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InterDigital Inc  (NASDAQ:IDCC)
Q3 2018 Earnings Conference Call
Nov. 01, 2018, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day and welcome to the InterDigital Third Quarter 2018 Earnings Conference. Today's conference is being recorded.

At this time, I will like to turn the conference over to Patrick Van de Wille. Sir, please go ahead.

Patrick Van de Wille -- Chief Communications Officer

Thank you very much. Good morning, everyone, and welcome to InterDigital's third quarter 2018 earnings conference call. With me this morning are Bill Merritt, our President and CEO, Kai Oistamo, our COO and Rich Brezski, our CFO. Consistent with last quarter's call, we will offer some insights 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 the third quarter Form 10-Q, published this morning. With all of those details in our Annual Report on Form 10-K for the year ended December 31, 2017, and from time-to-time and 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, such as free cash flow and non-GAAP net income. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our third quarter 2018 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, 2018.

With that taken care of, I'll turn the call over to Bill.

Bill Merritt -- President and Chief Executive Officer

Good morning, everyone. Thank you for joining us on the call today. As you saw in the press release this morning, the company delivered another very strong quarter. Rich will go into the numbers in more details in his remarks, in particular covering some of the accounting around our Technicolor acquisition. I was going to keep my remarks fairly brief, covering the Technicolor integration, our efforts in China and the recent management additions.

So starting with Technicolor, we're working through the integration of the teams and the two patent portfolios. To-date, that has progressed extremely well. This is not surprising given the level of business alignment between the two organizations. We remain on target to get back to our 2017 cost levels using the matrics that Rich laid out earlier this year. Perhaps more important, we are currently engaged with our core licensing customers and are including the Technicolor video coding assets in those discussions. As expected, the assets have added a very positive dimension to those discussions and we remain confident that our combined patent portfolios will drive strong value for our licensing business. We are also engaged with a new set of customers in the digital TV an set-top box space. The more we drive down this path, the more we are intrigued by it and it's growth potential.

As for as the Technicolor relationship, InterDigital Labs has also begun to engage with the Technicolor and research and development team. We are extremely pleased again at how well the teams operate together and the opportunities for research they are uncovering, it's like we always thought, there is magic at the intersection of wireless and video.

Moving on to China, we continue to be highly engaged with the major players in that market. The meetings are incurring at a frequent pace and we've had a large and continued presence in China for much of the summer and into the fall. That level of engagement is bearing fruit, has also made us think about the level of permanent presence in China that may make sense for us, given the continuing importance of that region through our ongoing business. Which brings me to last topic, namely the management additions at the company we announced a few weeks back. In a nutshell, both are directed at the items I just spoke about.

With the Technicolor acquisition under our belt, InterDigital, while still running in fundamentally the same type of R&D backed licensing business.It's simply running a much larger one today. Indeed, our business has evolved dramatically over the last three to four years with what broader research efforts over more geographies, more tools to work with and a larger set of customers with whom to engage. We are also highly sensitive to the new licensing environment, which I believe requires extraordinary knowledge of your customer. Those changes in our business drove my thinking in terms of how we should we structure the management team.

Starting with Kai, our new COO, I can think of no one better able to handle the new opportunities for the company and the new environment we live in. Having run the largest division within Nokia and also having a good visibility into their patent licensing business, he brings the specific skills we need to oversee our customer-facing groups, mainly our R&D, licensing, product and business development teams. He has done all of this before. Also having been intimately involved in the handset business, he is uniquely positioned to understand the customer's needs, our needs and drive our customer engagement accordingly. I also know Kai very well, both in his days at Nokia and as a Board member in InterDigital. He is a great catch, a great talent, a great fit, and we expect great things out of him. I have no doubt he will deliver.

Jeff Belk, as additional important capacity at the company as we engage more deeply in China and more deeply generally with our customers. The environment in China is changing rapidly. And navigating that changing environment is something that Jeff is extraordinarily capable of doing. At Qualcomm, he managed one of the strongest and and trickiest pivot ever as Qualcomm moves in something of an outsider with its IS-95 and cdma2000 market position that's become the world's leading supplier of WCDMA and LTE chips and valued by customers. I was in the industry back then, and I recall that transition very well. I also recall how much Jeff contributed to its success.

Jeff is also a Board Member here for eight years, so I know him very well. I was thrilled that both he and Kai, saw how well the company was positioned and how much we could grow. It's not the usual career path for executives to come off the Board to take on long-term management role that company -- at a company that is doing so well. But these two gentlemen has made the leap, believing like me, that we can take the company even further. And we are already seeing the benefits of that transition.

With that, let me turn the call over to Rich.

Richard Brezski -- Chief Financial Officer

Thanks, Bill. We are happy to report another strong quarter of financial results. For the most part, I'll let the results speak for themselves and focus instead on a few areas you may have questions on. Mainly, the impact of the Technicolor acquisition on our financial results, two opposing non-operating items we recognized in the third quarter and capital allocation. When we first announced our binding offer to acquire Technicolor's patent licensing business last March. I noted that, we expect that the acquisition would in the short-term, add some expense with a modest revenue impact. This proved to be true in the third quarter, which included two full months with the acquired Technicolor business. Over that time, the acquired Technicolor business contributed about $2 million of revenue, and about $12 million of operating expense, including $5 million of one-time costs, $3 million of amortization and $4 million of recurring cash operating expense. In addition, it contributed $2 million of capitalized prosecution costs.

Now, let me unpack those numbers a bit. The revenue number is based on the very modest revenue stream we acquired. The strategic rationale for the transaction is that the Technicolor patent assets will enhance the value of our core handset licensing business by driving higher recurring revenue, reducing the time to get deals done and or eliminating the cost of litigation. As Bill mentioned, the early returns from our engagements with customers certainly support that strategic rationale. As I noted, the recurring cash investment for the period is comprised of $4 million of operating expense and $2 million of capitalized prosecution. So all the equal, our recurring net investment before realizing additional synergies, was about $2 million per month. Which tells me the following.

For a headline price of $150 million, we secured valuable patent assets that we are confident will drive strong value in our core handset licensing business, as well as drive a new licensing business in consumer electronics. And given the numbers above and our commitment to return our expense levels to those of 2017 overtime, the cost to maintain that asset is negligible. That is just fantastic.

Let me expand a bit on our commitment to return our cost back to 2017 levels, as I described in prior calls. When we announced the acquisition last March, we noted that Technicolor's portfolio included more than 21,000 patents and applications. Between that March announcement and the July close, we identified opportunities to reduce the size of the portfolio being acquired by almost 15% to approximately 18,000 patents in applications. While at the same time, working to prune cost from our owned existing portfolio and overall cost structure. In fact, even with the acquisitions, $12 million contribution to our operating expense in the two months post close, our 2018 year-to-date operating expense, excluding depreciation and amortization is less than the prior year.

We are continuing to -- our efforts post close, with an expectation that the end result will be a portfolio that is larger than either of the individual portfolios and with the best attributes of both. In addition, we are encouraged by the opportunity to integrate the acquired team, thereby increasing the proportion of our portfolio that is filed and prosecuted with less expensive in-house resources. These factors make us highly confident, that we will reach our cost target.

Remaining on the transaction for a moment, we detailed the accounting for the acquisition in Note 9 to the financial statements in our third quarter Form 10-Q, which we filed this morning. I'll note that, in addition to the patent assets of approximately $150 million, we recorded a number of other assets and liabilities related to the acquisition. These include a contingent consideration liability and a long-term debt obligation, each of which represent the estimated fair value of a portion of the revenue share obligation we may make -- been required to make to our partners as a result of the acquisition. In addition, we recognized an estimated transaction related receivable. All of these amounts are based on long-term estimates, each of which includes a number of assumptions.

As our estimates change, we will run adjustments to the fair value of those amounts through the P&L and we will clearly disclose such adjustments if they are material. The remaining portion of our revenue share obligation is not reported upfront on the balance sheet, and instead will be reported as an expense in the same period we recognize the related revenue. At this point, I'll remind everyone that all revenue sharing obligations are net of estimated cost and limited to the new consumer electronics market. We have no revenue sharing obligation related to the wireless terminal unit and infrastructure markets, which historically have made up the vast majority of our revenue.

With that, I'll move onto two non-operating items of note in the quarter. First, we recorded an asset impairment of $8.4 million, almost entirely related to the liquidation of a single investment. Second, we recorded a tax benefit of approximately $15 million, primarily related to anticipated refunds on ended returns. This is a net one-time benefit that doesn't change our outlook for 14% to 15% rate over time. So I'll remind everyone that our estimated long-term tax rate is before giving effect to timing differences resulting from our foreign-derived intangible income deduction. Such timing reductions have been favorable this year, driving a negative effective rate, even without giving consideration to the one-time tax benefit.

Finally, a few words on capital allocation. We returned almost $75 million of capital to our shareholders through share buybacks from the start of the third quarter through yesterday. This is the latest reflection of our commitment to return excess capital to our shareholders.

I'll now turn it back to Patrick.

Patrick Van de Wille -- Chief Communications Officer

Thanks, Rich. Now, I'd like to turn to the newest member of our executive team, Kai Oistamo, who is with us today. Kai joins us after a 23-year career at Nokia, culminating in his role as Executive Vice President and Chief Development Officer. Followed by a role as Executive Partner at a Private Equity Firm, Siris Capital. I would encourage the listeners to see our press release dated October 11, or our Website for a full Bio. Kai, thanks for Joining us today.

Kai Oistamo -- Chief Operating Officer

Thanks, Patrick.

Patrick Van de Wille -- Chief Communications Officer

You spent almost exactly four years on the Board of Directors joining in 2014. And before that, in your company, well obviously, in your role at Nokia. What is your impressions of InterDigital over that time?

Kai Oistamo -- Chief Operating Officer

I was always very impressed by the performance of the company, and especially the people inside of the company. And I view at the company as being somebody who is -- at the same time very thoughtful, but getting results, getting things done, which is not very common combination.

Patrick Van de Wille -- Chief Communications Officer

What do you see as your key role of at InterDigital as COO?

Kai Oistamo -- Chief Operating Officer

I think it's getting closer to our customers. Bring what -- how do the customers think, what are the relative importance of different things, and eventually leading into how do we strike deals that are really win-win between them and then among us.

Patrick Van de Wille -- Chief Communications Officer

Okay. What excites you about joining the company at this time?

Kai Oistamo -- Chief Operating Officer

Well, we are in a very sound financial state. We've done just a very transformational deal on the video side. And as bill put it, the future is full of opportunity and that makes me very excited. At the same time, having met now more and more people inside the company, and it's really is a privilege to work with such talented group.

Patrick Van de Wille -- Chief Communications Officer

Well, Kai, fantastic. Thanks for joining us today. Katy, with that I will be happy to open the call for questions.

Questions and Answers:

Operator

Thank you, sir. (Operator Instructions) First question comes from Eric Wold with B Riley.

Eric Wold -- B Riley -- Analyst

Thank you and good morning. So few questions kind of around Technicolor and the license discussions you're having with some of their prospective customers, I guess, some existing customers. I guess, one. With the handset discussions that you've been having with the unassigned OEMs kind of prior to adding Technicolor. Now you bring Technicolor into the mix of discussion. Do those companies tend to understand the importance of Technicolor to their products and to value or is this almost essentially restart discussions around new set of paths and kind of help to get over the hub of understanding those and the value, this might be to shorten I guess or lengthen discussions from this point?

Bill Merritt -- President and Chief Executive Officer

So, on that question. Technicolor, one of the things we really liked about Technicolor was, it very well-known brand in video and also the very well-known patent portfolio that they have. And if you go back to various video coding standard, they've always been a prominent figure in all those video standards. So, there's actually very little education you have to do with the customer regarding the Technicolor portfolio, the Technicolor research capabilities. So, you really move very quickly to a discussion of how much is it worth versus what's it orgin. So again, that was one of the things that really attracted us to the asset to begin with.

Eric Wold -- B Riley -- Analyst

Okay. And then the current licensees, you're kind of going back to and kind of talking about Technicolor. Are there any handset partners you had in place that already had agreements with Technicolor or kind of are you currently or in the past or is it all brand new from this point?

Bill Merritt -- President and Chief Executive Officer

There's a mix. So, you would have, let's say three types of customers, right? One would, one where there is no license on the Technicolor side, and there's actually no rights under our agreements and so you have, basically a fresh licensing opportunity. You have one's, where Technicolor had license in for a period of time, and so you'd have to wait for that -- those licenses are around, but there is limited amount of that. And then there's ones with that would get captured under ours to a degree. So, we have a mix, but between the unlicensed folks and the folks that there is a clear lane, that's a huge amount of opportunity for us at the current time.

Eric Wold -- B Riley -- Analyst

Perfect. And just final question. Can you give us any sense around where you are with the discussions on the Huawei renewal? I know you which was signed essentially two years ago, it was a longer deal technically, you know the Technicolor can be join in the mix. How would you characterize those discussions given as they come up for expiration pretty soon?

Bill Merritt -- President and Chief Executive Officer

But, I think overall in China, we have, as I said in the prepared remarks, a broad level of engagement, it's a much different level of engagement than I've seen here previously meeting occur more frequently, there are longer meetings. They are more comprehensive in the sense that, there is discussion not only around licensing, but the research and development opportunities. So, obviously, with companies like Huawei or Oppo or others, these are very, very high-value license discussions. So they -- both sides move carefully in those discussions. But I think not only the companies, our own growth from the wireless perspective, but also now with the addition of Technicolor on top of that has just created a different type of dialog that I really appreciate. And I can personally know the difference between what they use to like, and what they like now. So, we're pushing them forward and we continue to be confident that we are going get agreements done on the right terms at the right time.

Eric Wold -- B Riley -- Analyst

Perfect. Thank you.

Operator

Thank you. (Operator Instructions) Our next question will come from Charlie Anderson with Dougherty & Company.

Charlie Anderson -- Dougherty & Company -- Analyst

Yeah, good morning. Thanks for taking my questions. Bill, I wonder if you could just elaborate a little bit on your comments around China, looking to potentially have more resources on the ground there, sort of what's behind that? And then, I guess, on a related subject, just geopolitical situation to what degree is that helping or hurting matters in some of these discussions? And then I've got a follow-up.

Bill Merritt -- President and Chief Executive Officer

Sure. So, again, I think as I mentioned, China is obviously going to be very important in our business ecosystem for a long period of time. And the way we historically engage with China, you've see us always go over there with teams and come back. What we have noticed is that, it will be much more effective for us to be on the ground over there in a more permanent way. So, the thing that we would think about and are thinking about is, you have people from our business development role that are on the ground in China. You have people from an R&D perspective that are on the ground in China -- and either are conducting R&D or maybe just assisting licensing teams in sort of the technical aspects of those discussions.

We have opportunities to engage with the universities in China. We did a recent tour with one of the -- the Hagley Museum in Delaware around patent models. And so, how much the community in China is embracing innovation and invention, as well as the monetization of innovation. So, I think there's a really good opportunity for the company to engage on those various topics in China. Much like we did in the United States, I think regular interaction with the government is an important component of our strategy, so that they know us better and understand how we operate. So, there's a lot of different engagements that we are planning. To do those the most effectively, we need to have a presence in China. I don't think it becomes as large-scale presence since I thought of that. But a nice sized presence over there that gives us a sort of constant touch points with the customer, I think will be really beneficial. And I think ultimately, will be very helpful in driving deals sooner and better value and developing much closer relationships with the customer.

Charlie Anderson -- Dougherty & Company -- Analyst

Okay, great. And then, a follow-up for Rich, just on operating expenses. Maybe just coincident with that, if you guys do expand to some degree in the China, do that within the envelope of sort of your plans on keeping around those 2017 levels line term and it is really allocate. And the, in terms of the extra Technicolor expenses, can we just -- about a full quarter of what you saw in Q3? Or -- I know there is the one-timer in there, but aside from the one-timer, does Q4 kind of looked like Q3, but for a full quarter? Thanks.

Richard Brezski -- Chief Financial Officer

Yeah. So, with regard to the first question. Yeah, our goal here is -- as this is typically the case, we want to try and fit initiatives within the envelope of the current cost profile. With respect to the Technicolor acquisition, we're absolutely confident that we're on track to meet our synergy targets. As evidence, I mentioned in the script by some of the reductions to the portfolio on both sides that we've already taken and with more to come. With respect to China, we're looking at that investment, and certainly there is cost there. But again, the idea is to fit it within the overall envelope, which is more or less been our practice here. As far as the -- kind of looking at the third quarter for Technicolor.

As I noted, it did include two months not three and it also was, at the end of summer, when some of the activity was a little bit lower. So, we're in the process of going through our budget and updated forecast. I think offsetting, maybe some of the reasons that might have been light in that period is the fact that's before additional synergies. And some of those synergies, even some of the ones that we've already taken, take a little time to bleed in. For example, as you abandon a patent asset that you no longer feel has value that, that's not a cost savings day one, it's not until the next annuity payment might be due which could be six months, 12 months or sometimes even longer. So, we'll be looking at that and considering that in connection with our upcoming guidance.

Charlie Anderson -- Dougherty & Company -- Analyst

Got it. Okay, thanks so much.

Operator

Thank you. Our next question comes from Scott Searle with ROTH Capital.

Scott Searle -- ROTH Capital -- Analyst

Hey, good morning. Thanks for taking my question. See, Rich, just to follow up on some of the cost fronts related to Technicolor patent administration costs specifically, was quite a bit higher. Is that the normalized level to start from before you start working down assuming three months of contribution rather than two months? Or are there any elevated costs that are going in there? You talked about $2 million capitalized prosecution costs and just trying to normalize that. And directionally, what we should be thinking about going into the fourth quarter? I know there is some seasonal issues on that front. And then just to clarify on the $5.4 million one-time transaction cost, is that in SG&A? And then I had a follow-up on two.

Richard Brezski -- Chief Financial Officer

Yeah. So the $5 million of integration cost are spread across -- there are certainly a lot of integration in patent side. So that's an element of the cost there. And I should mention that, as we are working to achieve the cost savings, there are integration costs that will continue to extend. So although that's a one-time element, we'll probably see some additional one-time integration costs in the next quarter. The capitalized prosecution. There, we have a policy that has been long-standing at the company. It's a little bit different than what you see with other licensing companies, so it's actually considered to be preferential. So at times, we consider changing, but the accounting rules don't let you change from a preferable policy to a non-profitable policy. And that is to capitalized cost, the external cost and an incremental cost of prosecuting filing your patents.

So we have had and internal team that's been relatively small. Technicolor was the opposite, they had relatively small external resources with comparatively large internal resources. So as we look to bring that group in, that results in a shift between capitalized prosecution and internal prosecution. That being said, there was an element of that, about $2 million of additional CapEx related to that acquired business. So, as we move forward in time, we see that our internal prosecutions going to be certainly much larger than it was before, that will help to generate some of that cost savings, but it also shifts things between those two items. And that's why, I think an important metric for us is looking at expenses, exclusive of depreciation and amortization, but then adding in the CapEx. Because at the end of the day, it's a cost either way.

Scott Searle -- ROTH Capital -- Analyst

Okay, great. Thank you.And Rich to follow up as well on the royalties front, the normalizing for ASC 606. It seemed there was a bigger change than usual in the per unit royalties. I was wondering if there was anything to clarify on that front. Usually, it's your one large fixed customer contract. And then from a high level, Bill, what do you see and what are the thoughts as it relates to IoT and engagement on that front? I know you're going through a voluntary, but there is in term of seeing some of that revenue recognition starting to ramp up. And I am curious as to the level of engagement on 5G and whether or not that's helping you to get to the table with some of the Chinese? Thank you.

Bill Merritt -- President and Chief Executive Officer

Yeah. So, regarding the per unit, the two things that come to mind there are, you do have more variability and even seasonality in per unit, because that's reported as the sales occur. It's a small portion of the overall revenue base. But if you look just at that line, you will see some variability there. In addition, under the new rules we're estimating -- for instance when we book third quarter, that's our estimate of the royalties that will be reported to us in the coming weeks related to third quarter sales. Third quarter -- we did a similar estimate in second quarter and then third quarter includes the true up for second quarter as well. So, those are things that impact that. I think if you look quarter-to-quarter, you may see some volatility, but that should be smoothed out over time.

Richard Brezski -- Chief Financial Officer

So on IoT. So, -- and separate Avanti, which is doing the licensing at cash inside for us and then the Middleware play, which is an internal effort at the company. So, Avanti, if you look at the license for us in Avanti, they've gotten up to substantial scale in Avanti now. So, I think they are in a position now where they have very, very powerful offer to the automotive manufacture that really is becoming one stop shop for the automotive manufactures. So, I think that's a really good development over last number of months. I think they also as they've chatted before needed to work through a market that traditionally hadn't that license at that level and come up with a structure that accommodated some of the historical structures there. And I think they've done a good job on that.

So, I think they are extremely well positioned now. They've got a couple of agreements under the belt. And so hopefully we will see acceleration from them on the licensing side from where they are sitting today. So, we still have a lot of confidence in that group and they've got -- from a personnel standpoint, they've got tremendous capability within that group. So I know the people personally and I think they are just fantastic. So in terms of 5G, there is two components there in terms of helping on licensing side. Obviously, our involvement in 5G in fact that we're continuing to have a very prominent role there and many of the agreements we're negotiating now with the cover 5G deployments, it certainly helps on the negotiation side. So it speaks to the perpetuity of our value.

The other piece that was there is continues to be a tremendous amount of 5G innovation opportunity that we can share and in fact that perspective licensees. So, like we did with Sony building with them a 5G portfolio by doing research together that research opportunity exists with us and other of our unlicensed customers that can be really valuable to them in building patent positions, which they can use to defense. And so it's -- and it's something that we are highly credible in both telling to customers. So 5G is I think very, very powerful not only as a long-term value driver or for the business, but also a tool that we've been using licensed discussions to bring additional value to our customers.

Scott Searle -- ROTH Capital -- Analyst

Hey, Bill, is that entering into the discussion with Chinese OEMs or still too early on that front?

Bill Merritt -- President and Chief Executive Officer

No, it's definitely part of the discussion with them.

Scott Searle -- ROTH Capital -- Analyst

Great, thank you.

Bill Merritt -- President and Chief Executive Officer

You're welcome.

Operator

Thank you. At this time, I am showing no further questions in the queue. I would now like to turn it back over to Patrick for closing remarks.

Patrick Van de Wille -- Chief Communications Officer

Well, thank you very much, Katy. Thanks to everybody for joining us this quarter. I would request that you keep an eye out for some announcements relating to our Investor Day, which is going to be December 10th in New York. So, we should be putting out some communications around that very soon and some of you will be receiving invitations as well. Thanks for joining us this quarter. See you in three months.

Operator

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

Duration: 33 minutes

Call participants:

Patrick Van de Wille -- Chief Communications Officer

Bill Merritt -- President and Chief Executive Officer

Richard Brezski -- Chief Financial Officer

Kai Oistamo -- Chief Operating Officer

Eric Wold -- B Riley -- Analyst

Charlie Anderson -- Dougherty & Company -- Analyst

Scott Searle -- ROTH Capital -- Analyst

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