InterDigital Inc

NASDAQ:IDCC

Earnings Call Transcript 2017-Q4

[Operator]

Good day, everyone and welcome to the InterDigital fourth quarter 2017 earnings conference call. Today's call is being recorded.

At this time, we’ll turn the conference over to Patrick Van de Wille. Please go ahead.

[Patrick Van de Wille, CCO]

Thank you very much. Good morning, everyone and welcome to InterDigital's fourth quarter and full year 2017 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 highlights 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 those detailed in our Annual Report on Form 10-K for the year ended December 31, 2017, both of which were published this morning as well as from time-to-time in 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 fourth quarter 2017 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 Q4 2017.

With that taken care of, I will 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 from the press release this morning, the company delivered yet another very strong quarter and equally strong year, driven by our broad base of licensees. The strong result on our topline combined with the continued efforts to control our costs resulted in strong profitability and cash flow as well. Rich will go into the numbers in more detail in his remarks. I wanted to do a quick review of the year from a strategic perspective and then talk about our objectives for 2018.

As you all know by now, our strategy is very straightforward, focused on growing the value of our core terminal unit licensing business. To do that, we continue to develop the critical wireless technologies that are so key to our customers. We also seek to develop and acquire deep new competencies in other pervasive technologies that are also important to our handset customers.

Next, we need to bring these technologies to our customers in a manner that produces stickier, more valuable customer relationships, finally meaning, to do all of this, respecting our cost structure and operating leverage.

Let me start by talking about the status of our 5G activities. The first release of the 5G standard was frozen in December, 2017. During this initial standards process, InterDigital made over 1,000 contributions, chaired and vice chaired in important working groups and filled other key roles in shepherding the process along. The result was not only a fantastic start for the industry in 5G, but also a continuation of our leadership and innovation success.

We also made significant strides in 2017 expanding our technology footprint. Internally, our video team continues to have great success in developing new technology solutions for adoption into next generation standards. We also continued our efforts on security technologies, WiFi and the like.

2017 also saw us complete the integration of our first significant acquisition, Hillcrest Labs. Hillcrest is a pioneer of sensor fusion technology with a rich portfolio of invention for a technology that will be pervasive in mobile devices. During the year, we mined and matured their patent portfolio, identifying innovation relevant to smartphones that are shipping today. This allowed us to very rapidly bring these innovations into the discussions with our customers.

Second, early this year, we fully integrated the Hillcrest research team into InterDigital Labs, providing the strength and stability of that broader research organization and perhaps more importantly providing the opportunity to cross-pollinate innovation across sensors, security and other key technologies being worked on at the company. Third, we repositioned Hillcrest’s product effort away from commodity markets to areas where significant new innovation will be necessary. These product areas are more aligned with developing innovation that can be used in our core business and also allows us to have informative customer engagements that can help guide the direction of our research.

2017 was also a year that saw us do better than ever in terms of bringing all the company has to offer to customers. For example, our LG agreement included the involvement of our Hillcrest team, which has had a long and productive relationship with LG around smart TVs. Other licensee conversations are also engaging groups from around the company. The result was a different type of dialog with our customers. Going into 2018, we had matured a number of discussions around more comprehensive relationships and are working to close on those deals this year.

We did all this respecting our expense structure, the incredible value of InterDigital’s core business is in its operating leverage. We create the greatest value when any added revenue comes with only nominal cost. In that instance, a 10% increase on the revenue line can yield two or three times that increase in our profit. That is a remarkable value to shareholders. We demonstrated that in 2017 as even with the Hillcrest acquisition as an example, our operating expense stayed relatively flat, despite having new innovation products and research to show to customers.

For 2018, our strategic objectives will be largely the same, continue to drive five research, deepen our technology position on selected area of innovation like sensors and explore through M&A other opportunities to bring deep and respected technology positions into the mix. All of these assets will come together with the customer where we expect to drive valuable and closer customer relationships.

As part of that effort in 2018, we will also have the opportunity to reshape the management team to have a broader set of technology skills and an even greater knowledge of our customer. The opportunity comes as three of my most trusted colleagues, Larry Shay, Scott McQuilkin and B.K. Yi have chosen to retire. All three have had long and distinguished careers with the company and had driven incredible results. For example, Larry was integral in many of our key negotiations, successfully concluding them, and driving our revenue platform to new heights.

Scott reshaped our innovation engine, making it more nimble, more cost effective and more diverse in both the technologies we sought, but also from where we secured them and B.K. took our wireless research to a deeper level, driving fundamental innovation that has become critical to our strong performance in the 5G standard setting process. While their departures are hard, the company being as strong as it has ever been can take the opportunity to broaden its talent base, consistent with our strategy to know our customers even better, deliver to them a wider range of technologies and do so creatively.

We've already announced the promotion of Tim Berghuis to lead the licensing team. Tim has been at InterDigital for 16 years in his time in the licensing team under Larry as well as his engineering and business background at Motorola makes him the perfect fit for the role going forward. And we look forward to announcing equally exciting talent joining the management team.

InterDigital remains an exciting and invigorating business with great opportunity. For that reason, I expect 2018 to be another banner year for the company.

With that, let me turn it over to Rich.

[Rich Brezski, CFO]

Thanks, Bill. Once again, we delivered a strong fourth quarter, capping off another strong year. Our fourth quarter revenues topped $200 million, including $106 million of past sales. A large portion of this past sales amount was expected in connection with the recognition of a non-refundable prepayment balance, upon the expiration of an agreement at the end of 2017. The balance of the past sales were driven by our fourth quarter patent license agreement with LG. 2017 is the fourth year out of the last five that we've recognized over $100 million in past sales, a tremendous driver of value for the company that has contributed nearly $800 million over that period.

More importantly, our new agreement with LG drove our recurring revenue in the quarter to nearly $100 million, our highest level since the first quarter of 2016. As we've discussed previously, on January 1, we adopted ASC 606, the new accounting standard governing revenue recognition. This morning, we announced that with the adoption of ASC 606, we expect first quarter revenue to be between $66 million and $71 million. This translates to $90 million to $95 million on a pre-606 basis, which would be roughly in line with our recurring run rate in 2017.

That guidance reflects the stability in our business as our new agreement with LG has roughly offset the expiration of a few agreements at the end of 2017. And of course, we hope to build on that stable base by adding new license agreements and renewals during 2018. As previously discussed, we expect that any new fixed fee agreements we sign or renew are likely to qualify for overtime recognition under the new revenue recognition standard. As a result, we have not changed our $500 million to $600 million target revenue platform for the business, even after accounting for the revenue recognition standard.

As a final note on the new accounting standard, I want to make everyone aware that in our 10-K, which we filed this morning, we have also previewed our detailed expectations for the impact of adopting ASC 606 on our opening balance sheet accounts, including deferred revenue and retained earnings.

Moving on to expenses, we continued to manage our expense profile with nearly flat overall operating expenses. As Bill mentioned and we have long discussed, we believe we can achieve our revenue goals without incurring significant additional expense. This operating leverage has proven to be very beneficial to our shareholders as we have been able to generate substantial pretax profits and cash flows in recent years.

Given that, we are excited about the recent tax reform legislation, which I'd like to discuss. We recorded a $43 million tax charge in Q4 to revalue our net deferred tax assets under the new statutory rate of 21%. This charge is a necessary counterpart to the significant reduction in the go-forward effective tax rate we expect to enjoy. In fact, there is a provision in the new law that taxes that form licensing of intellectual property at 13.1% through 2025, at which point, the relevant rate increases to 16.4%. While the detailed IRS regulations necessary to fully implement the new tax law have not yet been published, on a go forward basis, we currently expect a significant portion of our income will qualify for this low rate. We expect to communicate a specific estimated effective tax rate in connection with our first quarter results.

With that, I'll turn it back over to Patrick.

[Patrick Van de Wille, CCO]

Thank you very much. Sherlong, we will open the call for questions.

[Operator]

[Operator Instructions] We’ll have our first question from Eric Wold, B. Riley.

[Eric Wold, B. Riley]

A few questions. I guess one just a quick follow-up on the tax rate. Make sure I understand that. So I know you're not going to give kind of guidance on what you expect the tax rate to be until the Q1 call, but just to make sure I understand the dynamics there, is it that some portion of your income will be taxed at 21% and some taxed at the 13%, so you’ll get something in between those two numbers?

[Rich Brezski, CFO]

Yeah. Eric, that's right. I think you nailed it. And adding to that, we think it's a significant portion that’s taxed at the lower rate.

[Eric Wold, B. Riley]

And on the adoption of ASC 606, one additional confirmation there. Confirm that, is that a sizable revenue recognition on the previously signed agreement, you noted that you're not going to sign anything else that would qualify under those static fixed fee deals and you’ll avoid that going forward, but that -- it's only impacting revenue recognition, it’s not impacting anything around cash flow from those previously signed deals that still generate cash flow, correct?

[Rich Brezski, CFO]

Yes. Correct. And it’s not even that we’d avoid it. I think that the conditions or circumstances that led to us signing the static fixed fee agreements in the past were somewhat unique and in our view, not likely to repeat. So we certainly expect that any new deals or even renewals would be signed on the dynamic terms.

[Eric Wold, B. Riley]

And then on the adoption on 5G, can you give us a sense of what your view as the timing of when license revenues from 5G, kind of 5G standard can start flowing into InterDigital and how do you expect this to impact your license agreements that have either been I guess previously signed that need to be amended for 5G or ones that will be signed going forward. Do you expect 5G to be incremental to kind of the ASPs you're getting from your licensees or more of an offset to reduce value from kind of the older 2G, 3G, et cetera, patents?

[Bill Merritt, President and CEO]

So a couple of things, right. In terms of the negotiations of licenses today, so that's part of the discussion since 5G is now real. I mean, the first standard drop is done, and while the, I think, a lot of the analysis around who's got what patent position will continue over the next months and years, I think our showing has been pretty good and the people that have been observing the standards process have seen InterDigital with another good round of contributions there. In terms of how the economics of that would play out, right, so, for most of our agreements, to date, many of them have not included 5G. So when the renewal discussion comes up, that will now be included in the discussion.

I think to some extent, it's what you said. There's obviously older technology that's falling away and 5G is replacing that. That said 5G has got some pretty -- has got broader use cases and so I think the TAM to an extent increases. And as you also know, the selling price of 5G devices will go up as they have in prior versions. So when you think about running royalties even at the same royalty, you would get a higher return. And then, that said, we would still move for a slightly higher royalty with respect to 5G reflecting the fact that the company has had a strong position there as well as the underlying technologies.

So I think that as we already said, 5G is really going to do two things for the company ultimately, right. So it's going to sustain and grow the core business, which is really -- that has been the licensing of handsets and terminals, but it's also going to enable some other markets, in particular the IoT market, because it's really a necessary component for the proliferation of connected devices out there and that will be a new and larger revenue stream for the company.

[Eric Wold, B. Riley]

And then just final question, with the LG license that was signed in early December, kind of give us a sense of how the structure of that license around, I guess, more around kind of past patent sales that are owed to InterDigial, you know may be not -- I’m not looking for necessarily the exact structure of that, but just how that structure possibly benefited or kind of has impacted your discussions with the remaining guys that are out there, Xiaomi, ZTE, Lenovo, is that something that was viewed positively, has it made an impact at all or is it going to just -- those other discussions are just kind of continuing to move along regardless of that LG patent?

[Bill Merritt, President and CEO]

So I think it's a very positive event for those discussions, right. One, it employed another flexible structure by the company, which says that there's a variety of ways in which we can bring value to folks and also how we can get paid under a license. It provides visibility for the unlicensed folks into what somebody else is paying and so that they can see what we are asking from them is no different than what we've already secured from LG. So and LG is another one of those groups that has a very well respected IP group. And so they obviously take these negotiations very seriously, and so having secured a license with them is also a strong indication of the value of the portfolio. So it's certainly a very positive thing when we go out to the unlicensed folks to have LG now again as a licensee for the company.

[Operator]

We’ll have our next question from Charlie Anderson, Dougherty & Company.

[Charlie Anderson, Dougherty & Company]

So in the K, you guys did disclose that Huawei expires at the end of this year. So I wondered if you could maybe give us a little bit of color on why we’re expiring in ’18 and it's a little bit shorter deal than some of the other deals that you’ve signed in the past couple of years and then maybe just your confidence level in renewing it, some of the factors that are going to be at play there? And then I think there were -- there was a discussion of one other $18.5 million deal or 18.5 million contributor in ’17. So similar question there, in terms of confidence level and renewing that. Then, I've got a couple follow-ups.

[Bill Merritt, President and CEO]

So, Huawei, if you recall, there was a process by which the agreement got put in place and then there was an arbitration process and a resolution. So actually if you look at that entire stretch of time, that was actually consistent with our license agreements. In terms of how the renewal discussions will go, there's a lot of positive things in play, right. So, we have the previously determined arbitration rate. It is still part of the record, here with respect to those folks. I think there's also a good relationship that's developed between the companies since the license agreement.

There's a lot of engagement at the standards bodies only because a typical percentage of bodies, you need to create alliances and other things and so we've been working with them on a number of issues, just as we work with others and I think that they respect what we do in that context. There's also opportunities with other things that we've developed as a company that we’ll add to the discussion with Huawei, including things that we've done around video, the Hillcrest assets will be very useful in that discussion.

I think following up on Eric's point, before the fact that we have LG done as well, it is also useful in that discussion, because it's a recent benchmark that Huawei can use. I also would say that Huawei itself has turned up its efforts around its patent, obviously using them in China with respect to Samsung. So, their respect level for pass through, I think, have been reasonably good, continues to be good. I think we can reflect that in our discussions as well. So, we've got a good amount of time this year to get that renewal in place. I think we're well positioned to do that and that's what we intend to do.

[Rich Brezski, CFO]

And Charlie, if I could just add one point to your comment, each of the agreements that you referenced, the Huawei and the second agreement, while they expire at the end of 2018, they both met the description of static agreements and therefore when you look at our revenue guidance for the first quarter, neither of those agreements is included in that revenue guidance. So while the agreement still runs over the balance of the year, the rev rec is out, beginning with our first quarter guidance.

[Charlie Anderson, Dougherty & Company]

That's a definite positive. So just real quick though to follow-up on the 18.5 million one. I know that you guys have talked previously about some M2M stuff that was rolling off. Is that in that category or is this classic terminal licensee and same applies in terms of ability to renew that, in terms of how you talked about Huawei?

[Rich Brezski, CFO]

Yeah. That falls into the latter category and I think that's also a situation where we have a very strong relationship and I think most of Bill’s comments apply there as well.

[Charlie Anderson, Dougherty & Company]

I want to ask about M&A, Bill, you did mention in your comments about, you still believe you want to develop and acquire some adjacent technology here that will help you with your conversations. I just kind of wonder where things stand as far as that's concerned. How does the landscape look to you? And then maybe a follow-on question on that, for Rich, in terms of just the capacity, in terms of size of deal that you guys believe you can do, how should I be looking about where you are in terms of your ratios right now, in terms of borrowing and kind of roughly how much do you have?

[Bill Merritt, President and CEO]

So in terms of the opportunity and our feelings our M&A, I think the -- a couple of things, right. The Hillcrest acquisition was very instructive for us. It was instructive in terms of how licensees reacted to that type of thing and the reaction was very positive. I think that was reflected in our LG discussions. It was very instructive in terms of how we can take assets or companies like that and reposition them into the company in a very effective way. There's nothing better than actually doing it to see how it all works out and how, as an example, as I said in my script, how the research teams can begin to blend, how the product positions can be put in place that will really drive new innovation.

So we were very encouraged by what we saw with respect to that opportunity. I think that the scale of the company is one that makes it -- makes it attractive for us to seek out things like that, because as I mentioned in the call, we're able to take on things and really do so with very little impact on our cost structure, which means when we go to a licensee, we're actually going to seek almost a lower royalty than they would be charged by a standalone company who's got to cover all of their fixed costs and other costs with respect to that licensing opportunity.

So there's a benefit to consolidation in the industry and so people see that. I think, that also having more capability at the organization in terms of research and other things is proving to be very valuable in license discussion, I am going to give you an example. One of the things that's been very useful for us in license discussions is actually to offer up a component of our 5G research as a deliverable in license agreements. So people really value that and to the extent we can go on in that research capability to other things, that's going to be really valuable.

So we're very encouraged by what we've seen from M&A, we’re very encouraged by the opportunities that are out there for us and we are firm believers in the value that that M&A can drive because ultimately, the deals that we would look at in terms of investment in the core business are really going to respect that operating leverage and design at the end of the day will be, can we bring in deals, restructure that not that asset or a business in a way that the added revenue really does drop to the bottom line [indiscernible]. We believe we can do that and if we can, that is extraordinarily valuable.

[Rich Brezski, CFO]

And as to the second part of your question, Charlie, the constraint or the criteria is the better word, is really creating value for the shareholders. At the end of the year, we have over $1 billion of cash, almost $900 million of net cash. So just with cash on the balance sheet, we have a significant amount of flexibility there. Certainly, the amount of cash flow that we've historically generated suggests that we have ample financing capability just in the last two years, it’s something like $600 million of free cash flow. So, we think that we're well-resourced to kind of, if we see the right opportunity to go after it, but at the end of the day, the real measuring stick is what at the end of the day do we believe that does for our shareholders.

[Operator]

[Operator Instructions] We’ll go next to Matthew Galinko, Sidoti.

[Matthew Galinko, Sidoti]

Couple of questions for you. You mentioned kind of a new tone of your dialog with a wider breadth within your digital groups and gate, is that in reference to presently unlicensed handset companies or does that extend to opt for renewal licenses?

[Bill Merritt, President and CEO]

It's really the full range of customers, right. So that’s going to the people that we’re having discussions for the first time with, because there's new entrants in the market. It's people that we’re in renewal discussions with and it’s also folks that may currently be licensee, because one of the things that we've been very adamant about in the organization is just because we’ve signed a license agreement, something doesn't mean you stop the conversation. The conversation needs to keep going.

It can happen at different levels, so our CTO will engage with their CTO, standards groups will engage, product groups will engage and we’ll kind of keep track of all those engagements so that when it comes time for renewal, we have a better sense of what that customer needs, not only in terms of license, but also technology and other assets that we have that we can bring to bear. So it’s a very purposeful, committed effort by the company to really know its customers much better and to use that knowledge in a way that creates value for both parties.

[Matthew Galinko, Sidoti]

And can you just kind of, I guess give us perspective on how new that is? Is it really just something that you started since the acquisition of Hillcrest and sort of the full level of engagement throughout the duration of the license? So, do we sort of expect to see the impact on the next renewal cycle or has this kind of been something you've been grinding towards over the course of a few years?

[Bill Merritt, President and CEO]

It’s more of the latter and that this has been an initiative by the company for a few years to more broadly touch our customers. Certainly, having more assets makes that easier. So, as an example with Hillcrest, we have now relatively straightforward conversation with folks within Samsung around certain of their products, because Hillcrest delivers partner to Samsung. And so I think there's a, to some extent, a limit to what the company can do only because it's sort of limited by the assets it has. We have great assets and so we can have great conversations around research, we can have conversations around Hillcrest solution.

We have had conversations with respect to the IoT solution, but I would love to have a few more things and those can come in a couple of ways. They can come through M&A of course, but not everything has to be an acquisition. They can also come through partnerships. So we can find companies that we can partner with and be a channel for their software in China as an example, because, we have greater strength and breadth than that company may have in, as a matter of fact, that was one of the things that we were doing at CES this year.

We’ve been spending a lot of time with smaller companies, chatting with them about partnering. Again, our goal is to create a large fabric of solutions for our handset customers and allow us to really create individualized deals for each of them. With the emphasis on doing it, while all along, respecting our cost structure as we understand the value of that.

[Matthew Galinko, Sidoti]

And I'm curious if you could talk about your processing confidence and I guess providing quarter -- Q1 guidance on the royalty business, just given the changes to how that works under 606.

[Bill Merritt, President and CEO]

Yes. So the primary change there with respect to the guidance is along the per unit side because now that, where in the past, our Q1 guidance, we'd be sitting year in late February providing guidance for the first quarter with the fourth quarter royalty reports in hand and that becomes the basis under the old rules for the first quarter revenue. Now, we're basically projecting or estimating on the per unit side where those royalties will come in and that's how we guide and ultimately at the end of the day, it's 14% of our revenue when you look at 2017 with 86% being fixed. So it's actually a pretty small portion of our revenue these days. That is of the per unit nature. You’ll lose some of that fixed fee revenue in 606, so that proportion maybe changes it a little bit. But it's still not something that we're especially concerned about.

[Operator]

And at this time, we’ll turn the conference back over to Mr. Van de Wille for any additional or closing remarks.

[Patrick Van de Wille, CCO]

Thank you very much, everyone. Thank you, everybody for joining us today. I just want to note that next week is Mobile World Congress in Barcelona. It's a phenomenally important week for the company and for the industry as a whole. One of our engineers will be speaking at Mobile World Congress. It’s the third time in two years that some of our folks are invited on stage to speak about 5G. And we have a number of great demos with various partners. I’ll be hosting a video tour of the booth for investors and anybody else and there will be some other content on our website as well. So I encourage you all to keep an eye out for content from Mobile World Congress, Barcelona next week. Thanks all for joining us and we'll see you next quarter.

[Operator]

That does conclude today's conference. Thank you for your participation. You may now disconnect.