The 2.5/3G Licensing of Interdigital

8/1/2003
Rick Currin - CurrinResearch.com

Perhaps some of you know this company has been referred to a “baby Qualcomm” in the wireless community.  For others this may be your first exposure to Interdigital.

Interdigital has a strong portfolio of patents resulting in revenues associated with 2G and 2.5G wireless.  These patents are already bringing in lump sum back payments and royalty bearing licensing from cell phone and wireless infrastructure players.

Interdigital has key enabling patents for the transfer of data associated with large downloads of digital media such as streaming video over cell phone interface standards.

Understand more how the adoption of high speed wireless connectivity to the internet via cell phones is married to 3G and to Interdigital.

Interdigital Communications Corporation (IDCC) is a Patent Leader

The first place I’d like to start with having you understand Interdigital is to realize there are over a billion cell phones in use in the world.  Despite the recent woes in the telecommunications sector, cell phone usage is continuing to increase and is forecast to be over 3 billion in several years. The second thing to realize is there are almost as many acronyms in the wireless world as there are phones.  With that in mind I have a mini glossary of items in this report to help you understand some of the terms you will see as we follow this company.  But understanding the minutia of each technology is not the key to understanding Interdigital.  The key is understanding that Interdigital’s patents enable many of the technologies.

The fundamental business of Interdigital is the world of developing and licensing technologies for wireless communications.  Before we even get into who is licensing which acronym just consider the roster of licensees Interdigital already has.  The list includes Ericsson, Sony Ericsson, NEC, Sony, Research in Motion, and Sharp as the most significant of the 35 licensees.  Interdigital is currently in negotiations to license and receive back payments as well as future royalties from Samsung and Nokia.  They already have reached such agreement with Ericsson and NEC. Obviously there is something Interdigital has that these companies need.  In a nutshell what these companies need is access to Interdigital’s patent portfolio and expertise.

The current volatility of Interdigital is due to issues associated with Nokia for licensing involving technologies widely in use already. Nokia during the course of the negotiations asked a court to unseal the Ericsson/Interdigital agreement.  What exactly Nokia is up to did not please the market.  Of course for a long term investor that can often be a good thing.

The Licensing Is Really Just Taking Effect

Interdigital has a strong patent portfolio that covers major wireless interface standards. The company only recently signed 2G and 2.5G license agreements with Ericsson, Sony Ericsson, and Research In Motion.  Additional license agreements will likely result from 2G and 2.5G including Nokia and Samsung.  The 2G and 2.5G licensing deals are essentially both backward and forward reaching licenses covering usage in both past years and future years for the wireless technology in cell phones and related infrastructure.  While these arrangements are good and bring the company immediate cash and a stream of revenues, the biggest upside to Interdigital is the adoption of 3G technology and beyond.

The signing of both 2G and 2.5G licensees is significant however.  The licensing does several things. It legitimizes Interdigital’s patent portfolio for enabling wireless.  It brings immediate boosts to earnings and revenues. It also gives Interdigital a nice degree of exposure as a legitimate enabler in the wireless space.  Again this is the why Interdigital has been referred to as a “baby Qualcomm”.  It seems though that the baby is now beginning to cut its licensing teeth and realizing both the leverage capability and the collaborative enabler effect that their strong patent portfolio provides.

Companies Relying On Patent Licensing Revenues

I’m going to take a small detour in this discussion to talk about patent rich small to mid cap companies.  By nature, companies that derive a substantial portion of revenues from licensing their patents are subject to risks.  The risks are that their patents could be unenforceable; that they will need to expend their limited resources in enforcing the patents, or that the patents can be worked around.  Because of this risk, intellectual property heavy companies, especially smaller ones, can be volatile in the market.  The news that a licensee has signed can send the stock up sharply, while the news that there is trouble with a potential licensee can have a similar downdraft effect. In the long term however, the valuation will be determined by the licenses ultimately secured, the metrics the market assigns to the business and business model, and the strength of the patent portfolio in a forward looking view for the direction of technology in the relevant business.

In this regard, I view intellectual property opportunities as often inaccurately valued in the marketplace.  If the patents are intact and required but untested by challenge, the value is often underestimated because of the associated risk. But when the patents are viewed as essential and marketable, a premium can be afforded the patent heavy company in the market because of the potential being realized for a stream of recurring revenues from a large array of vendors.  This premium is due to the fact that licensing technology is a good business model.  In such a model, capital requirements are maintained low in a competitive research, development and licensing operation versus a competitive product development and manufacturing and service operation.  Often the patent enabler moves from a potential nuisance to a key competitive asset for a licensee.

In Interdigital’s case, the value and essentiality of their patents for 2G and 2.5G seems to not be in question as the presence of Ericsson, NEC licenses and even the Nokia and Samsung negotiations already suggests.   In the present situation with Nokia, it is not so much a question of if Nokia will pay Interdigital for their patents, but it is apparent that Nokia wants to flex some negotiating leverage into the equation.  Recently Nokia requested to see the sealed patent licensing agreement between Interdigital and Ericsson in a move to arbitrate the royalty issue.  This news sent the stock down about 25% presumably on fears that there was litigation trouble ahead or a lack of favorable royalties in store.  The stock has behaved poorly in the short term since that news as well.

On the other hand, Nokia's request during licensing negotiations with Interdigital could be an attempt for Nokia to get a free look at Ericsson’s agreement or glean other competitor information in the process.  The market doesn’t really know what to assign to it other than risk it seems.  Regardless of the Nokia request however, Nokia is presently in a situation where they face arbitration of the patent licensing fees and any royalties due to Interdigital.  At the same time as these seemingly now contentious negotiating tactics are being employed, Interdigital and Nokia have been and are working closely on 3G designs for future applications being deployed.

Investors in Rambus know that a litigation of patent rights can produce volatility or even downward pressure on the stock performance.  Stock traders are happy to pile into either side of stocks that are driven by fluctuations due to news events such as licensing deals or threats of pending litigation.  This is simply part of the volatility landscape equation of Interdigital and other patent heavy companies that trade publicly and move on “news”.  You need to understand this or you may not gather the big picture on these types of stocks and find yourself on the wrong side of “trading” events.   So does that make Interdigital a good stock for traders?  Perhaps.  But the focus of this newsletter is to identify Interdigital as a high return investment in the long run, not to time traders trading the stock.  So with that potential for volatility in clear sight, back to the report.

The wireless technologies

Now I dip into an unavoidable bowl of wireless alphabet soup.  If you don’t know what CDMA, WCDMA, TDD, TDMA, TD-SCDMA or GSM/GPRS are that’s fine.  I’ll do my best to have you understand enough of what you need to about a few of them.  The first thing to understand is Interdigital has patents that enable these critical wireless interface technologies.  The second thing you need to realize is that the company is receiving some revenue for products made to any of them already through various licensees.

Cellular Primer/Glossary

Cellular Communications

Refers to communications systems, mobile communications in particular, which divide a geographic region into sections, or “cells”. When you see the little towers you already know are for “cell” phones just remember think they are little because they are serving a cell. The purpose of this cell division is to make get the optimal use out of a limited number of transmission frequencies. The total number of frequencies is about 1,000 but capability for more than 1000 simultaneous transmissions is obviously required since each connection, or cell phone call, requires its own dedicated frequency.  Cells are utilized to allocate the available frequencies by cell.  In this way, two cells can use the same frequency for different communications as long as the cells are not adjacent to each other.  Another thing to keep in mind is that from the beginning cells were used because of limitation to spectrum or radio frequency.  Defeating this fundamental limitation drives several technical innovations that have occurred.

TDMA

I short for Time Division Multiple Access.  TDMA uses time division multiplexing a technique which works by dividing a radio frequency into time slots and then allocating slots to multiple calls. BY doing this, a single frequency can support multiple, simultaneous data channels.

GSM

Is short for Global System for Mobile Communications. GSM uses narrowband TDMA which allows eight simultaneous calls on the same radio frequency.  It is the current de facto standard for Europe and Asia and used in more than 100 countries.

CDMA

Is short for Code-Division Multiple Access. CDMA is a digital cellular technology that uses spread-spectrum techniques. Unlike GSM, which uses TDMA, CDMA does not assign a particular frequency to each user. TDMA uses instead full available spectrum and encodes a digital sequence in the division scheme.

CDMA is really the hallmark technology base of Qualcomm.

TD-SCDMA

Is short for time division synchronous code division multiple access.  Siemens in collaboration with the China Academy of Telecommunications developed TD-SCDMA.  It combines the Synchronous CDMA with a time division CDMA. Synchronous mode means base stations transmit and receive synchronously.  This eliminates feedback interferences that occur with asynchronous methods.  As far as understanding TD-SCDMA it probably is enough to know that a billion of cell phones in China will ultimately be using it.

WCDMA

Is short for Wideband CDMA.  IT is a higher bandwidth CDMA used for 3G.  Interdigital has worked closely with Nokia on WCDMA using their TDD technology.

1G, 2G, 2.5G, 3G

Are short for first generation, second generation, 2.5 generation and third generation wireless.  1G is analog cell phones.  2G is second generation digital cell phones.  2.5G is essentially 2G with faster data services as opposed to voice only, and 3G is third generation or generally a “wideband” service.

Where Interdigital Fits In All this Alphabet Soup

I don’t expect you to understand all this acronym business in order to understand Interdigital well enough to invest.  In simple terms, it appears Interdigital will have patent coverage in 2G and anything after that.

Know as some of you may already know, all of these myriad standard are not interchangeable.  That is one reason service in Europe and in the US was typically not compatible. What many also may not know is that there is a move to converge the technologies at the 3G level.  With a convergence of standards it is also more likely that the enabled increases in bandwidth and the capital costs to make it so, will be a far more efficient market.  That is, it will help costs to have technologies more universally deployable.

3G technology is thought to have looming competition from wireless Ethernet.  In reality the sheer proliferation of cell technology will likely leave wireless Ethernet (a growth market in its own right) in suitable applications of concentrated infrastructure or “hot spots”.  On of the keys to converging standards and maximizing the bandwidth of wireless is something called TDD.

What is TDD?

TDD is short for Time Division Duplexing.  TDD allows a better utilization of bandwidth.  In simple terms, if you are connected to the internet via a cell phone you don’t need your information traveling onto the net as fast as you need to download information.  That is your request for the streaming video need not have the same bandwidth as the streaming video that will come back because of that request.  Net traffic is a burst environment.  By burst I mean it is slow at times and instantly very fast at others. Uploading files is a burst of data; entering a search word is not.  Downloading media is a burst of data; logging onto the server is not.  TDD allows the two lane highway of data to have two different speeds but handle bursts much better without always “over-dedicating” bandwidth for the burst speed.

Interdigital has key enabling patents in the area of TDD.  And it is TDD that will maximize bandwidth, converge standards and reduce costs while advancing cellular technology.  The real reason this is critical is because you cannot reasonably afford to have two way full bandwidth cellular connections which you don’t need.  Technology itself often helps to fix the financial bottlenecks of advancing technology.

All the freed up functional bandwidth that TDD enables will allow it to be sellable by a carrier or available as capacity.  TDD for capacity enhancement can provide approximately 50% savings in projected network capital and operating costs over a ten year period. In my view, with Interdigital’s strength in TDD the question becomes when does it happen and when will Interdigital’s stock reap the benefits of the enablement.  In my view it is a when, not if, question.  Time Division is a key enabler to the fundamental improvement in a ubiquitous technology. Add to that the fact that cell phone usage is growing and ubiquitous gives a such a network effect as to make a broad based deployment of Wireless LAN not a credible possibility to topple it for many years; if ever.

I mention Wireless LAN (WLAN) because another question in the technology markets is “can WLAN topple the cell phone as the wireless interconnection to the net?”  The answer to that one is not in any perceivable time frame that will matter to Interdigital.  The simpler answer is probably just no.  I’ll tackle WLAN vs. 3G in a separate topic later because it is interesting, useful for understanding and coincides with the continuous search that is leading me toward analysis of couple of WLAN enablers as well.

Financial

Current revenues are largely driven by four main licensees.  These are Ericsson, Sony Ericsson, Sharp and NEC.  Revenue from Nokia and Samsung will substantially increase the current stream of revenue once similar agreements are realized with these two companies as the agreement reached with Ericsson.

Earnings per share for Interdigital should exceed $2.25 per share in 2003.  This will reflect one-time effects from licensing settlement agreements however.  Earnings for 2004 will depend on license negations especially with Nokia which is why the stock is currently under some pressure.  Current estimates range from about $2.50 to over $4.00 for 2004 EPS.

On first glance of a trailing PE, Interdigital looks like a richly valued stock.    But take a closer look and you will see the power of patent this company is adding to the bottom line will quickly change that.  In an industry under capital pressure, Interdigital reduces capital requirements.  In an industry that needs to have bandwidth they enable bandwidth while reducing cost.  Interdigital has healthy profit margins, no debt, and a strong patent position in an industry that is reviving itself financially while experiencing constant growth.

In my opinion, Interdigital truly does represent a potential for incredible returns.  This stock could easily double within the next 18 months and move higher from there in the long term.