InterDigital, Inc. Q2 FY2020 Earnings Call

Good day, and welcome to the InterDigital, Inc. Second Quarter 2020 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Patrick Van de Wille. Please go ahead, sir.

Thanks very much. Good morning everyone and welcome to InterDigital's second quarter 2020 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'll 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 during 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 our Annual Report on Form 10-K for the year ended December 31, 2019, and from time-to-time in 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. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our second quarter 2020 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 Q2 2020. Finally, with COVID-19, the participants on this call are all in different locations, some of which are experiencing significant weather events. If there is a weather-related technical issue during the call, I’ll just ask everyone to be patient while we exercise the pull back option. And with that taken care of, I'll turn the call over to Bill.

Thanks, Patrick, and good morning, everyone, and thank you for joining us on the call this morning. I appreciate that the world continues to go through a crazy period and I hope all of you are well and finding some time to relax. With that in mind, I am going to keep my remarks fairly brief today touching on the status of our licensing business, a quick update on the litigations, and then closing with some remarks on the company’s operations in light of the continuing pandemic. As for the business, we've proven once again how resilient our business model is, growing revenues by 15% during arguably one of the more difficult global periods in recent memory. While that revenue increase was driven partly by our renewed agreement with Huawei, we’ve also signed over half a dozen new agreements in the last three quarters, all of which have contributed to revenue. We also signed a small new CE agreement early this quarter that will contribute to third-quarter revenue. Licensing is also about momentum and we certainly have a good amount of that now. In addition to that licensing success, we continue to move forward with other potential licensees on both the mobile and CE side. All of that speaks to how well our now larger and more diverse licensing business is operating. It gives us confidence that we can deliver on the revenue goals we articulated for the different licensee programs. Of course, we occasionally do have a customer that simply refuses to negotiate. In the case with Xiaomi, despite years of effort by InterDigital, Xiaomi has failed to take the licensing initiatives seriously. This type of behavior we have never seen before. Xiaomi's success in the cellular handset market would not have happened but for cellular standards. There is virtually no upfront investment in developing wireless technology. We've provided to them, and furthermore wide cellular standard processes an incredible process that eliminates barriers to entry and enhances competition, benefiting product manufacturers and consumers alike. Essentially billions of dollars of research are made available to brand new market entrants, allowing them to quickly scale up production and become a market force. And that is exactly what Xiaomi did, and they have profited enormously. The only thing asked of them is that they pay a fair price for the billions of dollars in technology to which they have been given access. Xiaomi has failed to do so. Hence, we made the decision to bring a patent infringement lawsuit against Xiaomi in India, which we filed last week. Although, we actually filed two patent actions in India. The first is based on cellular inventions created by InterDigital. The second lawsuit is based on the video coding technologies developed by our R&I team, which we acquired as part of the technical transactions. The suit demonstrates the broader reach of the company’s innovations and the value that we believe we are due for the use of our inventions. Among other things, the lawsuit seeks injunctions against Xiaomi's sales of handsets in India, which is a significant market for them. Of course, we continue to be willing to enter into a license agreement with Xiaomi on fair, reasonable and non-discriminatory terms. We will also be willing to arbitrate the terms of the license, which is something we offer to all prospective licensees. What we're not willing to do is allow Xiaomi to use our technology without appropriate compensation. And as we said before, litigation tends to be the last option for us, which we pursue only when other options are exhausted. That said, litigation can be effective as our recent agreements with ZTE and Huawei show; the filing of litigation has been successful. Every company that we have ever litigated against has ultimately signed a license with us. We believe that Xiaomi and Lenovo will do the same. Next, let me touch quickly on the overall operations of the company in this period. As is evident from the financial results, we continue to operate well. The company remains in a remote work mode and will remain so at least until the fall, depending upon the status of the pandemic at that point. We will reopen the offices consistent with all safety best practices for doing so, but we'll maintain the remote work option for all of our employees for the foreseeable future. Our employees have been highly productive working from home, and we have also been very effective at recruiting new talent and integrating them into our employee population. So we don't see the need to rush back to the office. That said, we have a subset of employees who prefer an office environment, so we're looking for the best way to balance these different interests. As I said, I thought I'd keep it short. We've had a great first half of the year, and we're looking to repeat that success in the second half of the year. With that, let me turn the call over to Rich, our CFO, for discussion of the financial results.

Thanks, Bill. We delivered strong top-line growth in Q2, bringing us in at the top end of our ranges for both total and recurring revenue. This growth was driven by new agreements, including our recent patent license agreement with Huawei. As noted in our 10-Q, as well as in the financial metrics published on our website this morning, Huawei made up approximately 30% of our total revenue in Q2, including contributions to both recurring and non-recurring revenue. The contributions from these new agreements were partly offset by our estimate for a sequential decline in per unit royalties of about 20% from Q1 to Q2. This represents our best estimates for the impact of the current health and economic climate on our customers’ Q2 sales of royalty-bearing products. As is always the case, we will true up all the estimates next quarter when we receive the related royalty reports. Our Q2 operating expenses increased $1 million from Q1. This increase was driven by an expected $2 million charge to step up compensation accruals based on newly signed patent license agreements and a $2 million increase in litigation expenses, both of which were offset by one-time and other cost reductions from Q1. The increase in litigation expense reflected increased activities in our series with Lenovo and our recently filed patent infringement case against Xiaomi in India. We currently anticipate our Q3 operating expense could increase in the $2 million to $4 million range driven by additional litigation expenses and revenue sharing within our CE portfolio. Let me take a moment to discuss our cash flow in some detail. Recently, I've received a number of questions about our cash flow and how it relates to our revenue in the given period. We reported free cash flow of $60 million in Q2; this is a $95 million increase over the $35 million cash outflow we reported in Q1. Many of you that follow us recognize that such quarter-to-quarter variation is not unusual. Over 90% of our revenue comes from fixed-price agreements. Such agreements typically have prescribed payment schedules. Some agreements call for quarterly or annual payments to be spread evenly over the term of an agreement. Others might include an uneven payment schedule that is, for example, front-loaded to a degree. Ultimately, these payment schedules result in a timing difference between when we recognize revenue and when we collect the related cash payments. To the extent the payments are front-loaded, we recognize a deferred revenue liability. That liability is then reduced as we recognize revenue over the balance of the agreement. The sequential increase in cash flow from Q1 to Q2 was driven in part by the collection of approximately $100 million under agreements signed over the last three quarters. These payments covered the $20 million of non-recurring revenue as well as recurring revenue we recognized from these customers in Q2. It also represents a partial payment for the royalties due over the remaining terms of these agreements. This is a big reason why we also see deferred revenue and long-term deferred revenue collectively increased by $50 million from Q1. In fact, you can look at the total deferred revenue balance of $280 million as the total amount of cash we have collected to date related to future periods under signed agreements. As a final comment on this topic, we sometimes accept non-financial consideration as a component of the consideration due to us under patent license agreements. Overall, this is a very small percentage, averaging just 5% of our total revenue over the last three years. All of this illustrates that while recurring revenue is such an important measure for our business, and while the free cash flow generated or used in any given quarter must be taken in context. Finally, moving on to taxes, our recent agreements helped drive a level of profitability sufficient to somewhat normalize our effective tax rate, coming in at about 20% for the quarter and 27% year-to-date. With continued success and expanding our revenue platform, we still expect our long-term tax rate to be roughly 15% until about 2026. And we expect it to increase to about 18% based on prescribed changes in the outlook. I’ll now turn it back over to Patrick.

Thank you, Rich. Thank you, Bill, and we will now open the call for questions.

Thank you. We'll pause for a moment to allow everyone the chance to ask questions. Our first question comes from Ian Zaffino at Oppenheimer.

Hi, thank you very much. I'm glad to see you guys are going after the patent enforcement pretty aggressively. Can you maybe give us some color on some of the other companies that are not paying right now? Are those close to litigation? Or are you presently just in negotiations, and what you'd expect as far as the remaining ones? Thanks.

So Ian, let me just thank you for initiating coverage on the company; we obviously appreciate that. And we welcome you to the first call as an analyst for the company. Yes, in terms of patent enforcement, I guess I'm wondering, there is a breaking point with customers sometimes that we just say that we've exhausted all options and we move ahead to litigation as we did with Xiaomi. The other customers, we have no reasonable engagements with them. They vary obviously between customers, and a lot of thoughts go into why we bring litigation at particular times. That decision is related to the company against whom we seek litigation, but there could be other strategic reasons as well. Whether we would commence additional litigation, either against the current folks with whom we're in litigation or new litigations, we take into account a lot of factors in making that decision. It's not something we do lightly. I always hope that we can secure agreements without resorting to litigation because there's a cost to litigation, and if you can avoid that cost, that's a good thing. But also, at some point, you have to ensure that you get people on the paying side of the ledger. So we'll see how it all plays out. The current litigations, I think are well-established meaning we've got good patents in these cases, and I think we will have good schedules to move forward on. They're also just part of a larger discussion with any licensee. So with Xiaomi, it's not going to be just all about litigation; we obviously would continue to engage with them in other ways and seek to reach an amicable result if that's their desire.

Thanks for that color. And just as a follow up, you guys are sitting on a lot of net cash even above and beyond what you need to run the business. So what are you thinking here as far as capital returns? You've typically bought back a lot of stock in the past. Where is your head now? What are you thinking as far as buybacks and dividends, specifically on buybacks? Thanks.

Yes, and I'll be happy to take that. So, yes, you're exactly right that we have a very strong history of returning capital to shareholders through dividends and especially through buybacks. I think it's more than $600 million over the last five years or so, including almost $200 million last year. And like a lot of companies in the current environment, we value cash right now, given the overall uncertainty that exists in the broader market, but also for us the potential for opportunities to invest in ways that could drive the utmost value for our shareholders. So, that's kind of our current posture right now, but this continues to be a topic as I always say it is every time we get together with the Board.

Our next question comes from Eric Wold, B. Riley.

Thank you. Good morning, guys. A couple of questions. Bill, can you maybe just talk about the rationale of filing the suit against Xiaomi in India? I know you mentioned obviously it's a big market for them just trying to get a sense of the benefit of that market versus the U.S. and the U.K., and whether the Indian courts are going to share the same stance toward global licenses like U.K. courts do.

I believe the Indian courts represent a significant market for us. The purpose of legal action is to ensure that the opposing party takes this matter seriously. Pursuing litigation in a crucial venue for Xiaomi helps achieve that goal. Early in the cases, Indian courts provide opportunities for preliminary injunctions, as well as bonding and escrow requirements, which can also lead to favorable outcomes. So far, the Indian courts have handled many matters related to this issue fairly, which is all we seek; we just want a level legal playing field. The Indian courts appear to be managing these cases effectively. Despite global pandemic challenges, they have been progressing these particular matters at a reasonable pace. For all these reasons, it was a beneficial decision. This also highlights the diversity of our portfolio, both technologically and geographically, allowing us to take legal action in various countries when necessary.

Now, once you get into your litigation strategy on a public call like this, but is there a thought on the global license versus single-country licenses? Would you ever stray from that if there's a market large enough for a single entity? Or would that hurt the negotiations for the larger global licenses you have?

Yes. It's a slippery slope. If you think about mobile devices, what's the nature of a mobile device? It's designed in one country, parts are sourced from another country, manufactured in a third country; it's sold in the fourth country and used in 20 other countries. The whole concept of a license that just covers one country is a difficult concept. I'm not saying impossible, but we've always taken the view that a worldwide license makes the absolute most sense here. I think the other approach does not really have a strong rationale. And that’s why we’ve been very adamant like other patent holders out there, it’s all about a worldwide license. If you think about the standards themselves, they don’t enable sales in a country. The nature of the standard is that it enables sales worldwide, so the license should fall in line.

That makes sense. And last question for me on the CE side, I guess you previously signed setup boxes and TV licenses. First question is, what end-market was the CE license you mentioned signing in Q2? And how should we think about the smaller licensees providing a tailwind towards larger licenses? Do the bigger entities consider these smaller deals as relatable and providing framework, or do they think they are more irrelevant?

Yes, so I'll go with the last question first. I think every deal becomes important for two reasons, right? They contribute to revenue, which is great. Second, when I go to a customer, an unlicensed customer, they provide validation because sometimes even though deals may be smaller, the companies that signed the deal are big, and therefore they don't give away significant sums of money for no reason. You can use those as benchmarks in negotiations with other people. The third piece is important too; when you go to litigation, all of those agreements become important. It’s because you’re actually in litigation this idea of significant volume discounts, there are some limits on that. So I think they're all important for those reasons. They provide price validation, patent validation, and usable materials in litigation. With regard to revenue contributions, I’ve been discussing the $150 million top-line goal we have for that business. We're roughly 10% of the way there. This will ebb and flow quarter-to-quarter because it is more per unit in nature. It is going to depend on our underlying customer sales. To put that into perspective, in the current quarter, when we are estimating a lower level of per-unit royalties, we also had some true-ups that reduced revenue for the current quarter. These haven’t changed like day-to-day, but they do set us up for more deals and further traction, and eventually, that begins to pile up.

Yes, and as for the most recent deals, I believe it was televisions.

Our next question comes from an undiscernible analyst.

Yes, thanks for taking my questions. Congrats on a great quarter. So, wanted to start with OpEx. Rich, I wonder if you can provide a little extra context here. I think you alluded to a $2 million to $4 million bump. I think I heard that right, that was sequentially. I know there was a performance-based comp increase embedded in Q2, around $3 million or so. So my thinking about this right, that it's actually a natural $6 million move up. And I know there was a revenue share component. Can you speak to how much of this lift is related to that and then I have a follow-up?

Yes, so at this point, there’s not too much more I can add. We typically don’t provide much in expense guidance, but we have a movement or charge that we anticipate. We have to do a little bit more than traditionally given the acquisitions and the kind of impact that has on the P&L. But, again, litigation is definitely a factor there with the recent cases picking up a little momentum, as well as now having a new case that was just recently filed. There’s typically going to be some runoff prior to filing a case. So it’s not as if it's not in Q2 at all, but not to the level that we'd expect it to be in Q3. So that's definitely a component, probably the biggest component of it. And then there are some smaller non-recurring items.

Okay, great. And then Bill, just thinking big picture about the ability to get the rest of China under license, obviously great progress with Huawei and ZTE, but I'm curious from your perspective. Is there anything over the course of the next year you see as maybe an external factor, whether it be 5G phone launches or otherwise that could cause some of those negotiations to hit the realms of normalcy?

Yes. There are multiple factors to consider. For instance, taking legal action or even threatening to do so can be beneficial. Our lawsuits against Huawei, Lenovo, and now Xiaomi clearly demonstrate that we are prepared to protect our intellectual property, which sends a strong message. However, I'm not convinced that the 5G launch or similar events will directly influence negotiations. On the legal front, there has been a significant development in Germany that has positively affected the industry. It creates a guideline stating that if a customer utilizes the innovation but fails to negotiate honestly with the patent holder, they might not be able to rectify that situation later. They cannot infringe on the patent and then make an offer; there could be severe penalties for negotiating dishonestly. Similarly, patent holders also face harsh consequences for bad faith negotiations. I believe the framework established by the German courts is well-considered, and it could greatly affect negotiations. If we can conclude agreements with Xiaomi or Lenovo, backed by litigation, it might encourage others to engage as well. Given the increasing emphasis on China's respect for intellectual property, it's crucial for us to continue proving our commitment to licensing.

Okay, great. Thank you so much for the call. I appreciate it.

Thanks, Charlie.

Our next question comes from Scott Searle, ROTH Capital.

Hey, good morning. Thanks for taking my questions. Rich, did you provide a number for video or Technicolor in the quarter? I have a couple follow-ups on India and China.

Yes, we’ve been kind of operating at roughly a $15 million annualized pace. Even with new deals, we're trending a little below that this last quarter due to a couple of true-ups related to our estimates for Q1 that were booked in Q1, and the actual reports that came through in Q2.

Great, perfect. And on the India front, could you give us a better idea of what the timing is of the Indian legal process in terms of injunction and otherwise? What can we expect in terms of the cadence of the litigation?

Yes, I think people have their self-disclosure in the queue around the case. Generally, it moves and it’s a little quicker on the front end. There are things that occur early on in the cases, such as preliminary injunction requests and also requirements for bonding and escrow that could expedite the process. After that, the timing has some unpredictability, similar to other courts. But the front-end process is important; it can potentially encourage Xiaomi to take negotiations seriously. I believe the process will develop further, and we can follow up on this as it progresses.

So just to follow up on that point, is there a timeline or a decision date associated with the injunction because that seems like it's the real trigger point here to get them to the table? Is that something that would be decided this year?

I don't know the specific timeline. I'll have to go back and look at the disclosures we've previously put out, but I sense that it will be relatively quick. So with that said, I think it’s a good thing.

Fair enough. And then to transition over to some of the larger China-based OEMs. In particular, Vivo and Oppo. You've seen Huawei get a lot more aggressive within the domestic market. Given the limitations on using certain Android features internationally, it’s translated to a meaningful increase in share from the first quarter to the second quarter. So I'm wondering if this licensing agreement with Huawei, in combination with the Xiaomi litigation, is changing the tone or cadence of engagement with Vivo and Oppo, particularly now that it seems like they're shifting more of their attention on the export front.

Yes, I think you're right. Huawei has focused on the domestic market, which has pushed others into seeking new avenues to grow their businesses. They'll go to the places we can't penetrate, such as India and Europe. Historically, as companies have moved into regions where IP enforcement is stronger and more predictable, they tend to take licensing issues more seriously. There are regulatory pressures that can also influence engagement levels. I feel the level of engagement is good, and when we feel it’s not, the company will not hesitate to bring appropriate lawsuits.

Great. Lastly, I’d like maybe a quick update on IoT. What are you seeing on that front? I know it's early stage and has taken longer, but it seems like the COVID environment highlights constant connectivity and optimization of connected devices. So, I’m wondering if there are any updates as we head into 2021. Does that become measurable in terms of results?

Yes, I think you're correct; while the IoT market has not accelerated as quickly as anticipated, the direction is clear. The need for connectivity is more apparent due to the pandemic. The platform has had some success and is seeing licensing uptake. Their litigation in Europe is being managed well, and they seem poised for growth. The challenge has always been how quickly devices roll off production lines, and how effectively we can advance licensing. We feel confident about where we are, and it's just a matter of time until it starts to gain the momentum we expect.

Great, thank you.

Our next question comes from Michael Cohen, MDC Financial Research.

Yes. Hi, Bill, thanks, and congratulations on the quarter. I was wondering if you could share the names of some parties that are not fully licensed that you would like to have under license besides Lenovo and Xiaomi?

So it primarily involves the Chinese manufacturers, such as Oppo, Vivo, and TCL. These are the major players that we want to license. There have been smaller players outside of China, but they are relatively small. So I think the ones mentioned are the key drivers to our revenue target.

And we saw the U.S. government's Department of Justice filed a statement of interest in Qualcomm's case and now we've seen it filed in your case against Lenovo. I was wondering if you have any comments on that.

Yes, I think the DOJ has taken an interest in ensuring that antitrust laws are not abused or applied beyond their intended purpose. The DOJ has been an advocate for maintaining discipline in the use of antitrust arguments, which is why they filed a statement in our case. We are happy to see their support. Ultimately, these disputes are straightforward, often revolving around contractual disagreements. If both sides negotiate in good faith, we can reach resolutions without the complexities that have sometimes clouded these discussions. I'm hopeful that this simplifies the issues at hand.

There are no further questions in the queue at this time.

Okay, well thank you very much, Travis, and thank you for joining our call this quarter. We look forward to giving you an update next quarter. Thanks, everyone.

Thank you, ladies and gentlemen. This concludes today's teleconference. You may now disconnect.