InterDigital, Inc. Q3 FY2020 Earnings Call

Good day, and welcome to the InterDigital, Incorporated third Quarter 2020 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Tiziana Figliolia. Please go ahead, sir.

Good morning everyone and welcome to InterDigital's third 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 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 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 31st, 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 Q3 2020. Finally, with COVID-19, the participants on this call are all in different locations. If there is a technical issue, I’ll just ask everyone to be patient while we exercise a pullback option. With that taken care of, I'll turn the call over to Bill.

Thanks Tiziana. Good morning everyone and thank you for joining us on the call this morning. I hope all of you are staying well and successfully finding a way through these interesting times. As for the company, we're certainly finding our way just fine. We had an excellent quarter and frankly, have had a fantastic year so far despite managing our way through the COVID crisis. That includes steady progress on the licensing front, where in October, we signed our ninth license agreement since Q3 2019. That includes a larger license on the wireless side and a number of small licenses, where the amounts in play result in less friction, but where we nonetheless stick scrupulously to our FRAND commitments. Rich will provide an update on our strong financial results. I want to spend time highlighting two areas where InterDigital's leadership is showing through this year, namely licensing practices and long-term technology development, in this case, 6G. As for the first, it's been a truly remarkable year in terms of the pendulum swinging back toward the middle in the patent regulatory environment. Now, I say the middle for a reason, throughout my time in InterDigital, we have always approached licensing the same way: it just needs to be fair and not undermine the great cooperative and innovative work done by engineers around the world. Those engineers, including ours, bring their best inventions in a form that historically was blind to culture, race or geography; what mattered was the quality of the invention and innovation. As a result, the best products for customers are created in a highly cooperative yet competitive environment with amazing speed. Licensing should not undermine that incredible process. So, a company should be transparent and morally consistent about their licensing practices. A company should have reasonable and fair discussions on licensing with the intent of actually getting deals done. When there is a dispute around licensing terms, there should be an efficient and fair process for resolving that dispute. Also, if the patent holder abuses its patent position, there should be a penalty, but also, when a product manufacturer refuses to negotiate in good faith, there should be a penalty for that, too. In short, our deal is simple: create incentives for good behavior, create penalties for bad behavior, driving companies to resolve licensing disputes in good faith on fair terms in a reasonable time frame, further incentivizing innovation for the benefit of all consumers. 2020 saw great progress on this front. After years of being almost a lone wolf in the wilderness on some of these topics, we saw a significant number of judicial decisions that brought fairness, pragmatism, and realism to wireless licensing. Let me recap them. In the U.K., we saw the Supreme Court affirm that to avoid an injunction, while they needed to take a worldwide license under the Unwired Planet portfolio. In doing so, the court recognized that forcing the SEP holder to sue the infringer on every patent in every country is fundamentally unfair, referring to it, in fact, as madness. They also found that the process would not be unfair to Huawei as its only obligation would be to pay for the use of patents on fair terms determined by the court. In Germany, a court found that by refusing to engage in good faith in a license discussion, a product manufacturer can correctly be labeled an unwilling licensee and may lose their right to a FRAND license. In an Indian case involving Interdigital, a Delhi High Court enjoined Xiaomi from enforcing the terms of an anti-suit injunction against Interdigital. As part of its decision, the Indian Court noted significant intentional suppression of facts and misrepresentations made by Xiaomi to the court. In a U.S. case involving Qualcomm, the Ninth Circuit found that antitrust law has little application to FRAND disputes, which are fundamentally contract disputes and should be treated as such. Most recently, the German courts have issued multiple injunctions against Daimler for the sale of infringing vehicular products, where Daimler had the opportunity to secure a license on FRAND terms but declined to do so. We also saw the U.S. Department of Justice discard a prior competition policy that's effectively protecting infringers of FRAND encumbered patents and instead adopt the policy that properly balances the interests of patent holders and implementers. Collectively, these decisions represent a global sea change in terms of the enforceability of standards-related patents. They are also a direct result of the leadership we have brought to bear, whether it was around in advocating arbitration, transparency or as a last resort, strategic litigation. In their collective weight, we expect these decisions to force companies to behave more rationally and to negotiate in good faith. And while it is still early in terms of the impact, they should start to reduce the need to litigate. This should hopefully lead SEP disputes from moving from the first hit on your Google search on patents to somewhere lower on the stack and ensure that the licensing process does not undermine the success of the technology development process that has given us the incredible devices we all carry today. Of course, there's still work to do to achieve this end result, in particular with the Chinese manufacturers. As we have seen on so many fronts, the Chinese manufacturers want to play by their own rules. Some of them, like Xiaomi, continue to resist licensing at reasonable royalties. But now, perhaps more than at any time before, we have the tools and the international support to better deal with these unwilling licensees. For example, we have litigation ongoing in the U.K. against Lenovo, where the outcome should be a worldwide license on FRAND terms. Also against Lenovo in the U.S., we have the U.S. DOJ supporting our motion to dismiss Lenovo's unsupported antitrust claims. We have litigation ongoing with Xiaomi to ban their sales of willfully infringing products in India. And we also have domestic and international support against China's blatant and unlawful attempt to control the determination of cellular patent license rates. All these tools will be very useful in securing licenses from these companies on fair and reasonable terms. Indeed, I think a good part of the momentum we are seeing today in licensing programs, including the signing of Huawei, ZTE, and others, is a direct result of this new atmosphere. Separately, on 6G, and yes, I said 6G, the company and Northeastern University were organizers of a recent 6G symposium, the purpose of which was to talk about lessons learned from 5G and what 6G should be all about. It's one of the things I love about this company, our long-term view. Well, apparently, others love the company's view as well. The virtual event gathered speakers from around the world, including Ajit Pai, the FCC Chairman, with whom I had the opportunity to have a fireside chat during the conference. Dr. Mazin Gilbert, AT&T's Senior VP for Advanced Technology gave a keynote address on his vision for 6G. A host of movers and shakers from the leading companies and research institutions in the industry provided their insight on what 6G can do, including the sustainability and environmental impact of this new technology and how it can impact the sustainability goals of other industries. Amazingly, over 4,500 people registered for the event and thousands attended the various panels and keynotes, including roughly 250 people from government and the military and over 400 leading academics. Based on what we know and can measure, that is 10 times more than any other 6G event that has been organized to date. Like the change in the licensing landscape, the speakers, the quality of the presentations, and the number of attendees speak to InterDigital's technology leadership and the high reputation it holds in the industry. We are thrilled to shape the next generation of technology just like we have shaped every prior generation of wireless and video technologies. In sum, while it has been a challenging year for all the reasons we know, it has been a really good year so far for the company. With that, let me turn the call over to Rich.

Thanks Bill. From the beginning of Q4 2019 to the end of Q3 2020, we have signed eight patent license agreements, including agreements with Huawei and ZTE. These new agreements helped drive a 21% year-over-year increase in recurring revenue in Q3, which, in turn, drove a quadrupling of our operating income to over $15 million. As Bill noted, we also added a 9th new license, when we signed another small mobile contract early in Q4. While many of the new licenses we have signed over the last year have been smaller CE deals, our total revenue from consumer electronics in the little more than two years since we acquired the Technicolor portfolio is now over $40 million. At that same time, we are excited that this only represents a small fraction of the CE opportunity, and we look forward to progressing toward our goal of $150 million of annual recurring revenue from CE. We'll provide our expectations for Q4 revenue in a few weeks after we have received our Q3 royalty reports. But as a final comment on revenue, we expect that for the 12-month period beginning October 2021, we will recognize an additional $7 million of revenue per quarter under an existing contract, where an early termination provision has lapsed. Moving on to operating expenses, we managed to keep our expenses flat despite our prior expectations for an increase driven by litigation and revenue sharing. As it played out, our litigation expenses were also flat, and our revenue share expenses were a little over $1 million. Excluding these two items, we achieved a $1.5 million sequential reduction in all other operating expenses. Looking forward to Q4, we are expecting that activity in our litigations could drive an overall increase in operating expenses of about $5 million over Q3 levels. As a final comment on the P&L, we had a largely one-time benefit of over $18 million in the quarter, due to an amendment of a prior year tax return and the reversal of a tax reserve. This drove a negative effective tax rate for both the quarter and year-to-date periods. We expect an additional much smaller benefit in Q4, but overall, we expect a positive effective tax rate in Q4, in line with our long-term expectations of roughly 15% to 17%. Finally, we delivered another strong quarter from a cash flow perspective with over $85 million in free cash flow, bringing the year-to-date total up to $117 million. I'll now turn it back over to Tiziana.

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

Thank you. We'll go to our first question from Ian Zaffino with Oppenheimer. Please proceed with your question.

Hi. Great. Thank you very much. The question will be on the video side. Maybe if you could talk about some of the developments that are going on there, establishing pools or maybe some of the negotiations with existing customers to start getting paid on the video side? Thanks.

Sure. As you mentioned, there are various initiatives in progress. We have a partnership with Madison focused on licensing, which is primarily a one-on-one approach. Additionally, we're exploring consortium-based licensing opportunities in China, similar to past successes by Technicolor. Regarding HEVC, that's a separate initiative, currently one-on-one, but there's potential to work within a collaborative pool there as well. On the consumer electronics front, we might consider a broader strategy for Wi-Fi licensing. All of these efforts indicate the evolving nature of our licensing business, which is transitioning from a focus on one-on-one deals to include pool formations and strategic partnerships, while still allowing for individual licensing. We maintain flexibility in our licensing approach and will choose the best strategies as opportunities arise.

Okay, great. And then just as a follow-up. Have you taken any other actions on the Chinese manufacturers just yet other than Xiaomi? Maybe an update on Lenovo?

Yes. The main litigation we have ongoing includes actions with Xiaomi and, although not in China, also with Lenovo. The most significant aspect regarding Lenovo is the U.K. action, which aims to secure a worldwide license on fair terms. There will be a couple of technical trials first, followed by a FRAND trial as the third. The litigation schedule can be found in our financial reports and appears to be solid and reasonable. Other situations, like what's happening in the U.S., are relatively minor. In the U.S., we've moved to dismiss the antitrust claims, which were recently argued, and we'll await the judge's decision. There have been other motions in that case as well; however, I'd emphasize that this case, while important, is secondary to the U.K. case. If we succeed in the U.K., it will resolve the main issue.

Okay, great. Thanks for the color.

Thank you.

Thank you. We'll move on to our next question, and that is from Eric Wold with B. Riley Securities. Please go ahead with your question.

Thank you. Good morning, guys. So, a couple of questions. I guess, one, kind of following up on the kind of the litigation question, but kind of more on kind of a broader sense. I'm trying to get a sense of kind of how a win with one of the entities would impact kind of future efforts if those efforts are necessary. As an example is, I guess, assuming you get a successful win against Lenovo in the U.K. and the judge is getting a global license direct per what the courts are kind of pushing towards. What does that infer to kind of future efforts in those courts? Does the court basically then look at that and say, we're not going to hear similar cases and make those similar cases go quicker? So, I'm trying to get to how that would impact other cases besides Lenovo itself, in that example.

Certainly. The case you mentioned is an excellent illustration of how establishing precedent can be significant. We believe we presented a robust case in the U.K., backed by strong patents and substantial evidence concerning our license agreements. Our expectation is that this will result in a solid license agreement with Lenovo, including a defined rate. As for its implications for future licensees, there are a few key points. If we were to pursue another case in the U.K. against a different party, my understanding of U.K. legal practice is limited, so I cannot predict the exact impact. However, it would likely be beneficial since we are addressing the same patent portfolio, compelling the other party to justify any differing outcome. This would essentially set a benchmark, established by the court, which is quite significant. Additionally, in other jurisdictions, such as China where we are currently engaged in rate cases, if we face decisions similar to those of the past that seem erroneous, this U.K. benchmark will be critical in illustrating that those decisions were biased. Regarding the antitrust matters we are managing in Delaware, the 9th Circuit has largely dismissed such claims in similar scenarios, while the Third Circuit possesses some older precedents we need to distinguish. However, if we are successful, we may present compelling arguments that simplify future litigations. Ultimately, the motivation for litigation stems from uncertainty, which justifies the associated costs. As we reduce that uncertainty, the nature of the cases becomes clearer. Instead of potential antitrust issues, we would strictly deal with contractual matters focused on rates. With InterDigital achieving judicially confirmed benchmarks, the uncertainty significantly decreases, resulting in a marked reduction in the incentive to litigate. This outlines our current position where we anticipate a surge in litigation activity, but our goal is to eliminate uncertainty. If it takes litigation to achieve that, we are prepared to proceed, as we believe that the evolving regulatory landscape and outcomes of these cases will foster a more predictable environment and diminish the reasons to engage in litigation.

That's helpful. Thank you. I would like to focus on the LG license that is set to expire or be renewed at the end of this year. I am not asking for your specific comments on your discussions with them regarding the renewal, but could you provide a broader sense of how your relationship has evolved since the 2017 agreement, particularly in terms of the relevance of your cellular IP, technical IP, and video IP to their product lineup?

LG has been a licensee since 2005 and is an outstanding partner. We expect them to remain a licensee, although there might be occasional gaps in the licensing. We're working to minimize these gaps, but if one occurs, it is not a major issue. Regarding LG's mobile business, it is smaller now than previously, but they remain committed and have recently introduced a new product line. Their units being produced are lower than before. We have a different array of assets now, including our 3G, 4G, and new 5G portfolios, alongside our HEVC portfolio, which adds more value. Additionally, we have separate negotiations regarding televisions, which could be pursued independently or combined with other deals. LG is aware that it is navigating a different litigation landscape than three or four years ago, where achieving a license is more straightforward. Our goal is to show them that there is minimal uncertainty in our licensing terms, with established rates that reduce any incentive to litigate. We also have greater opportunities for collaboration on R&D with them now. Overall, we are in a stronger position compared to previous dealings, and we intend to continue our successful licensing relationship with LG.

Last question. Essentially, zero shares you purchased year-to-date. Is that more a function of the uncertainty around COVID and just preserving the balance sheet with that uncertainty or is it more around preserving a balance sheet around litigation efforts?

Yes. So, I'll take that, Eric. It's a little bit the former like a lot of other companies in an uncertain environment, valuing cash. But the secondary impact, but I don't think this is anything different than I have been saying over the summer, would be keeping some dry powder for any opportunities that may come up in this unusual set of circumstances.

All right. Thanks Rich and Bill. Appreciate it.

Thank you. And we'll move on to the next question, and that is from Charles Anderson with Colliers Securities. Please go ahead with your question.

Yes, good morning and thanks for taking my questions. I just wanted to follow up on, Rich, I think in your prepared remarks, you talked about an incremental $7 million, and there was a reference to October of 2021. So, I wonder if you could just elaborate on that, all the puts and takes involved in what's happening there? And then I've got a follow-up.

Yes, I'll try to elaborate. As you know, Charlie, with our agreements, there's a strong confidentiality provision. So, I'm limited in the extent I can do so. But the first thing I do is refer you to our 2019 10-K. We have descriptions of our larger agreements in there. Certainly, we had a situation before with Samsung, where there was a rate to terminate early, and that wasn’t exercised. So we have sometimes similar provisions and other agreements. Now that that has lapsed and was unexercised, for this particular agreement, we have better insight into the full term of the agreement and our original accounting model. In this particular case, it could not assure that it would lapse. There's a pretty high standard for that. Now, that it has lapsed, the impact of that will be from October 2021 for that 12-month period; we'll have another $7 million a quarter.

Okay, did that effectively change the term of the agreement, Rich?

So, it didn't change the term from our perspective. Even though this wasn't necessarily how we accounted for it. Again, because of the threshold of probability you need to meet. What we had signed was an agreement that runs a certain term and there was an option to terminate a year early in this case. So, that option no longer exists.

Okay, perfect. And then I noticed your variable royalties were up significantly year-over-year after being down in the first half of the year. I know it was sort of the reverse on tech solutions. You were down after being up. Just curious if that was reflective of what's happening in the market or was that sort of true-up activity related to what happened in the first half?

Yes. We discussed the agreements we signed year-over-year, many of which were smaller variable agreements. That's a contributing factor. There's always a minor adjustment factor involved. So, I would say it's a mix of both, and the new agreements certainly played a role in that.

Okay, great. And then last one for me, Bill. Clearly, what we're seeing in China is a bid to take market share from Huawei given all their export issues or export restrictions. It feels like there's a land grab going on out there, and I imagine that extends to not just China, but outside of China from some of the parties that you don't have under license. I'm sort of curious how you view this as an interesting strategic window in time to engage with them relative to other periods. Thanks.

I agree, Charles. You're absolutely right. We have indeed lost considerable market share outside of China, which companies like Xiaomi have capitalized on. Europe, in particular, has emerged as a significant growth area for them. Interestingly, their growth is occurring in regions with strong intellectual property systems. While they have seen some growth in China, the majority of their expansion will be outside of it. To sustain this growth, they will need to secure licenses; otherwise, we will pursue sales in locations where it is appropriate. Xiaomi and Oppo are gaining traction outside of China. The situation within China remains somewhat unclear, but that will become clearer over time. There's a speculative element regarding the actual market share these companies will capture. Periods of forecast uncertainty can actually present good opportunities for licensing, as both parties can interpret forecasts differently and find a mutually agreeable number. I believe we have that opportunity currently, but as forecasts become more defined, the flexibility around that uncertainty will diminish.

Perfect. Thank you guys so much.

Yes, Charles.

Thank you. We'll move on to our next question from Scott Searle with ROTH Capital. Please go ahead with your question.

Good morning. Thanks for taking my questions. Rich, I would like some clarification on the tax benefit. I believe you mentioned an $18 million total for the third quarter and the current quarter. Can you provide an estimate of how much of that we saw in the third quarter on a normalized basis?

Yes. To clarify, the $18 million pertains entirely to Q3. We anticipate that there may be a slight adjustment; we're referring to it as a one-time item, but when recognizing the provision for the year, you need to consider various elements over time. We foresee a much smaller benefit in Q4. Ultimately, this is mostly an estimate, and there may be a slight adjustment regarding that estimate. Looking ahead to Q4, we expect to be in the range of our typical long-term rate, which is between 15% and 17%.

Got you. Thank you. And maybe to follow-up on Charlie's question related to variable per-unit royalties being higher in the quarter. I think you referenced earlier in the call that now you've gotten up to $40 million in total CE revenue since acquiring Technicolor. Can you give us an idea of what CE looks like in the third quarter? And maybe remind us what the time frame is of getting back to that $150 million in annualized revenue on the CE front? And maybe as part of that, give us a quick update in terms of IoT and Avanci.

CE for the quarter was just over $3 million. When annualized, it’s probably around 10% of our $150 million target. Although we may not fully reach that on an annualized basis, the $40 million figure includes some past sales. I see this as a positive indication that we’re closing deals and confirming the market rates. Our new deals really picked up around December last year, so it took some time for us to establish our new portfolio. While we don’t set specific timelines, we aim to progress as quickly as possible. Ultimately, the priority is securing the right deals, even if it takes longer to maximize the benefits of previous sales. We hope to make further advancements, which will necessitate significant contributions from larger manufacturers, especially in TD, while also pursuing smaller deals. Regarding your second question, I can update you on IoT and Avanci.

Correct, IoT and Avanci? Yes.

Yes. Well, I don't have those numbers at my fingertips, but they're contributing, but still at smaller levels. That's another area where the larger opportunity lies in front of them.

Got you. And lastly, just two quick ones to follow-up. Could you give us a time frame now with India and Xiaomi? What is the current timeline to have some sort of conclusion or moving towards a resolution? And lastly, given the current presidential implications, the existing administration has been very supportive and aggressive from enforcing intellectual property in China. Any thoughts in terms of if there's a change within the White House, does it change any way in terms of how we're engaging with China as it relates to intellectual property and otherwise? Thanks.

Sure. I’ll address the second question first. China is no longer just a partisan issue; it has become a bipartisan concern. The Trump administration clarified that China had no intention of collaborating with the world or opening up a completely free market, and that understanding is now widespread. I anticipate that the Biden administration would maintain a similar approach, and I believe the Trump administration would do the same as well. While they might use different methods, there is a general consensus on the need to address China. Regarding patents, the negative narrative surrounding patents has lost its credibility. The mom-and-pop coffee shop analogy used by Google and others no longer resonates. Companies like Google and Facebook, known for their anti-patent stance, don't seem to enjoy support from either political party. I doubt this will change significantly. In a Biden administration, we have Chris Coons, who is a close ally of our company and a strong supporter of patents, which could influence the administration positively in that regard. As for the timeline concerning litigation with Xiaomi, there are cases in India and China that will progress at their own pace. The case in China will likely move quickly once it starts, although it shouldn't, given the way things operate there. The situation in India is expected to take a couple of years, with outcomes that could be injunctions or licenses. Litigation is not about reaching an endpoint; it's about clarifying information and applying pressure, ultimately leading to negotiation. An important tool available now that wasn't before is the risk Xiaomi faces in Germany if they do not negotiate in good faith. Germany has stated that lack of good faith in negotiations can lead to losing the right to a license, which poses significant growth risks for Xiaomi. Litigation is merely one tool among others, and our role is to leverage these tools effectively to reach a solid licensing agreement with the customer.

Yes. Just to add on to Bill's comments. Again, if you look at Huawei and ZTE, they were both in litigation that we started last year, and we were able to sign them at the end of last year and then earlier this year. It's not like these things always run their full course. They are fundamentally a means to an end.

Great. Thanks so much, guys. Stay healthy and safe.

You too.

Thank you. We'll take our next question, and that is from Anja Soderstrom with Sidoti & Company. Please go ahead with your question.

Hi everyone. Good morning. Thank you for taking my questions. I wanted to follow up on the litigation cases as well. It seems like there have been a lot of positive developments. Do you feel like the attitude among your counterparties has changed during this timeframe?

I believe that litigation will provide clarity over the next few years. Some licensees and potential licensees prefer to avoid litigation and seek a resolution with favorable terms. There are others who may want to observe the litigation before taking action. We need to ensure they realize there is no chance for a free assessment. For those currently involved in litigation, our goal is to change any misconception they may have about their strategic advantages. From an outside perspective, the litigation landscape may seem chaotic, but I see it as a critical period for resolution. We may already be seeing some shifts in attitudes, and as the cases progress, I expect more changes and greater clarity.

Okay. Thank you. And then just one housekeeping question on the CapEx. What drove that up for the quarter?

I don't think there was anything too specific other than just the timing of things. So, I don't think I have anything to add at the moment.

Okay. Thank you. That was all for me. Thank you.

Thank you, Ryan and thank you all for joining us today. This concludes our call. We look forward to giving you an update next quarter.

Thank you, ladies and gentlemen. This concludes today's conference. All participants may now disconnect.