tax benefit through this fiscal year. As I said before, timing differences between book and tax revenue will continue to cause year-over-year fluctuations in tax rate but the impact of 606 was unusual, significant and from an effective tax perspective beneficial.

With that, I'll move on to my third and final topic. Our pending acquisition of Technicolor's patent license business. As Bill indicated, we expect to close the acquisition this summer, so there will be additional time to get into the details. Today, I'd just like to reiterate and perhaps expand on [two] points we made in our press release announcing the acquisition.

First, we are very excited about the acquisition. There are many reasons why this is a great opportunity for InterDigital. But from a CFO's perspective, there are three reasons at or near the top of the left. Number one, the acquisition will provide us with a great portfolio of video technologies which will benefit from the continued contribution by a world class research and development team. This will enhance the value proposition to our core customers. Secondly, this acquisition opens up the consumer electronics market to us, which provides the opportunity to cultivate our revenue stream outside our traditional market. Even though it's worth noting that we expect only a modest impact to revenue from contracts acquired as a result of the acquisition.

Finally, we expect to run the combined business without any major long-term impact on recurring costs. Our first quarter operating expenses already reflect some of the cost initiatives we have undertaken within our own business to absorb the cost of the acquired business. Of course, we expect some interim one-time increases and expense during the transitional period that we estimate will be 12 months to 18 months. And in fact our first quarter results include just under $2 million of one-time acquisition related costs.

Specifically, we believe the most appropriate metric to measure our management of long-term costs is to add together operating expenses and capitalized patent prosecution and then subtract depreciation and amortization as well as litigation. Putting aside transitional costs, we expect to see relatively little long-term impact on this metric from the Technicolor acquisition as compared to our 2017 results. Beyond that, I'll just say that we are busy planning for the integration of this business and we'll provide more detailed expectations around the financial and accounting impacts this summer.

With that let me turn it over to Patrick.

[Patrick Van de Wille, CCO]

Thanks very much, Rich. Alicia, we'd like to open the call for questions.

[Operator]

Yes sir, thank you. [Operator Instructions] We'll go first to Charlie Anderson with Dougherty & Company.

[Charlie Anderson, Dougherty & Company]

Yeah. Thanks for taking my questions. So, Bill I want to ask Qualcomm's call last night. They talked a lot about sort of the new offering on patent licensing from them which is a kind of standard essential only version, sort of the way to quicken the pace and maybe in China and elsewhere where people can access the 5G. I wonder if that's something that you guys have contemplated as well that you have done something like that. To a degree that Qualcomm does that and does that change the environment at all separating now same essential patents from everything else? And then I've got another.

[Bill Merritt, President and CEO]

So, I think we've been flexible around that, we've done agreements that were SCP only, but frankly the customer really very rarely wants that. And I think there is a significant difference in the economics between our licenses and theirs. So, I think our program as always had a level of flexibility in it in terms of how we structure the deals, the discounts we offer and other elements that we bring in. The fact that they're doing something to bring flexibility into the business and doesn't really affect us we've always have flexibility in our system.

[Charlie Anderson, Dougherty & Company]

Got it. Got it. And then Rich I wanted to ask about the difference from ASC's impact on some of the variable royalties and also on the tax solution side. I might understand that that's basically the timing difference now from one quarter arrears versus real time. And so I guess what I should expect there is just a change in the seasonal pattern. And now within tax solution it seems like a pretty big haircut. So I just want to understand what's going on there specifically?

[Rich Brezski, CFO]

Yeah. So I'll start with tax solutions. The difference there is driven kind of by two things. Putting aside 606 we had the expiration of a tech solutions contract. Typically that fourth quarter that expiration may have resulted in some royalties that spill over into the first quarter on a lag basis. Like as a result of 606 you get that change over where you lose that. And I've seen impact in terms of moving from the lag to quarterly estimates shows up a little bit in the variable line as well.

But really, if you look year-over-year on that variable line, which really driving that adjustment down was when you look to first quarter last year, I think it was maybe $60 million or so variable dropped down to 10 to 11 the balance of the year which is more consistent with what we have this year on the 605 basis. So you had in first quarter of '17 the recognition of a couple of variable agreements that expired in fourth quarter of '16. And then you have the drop off in Q2.

[Charlie Anderson, Dougherty & Company]

Got it. And then just one for me, for Bill. Bill I appreciate the commentary around the China stuff. I wonder if you could maybe just talk to in the real time how is it impacting the conversations you're having with potential licensees. Does that change any urgency one way or the other in terms of when people want to transact with you? Any additional commentary there will be helpful.

[Bill Merritt, President and CEO]

So we haven't seen anything in terms of a change. I think as I mentioned with respect to DC, the impact will really be on just some elements of flexibility in terms of other things we could add into the deal. But it doesn't impact our ability to do a deal with them, so there is conversations that continue with them. And everyone else is pretty much at least so far, and I expect this to be the case. It's been business as usual. So we continue to have good discussions there. I think not so much, the China trade issues, I think people are more interested now in terms of understanding the Technicolor impact with us.

And I think that's a very positive thing as we work to close on that deal. Because obviously it brings added value into the transaction. So nothing specific around the trade thing and no specific change in the pace of the discussions, if anything the change in discussion has been more driven by Technicolor.

[Charlie Anderson, Dougherty & Company]

Just I got one more. Would it be your preference then to wait until you close Technicolor to close? I mean it would give you I assume a better overall rates with the counterparty. That's all I have.

[Bill Merritt, President and CEO]

You don't really need to wait. You can kind of build it in appropriately. Typically within license agreements we'll deal with acquisitions and what the impact of acquisitions would be. And so without getting too far ahead of ourselves, one way to deal with the Technicolor acquisition will be it's basically designed -- it's designed in rate bump when the transaction happens. So it leaves open the possibility which we think is well if the transaction doesn't close, but it provides a solution as soon as the transaction does close. So, the transaction isn't slowing anything down. It's just I think creating a better dialog and I think we had the flexibility to deal with that and other types of acquisition in the frameworks under the agreements.

[Charlie Anderson, Dougherty & Company]

Got it. That will make sense. Okay. Thanks so much.

[Rich Brezski, CFO]

Thanks, John.

[Bill Merritt, President and CEO]

Thanks John.

[Operator]

[Operator Instructions] We'll go next to Matthew Galinko of Sidoti.

[Matthew Galinko, Sidoti]

Hi, good morning guys. Thanks for taking my question. I want to make sure I understand the 10% guideline you shared regarding potential incremental revenues from the Technicolor IP applied to your handset business. Is that regarding your long-term kind of platform target that you've talked about or is that of your 2017 kind of 605 revenue base or is it of your 2018 606 revenue base, just could you kind of collaborate that for me?

[Bill Merritt, President and CEO]

Sure. I'll take a shot at it and then Rich you can come on top. So, the 10% is, if you think about it in this way, it sort of put accounting standard to the side appreciate the clarity that they're bringing in. The thing about the 10% is, if we had an average rate of X in our system that the average rate goes up by 10% in our program. So, now it leads in over time right because we have agreement that are in place for a while that we'll go back to later and with respect to Technicolor asset there is other agreement that we will deal with now. So, I think it's a 10% increase in our base line revenue for that program over time. And that's a number as we said in the script that, when we look at the licensing history in video the strength of the Technicolor portfolio and a number of other factors that we're very comfortable setting as a guideline for the transaction. So, hope I got it right. Rich, anything else you want to add?

[Rich Brezski, CFO]

No I think that pretty well address it unless Matt you need further clarification.

[Matthew Galinko, Sidoti]

No, no, I appreciate it, that's helpful. And then secondly another accounting question there on the acquisition. I think you have mentioned in terms of any revenue that Technicolor brings over from the existing licenses, any kind of preliminary thought on how purchase accounting goes through now under 606, are there any changes to how that looks?

[Bill Merritt, President and CEO]

Yeah. So, it's less about purchase accounting and more just about how revenue looks under 606, so that would be an impact on any contracts that come over. I think that we've spent a lot of time focusing on that though, because I did mention maybe you missed it Matt, but there is only a modest impact that we expect from kind of contracts that come over day one. It's much less about the contracts that we acquire and much more about the impact through our core business and adding new markets and the growth that provides going forward.

[Matthew Galinko, Sidoti]

Got you. Appreciate that. All right, one last one, I know I think maybe at the last Analyst Day over the last little while you've talked about kind of managing the number of total maybe patents in your portfolio or kind of pruning where you have an opportunity to kind of manage your amortization expenses. I guess I'm just curious just given the large portfolio that comes in, do you have a perspective on kind of curating that at all to bring the number down in aggregate and focus on the higher quality assets in the portfolios or just how do you think about that with regards to the comments you've provided in the past?

[Rich Brezski, CFO]

Yeah so…

[Bill Merritt, President and CEO]

We estimate that…

[Rich Brezski, CFO]

Yes. Go ahead, Bill.

[Bill Merritt, President and CEO]

Yeah I'm just going to say that's certainly something that we and I think a lot of large scale licensing companies find to be a sensible activity in the norm. And when you have the opportunity to bring two very large assets together, it certainly create those kinds of opportunities as well.

[Matthew Galinko, Sidoti]

Got it. All right, that's all for me. Appreciate it.

[Operator]

And that does conclude our conference for today. I would like to turn the call back over to our speakers for any additional or closing comments.

[Patrick Van de Wille, CCO]

Thank you very much Alicia. And thank you for our shareholders for joining us again this quarter. We'll see you in three months.

[Operator]

Thank you. That does conclude the conference for today. We thank you for your participation. You may now disconnect.