InterDigital Looks Overrated

Last week, InterDigital (Nasdaq: IDCC  ) released word that it's in talks to settle an ongoing patent dispute with mobile-phone maker Nokia (NYSE: NOK  ) . Considering that InterDigital generates most of its revenue by licensing its wireless technology patents, and that Nokia is the world's largest handset maker, the news was quite welcome to shareholders.

The announcement follows a recent court ruling awarding InterDigital $134 million from Samsung. Samsung is appealing, but it's posted bond for the amount. If the appeal fails, the after-tax payment will be worth an immediate $2 per share.

InterDigital has a five-star CAPS rating, with most of the bulls citing the company's patent portfolio as a key reason to own shares. Has these players' day in the sun finally come?

Don't hold your breath
I don't think so. For one thing, Nokia can talk for a long time without actually coming to any agreement. Just ask Qualcomm (Nasdaq: QCOM  ) . Its last licensing agreement with Nokia expired nearly a year ago. The two companies finally quit talking this month, but only so they could continue in court, rather than in arbitration.

InterDigital has been through this before. In 2006, it received a $253 million settlement from Nokia for patent disputes dating back to 1999. Based on that example, this issue ought to be settled sometime before 2015.

So I'm not holding my breath in hopes that Nokia suddenly decides to play nice on patents. Meanwhile, investors who've held their breath have been rewarded with a stock that has gone exactly nowhere for the past five years, and is down around 37% from last year's level.

Valuation check
Trading at 50 times trailing earnings, InterDigital's valuation looks rich. Bulls like to point out that the consensus estimates expect $0.57 in EPS (43% growth) in 2008 and $0.80 (40% growth) in 2009. However, just three months ago, the same analysts expected 2008 earnings per share of $0.73 (83% growth), and $1.38 (89% growth) in 2009. For some reason, I have a hard time putting much faith in the consensus estimates.

A better estimate, in my opinion, would come from the company's reported results. InterDigital typically receives a cash royalty payment up front, then recognizes the revenue in future periods over the life of the contract. As a result, it initially books the license sale as deferred revenue. The change in deferred revenue can be an indicator of future sales trends.

In 2007, current (expected to be recognized within one year) deferred revenue grew by just 12%, well below the 43% expected growth this year. Total deferred revenue grew a healthier 31%, but that still signals potential disappointment relative to the current estimates.

Not-so-free cash flow
The most bullish argument, in my opinion, is that the price is low relative to free cash flow. Be careful, though, to include all of the appropriate costs.

For example, in 2007, cash flow from operating activity came to $152.7 million, while capital expenditures totaled just $13.8 million. The apparent free cash flow of $138.9 million would represent a 15% yield on the current market capitalization.

However, capital expenditures are not the only investing item Fools should deduct from InterDigital's cash from operations when calculating free cash flow. Capitalized patent costs of $23.9 million, made in 2007, were not recognized in cash from operating activity. That figure should be treated the same as capital expenditures, as should capitalized technology license costs of $24.4 million.

After deducting these expenditures, free cash flow comes out to $90.6 million. It may yield a still-generous 10%, but it's not quite as high as many think. Furthermore, with advance royalty payments accounting for a significant portion of this cash flow (more than $70 million in 2007), InterDigital's cash flow could decline if new license sales fail to match past levels.

This is a real possibility, since the 16% annualized growth rate in total worldwide handset units from 2005 to 2007 is expected to drop significantly. According to an exhibit in the company's latest 10-K filing, industry research firm Strategy Analytics expects total unit sales to rise from 1.21 billion this year to 1.36 billion in 2012 -- an annualized growth rate of less than 3%. InterDigital would have to grow revenue at a much faster rate than handset-unit sales to sustain its current estimates.

All in all, color me skeptical about a stock with declining estimates, a high valuation, and large discrepancies between its cash-based and accounting-based earnings.

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