InterDigital: Setting Wireless Standards - [Business Breakdowns, EP.166]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from, and we are here to bring them to you. To find more episodes of Breakdowns, check out joincollossus .com. All opinions expressed by hosts and podcast guests are sole their own opinions. Hosts, podcast guests, their employers, or affiliates, may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only, and should not be relied upon as a basis for investment decisions. Welcome back to Business Breakdowns. Today we are diving into inter -digital. Now inter -digital is one of those really interesting businesses that sits completely under the radar for most investors. If you're unfamiliar with the name, join the club. That was me prior to this episode. But inter -digital has the foundational technology, the foundational patent technology, which makes mobile phone communication and device to device communication possible. Everything revolving around 2G, 3G, 4G, 5G, the Internet of Things, all of these devices in the world that are communicating with one another is underpinned by Interdigital's technology.

1:32My guest is Jenny Wallace, co -founder of Summ Street Capital Management and Portfolio Manager of the U .S. Equity Value Fund. We get into the history of Interdigital. This business has been around for five decades and always focused on this area of technology. We talk about their patent portfolio. They have 30 ,000 patents and what that means. One of the most interesting dynamics about this business is that they have to keep that strong balance sheet because when you have patents and when you have licenses, oftentimes you need to enforce those patents. There's some interesting dynamics here that actually remind me a bit of our episode on a line.

2:11two completely different businesses, but something similar underpinning them in terms of the litigious nature that you need to have when you work around patents. Now please enjoy this episode on Interdigital. Alright Jenny, I am excited to have you here, excited to cover interdigital, maybe not the sexiest or most exciting name from the outside, but maybe try to bring it to life a little bit. And it's a company with five decades of history and it's still small in many ways, but the history is there and that really stood out to me. I thought maybe we could just start very high level off the top describing what inter -digital actually does.

2:55It is one of the most important companies that you have never heard of. Inter -digital develops the underpinning technology by which all wireless communication using our phones and other devices is possible. Well, since the company's founding, the engineers at Interdigital have led the development of a wide range of innovations that are used in digital cellular and wireless, starting with the original 2G cell phone in the mid to late 90s, 3G, 4G 5G, and today even looking forward to 6G. Also your consumer electronics that speak to one another, whether it's your connected dishwasher or your smart TV, the internet of things and even automobiles.

3:48Interdigital's technology has actually been licensed to more than seven billion devices over the last decade, and the company is one of the largest pure research and development and licensing companies in the world. I don't know what the world population is today, but seven billion devices basically got 100 % of the population of the world understanding there's some numbers to finagle around there. Today our cell phones obviously have a lot of different things going on beyond the communications. It sounds like what interdigital is doing is very much revolving around communication between devices.

4:26Is that technology working with satellites? Can you break that down a little bit just in terms of what's actually going on with our technology? What makes an original sort of hard to understand slightly unsexy, as you point out, is that its patents help with connectivity because at the end of the day cellular connectivity is simply the utilization of electromagnetic spectrum. So governments own essentially the spectrum in auction off different bandwidths of spectrum to wireless carriers. But kind of like ocean front property in Florida, some of it's nicer than others. So different spectrums may be more efficient or better for different use cases.

5:13And there's a finite amount of it. So with a finite amount of differentiated quality spectrum, and of course an ever increasing set of technological demands for using this spectrum, It's really important to have standards and efficiency at the forefront of how voice and data and video is transmitted over the spectrum. So for example, in 2009, the United States made a transition from analog, you know, the U .F .H. signals to digital TV. This freed up the 700 megahertz spectrum, which is considered very valuable because it's low frequency and as a result allows better transmission of cell signals particularly in less populated areas.

6:06At the end of the day, what interdigital engineers develop is a digital pattern of zeros and that efficiently transmits data in this electromagnetic spectrum in a standardized way. So that your phone can communicate to the wireless towers. You may have AT &T and you are in a location where there is a Verizon cell tower. Because of the standardized nature of data transmission, your phone can connect to the wireless tower of a different carrier and communicate again, then off to another phone that may have a totally different carrier. So what is it that makes a technology get chosen as part of a standard?

6:55Well, what it really is is the efficiency, the effectiveness of the division or the utilization of the spectrum. And then once in the standard, It is simply a pattern of zeros and ones. If we can go back in time, five decades, this business has been around. It was named into digital then, what foresight they add into the future in terms of the communications that would happen. Bring us back in time in terms of what this company looked like maybe at the beginning and whether there were key players and the milestones that they hit because the market that they were operating in then looks a lot different than what they're operating in now.

7:36So, Interdigital was actually incorporated in 1972 under the name International Mobile Machines, which is also a forward -looking name. So as you mentioned, it's a small company. It has only about 400 employees. It has a $3 billion market capitalization, but it plays this, as I mentioned, indispensable responsible role in the smartphone market, which is a half a trillion dollar market by most estimates. The other players in the space are people you might think of household names, like Qualcomm, Erickson, Nokia. But these companies, interestingly, all have market caps somewhere between six and 60 times that of interdigital.

8:21The founder of interdigital is a man by the name of Sherwin Sellingson. and he was really a true visionary. He actually dropped out of high school and made a fortune in the stock market in the 60s. Well, he was still in his 20s. He was a guy that remained passionate about stocks, but he also liked being at the Jersey Shore with his family. What he wanted was access to live information about news and stock quotes and to be able to communicate with his broker without ever leaving the beach. This really inspired Selekson to develop a portable data machine, and that was the origin concept, if you will, of interdigital.

9:02Obviously, his vision took many years to come to fruition. But in 1976, during the United States bison 10 -year -old celebrations, the company actually demonstrated the first wireless telephone ever and chose to demonstrate it in Franklin Park in Philadelphia, which is the same exact place that Alexander Graham Bell made his first demonstration of the wired phone 100 years prior. So there is a deep history of innovative communication at an or digital. But interestingly, obviously a terrific and great accomplishment, it still took this company a while to find its footing. They had developed digital cell technology, but there was at the time no market for it.

9:56In the mid -80s, this company pivoted to what is known today as fixed wireless or wireless local loop. And they built product that they sold to the phone companies, basically to provide telephone services to rural areas. They called it the ultra phone and communication was basically possible through a system of radios. They were called cluster boxes and they had antenna and they transmitted telephone signals to a taller antenna, miles away, that then transmitted the signal into what you would think of at the time as the wire telephone system. What this allowed was voice communication to and from rural areas without incurring what had been the hold up, which is this sort of prohibitive cost of laying the proverbial last mile of copper that had previously been required.

10:54The company's motto became dial tone anytime, anywhere. And while obviously it seems like a given today in a world of ubiquitous cell phones, this was actually a revolutionary innovation at the time. If there's a way that you can bring to life, the capabilities that they had that were allowing them to continue to sell into this market, it seems like a theme here that for decades and decades, They've been providing technology to this market. What were some of the ways in terms of real world application or stories that you can share in terms of how it was happening? A great story that highlights Interdigital's unique capabilities as an early developer of secure digital wireless, Harkens back to 1990, when an Avionca airline flight from Bogota to New York encountered bad weather and tragically ran out of fuel.

11:49The plane actually ended up crashing in a remote location of Long Island, which had no telephone service. As the first responders arrived, they realized that this plane had been loaded with diamonds and drugs, that they found scattered over a wide radius of the crash site, that while remote, enough not to have phone service, was also less than 50 miles from the huge population center of Manhattan. under ordinary circumstances, first responders would have communicated using radios, but radio communication wasn't secure. And they absolutely did not want the public to know about the diamonds and the drugs.

12:30So a secure means of communication for this remote location was needed. And there were other companies out there building analog, but analog could certainly be hacked with a scanner. As we have seen over history, Interdigital was already well -known to several government organizations as the only company developing digital communication. The national communication system called Interdigital to see if they could help, and the company was able to get a secure communication system up and running almost immediately. Because it had basically already been building these mobile base stations, and for the prior eight years have been providing secure communication systems to the White House so that they could link one end of the Reagan ranch to the other while the president was out horseback riding.

13:17I love these really unique use cases that are coming out of this. Some of the better stories that we've heard and I feel like I need to look up some history on that diamond drug crash. It's clear that there's something differentiated in the technology, but at the same time it was eventually being adopted by the largest players in the space. and you've referenced where Nokia, it sounds like they were a competitor. I imagine they could have been a customer as well. Did the evolution of the business really take off once mobile phones rose to dominance in this 21st century era? Was there a big shift then?

13:54There was a big shift in actually a big turning point in Interdigital's business model. So Interdigital was then and frankly still is small, but its intellectual presence has been quite significant in the communications industry. So much so that you talked about Nokia. In the late 90s, Nokia was the world leader in cell phone communications. They had 40 % percent market share, but they reached out to Interdigital to help develop technology for TDD, which is time division duplexing, which is a way of splitting bandwidth, but to develop the TDD standard of 3G communication and to figure out a way to make the leap from from 2G to 3G commercially viable.

14:39This was a really important turning point for interdigital. And it went at that moment from being a creator of these proprietary technologies, the mobile base station, or something that they sell to the phone company, to a developer of what's called today standard based technology. So what that means, and instead of developing and selling products themselves, the company was developing and patenting processes by which all wireless products would communicate. And the basic importance of standardized technology is back to this idea of interoperability. I think we've seen many examples whether in credit cases like the FICO score or even the 80 -20 rule with underwriting mortgages, you can name industries, standardization of the logistics box and how that started to work with Intermodal, how much it on locks in industry and as a complete game changer, you reference that can lead to commoditization of so many different people are using it.

15:44Here it seems like patents are very key in the process. In the center of this all, it seems like the main asset is your engineering and technological capabilities. And right next to it is the patenting of those capabilities. Is that a fair representation? Yes, interdigital has around 400 employees. Half of them are engineers and nearly all of them have advanced degrees. What's interesting about these standard processes is that there's actually a committee of engineers that comes together to decide what technology will be in the standard. Several people may develop a method by which some type of communication can occur.

16:30The engineers on the standard committee come together and they debate, promote, argue and decide what are the best processes, the best patents to bring into the process. And what's interesting is Inter -digital of their 200 engineers has leadership positions on 100 different important standards committees. Technology has always been and continues to be the DNA of this company always looking at what's next. But to have that kind of a presence, not just on the committee, but to be in a leadership position, is really important. First, it's a good indicator that the inter -digital engineers are among the best of the best.

17:22Being given a leadership position certainly means that your engineers have the respect of their peers, but it also puts inter -digital in a position to advocate for its technology. Most of the other licensing and patent developing companies are also manufacturers of devices and product one way or another. Interdimensional is a pure research company, so that gives it this interesting, non -biased image and ability to be perceived not as a competitor by anybody. Independently, without that same conflict of interest. When they are thinking about the various technologies that get incorporated into a new standard or various patents, I think you've referenced in that previous question.

18:11Is it ultimately just coming down to efficiency and size requirements for certain technologies to be mixed together. I'm sure there's interoperability between the different technologies and how that's going to work. Is there anything else that goes into that decision making? When I was first looking at this, assume one patent, one technology for this use case, never really thinking that you're ultimately combining a bunch of these together. Well, you are, but the other interesting thing is the evergreen nature of the patent portfolio. video, you might have a 5G phone, but you can call someone with a 2G phone and speak all of the patents and the communication mechanisms in the most sophisticated phones have to have the ability to work reverse to less sophisticated phones.

19:00And that's really interesting because what that does for inter -digital is it creates almost an evergreen patent library, but that doesn't mean they're not looking forward. Over the last six years, its patent portfolio has grown by 60%. Today this company holds 30 ,000 patents across wireless video DTV. Interdigital normally issues or receives new patents every day. And 90 % of its patents are basically developed in -house. I was wondering about that 30 ,000 number. I saw it and it seemed impressive, but I stepped back and didn't really have context for what it meant. I think they grew from 19 ,000 to 30 ,000.

19:43You mentioned the percentage growth, which is an eye -catching number. But if you told me there's four or five patents that actually drive 90 % of revenues, that would be one thing. And then the patent portfolio is maybe just more vanity. Can you mention anything just about those 30 ,000 or a large percentage of them being used? How do you view it just as an investor? Is that a number that you want to see consistently growing? Does it carry much meaning besides what you mentioned before? They're getting new patents every day. There's clearly a lot of engineering work going on. If they were to miss out in certain standards, you would start to wonder, it's not just do they have the patents?

20:21Are they getting new patents? But are they the best patents? Are they the ones that will be used? That is absolutely what's critical. There's a cost every single year to sustaining an old patent. From an digital standpoint, those 30 ,000 patents are not free. Once you get a patent, you still need to pay to maintain that patent. As an investor, we're interested in how does all of this innovation lead to profits. Since the 90s, as I said, their business model has been to develop these technologies on which it then secures a patent and then they license to device manufacturers who pay interdigital to use the technology.

21:02So its customers include Samsung, who's been a customer since 1995, Apple, Jiao Mei, Lenovo, LG, Panasonic Sony, and even Amazon and consumer electronics. Some of the auto companies like Toyota and what's interesting from a business standpoint is that about 90 % of its license agreements are on a fixed price basis. It doesn't matter if smartphone purchases are going up, going down, and in fact, inter -digital technology today is in literally every single smartphone. So in 2023, there were over a billion sold, but also, of course, as I mentioned, all of the older wireless standards. That said, from a business standpoint, Only 50 % of the smartphones are paying to use interdigital's patents through license agreement.

21:56The other half are using interdigital's technology without paying. Can you go into that a little bit more? So at this point, the vast majority of non -pares are manufacturers that produce and sell devices in the Chinese and to a lesser extent, the African markets. They include companies like Lenovo, OPPO, Vivo, and a smaller company called Transion. To say adelegately, these markets have historically had a different set of business practices around the use of and payment for intellectual property. Historically, it's been tough to break through those business practices and enforce fair compensation.

22:39The good news is that many of these companies are now exporting their devices and selling into global markets. And as such, they are now subjected to globally accepted business practices. By and large, inter -digital does come to agreements with its customers through bilateral negotiations. However, occasionally, it is forced to litigate. And the company has a very strong track record in litigation. Recently, Interdigital was awarded an injunction against Lenovo in the German courts. And the courts had some strong words for Lenovo and for their behavior. And Interdigital also received a positive ruling from courts in Germany and India against Opo.

23:24So they are making progress, but it does bring up a very important point about the Interdigital balance sheet. Interdigital has a very strong balance sheet. Today has over a billion dollars in cash, which is a lot for a $3 billion total market cap company. But it's critical because as a small company, negotiating and potentially litigating with much larger companies, we view this cash as sort of an essential competitive requirement. The threat of litigation by a small company is not very concerning if you're Apple. and the small company doesn't have the financial ability to back it up. From an investor standpoint, somebody might, from the outside look and say, wow, they have all this cash, we can deploy it to give it to shareholders.

24:11We actually view a good portion of that cash as necessary for the company to hold. Apple, for example, the second largest company in the world is a key customer. And interestingly has been since the very first iPhone. But when we look at the value of the patents, as you asked earlier, inter -digital renewed its license agreement with Apple in 2022. Seven -year deal valued at just under a billion dollars. So that's over $130 million a year at, importantly, a 15 percent price increase versus the expiring agreement. In that previous agreement, was it in a similar seven -year context? Most of these agreements are in long -term contracts.

24:55So if you think about Apple shipped, probably 225 million smartphones in 22, 60 cents of the cost of every iPhone goes to interdigital. Before we get too far away from the patent and litigation point, when you look back in history, were there major litigations that took place that solidified interdigital or they won and showed that they are willing to go to bat, because to your point, the 50 % number is a staggering number just in terms of those that are not paying to use the technology. We've followed and invested in interdigital for a long time. And a long time ago, interdigital was viewed negatively in the marketplace by anyone who knew them as more of a patent troll than an innovator.

25:48And when we started to look at the company, we realized that it was actually an innovator developing new technologies, securing patents, not just going out to buy other patents that existed. There was a case that drove home, but what's become increasingly more important is that if you look at the competitive landscape, it's typical for an industry standard to have multiple competitors, like 5G. there are more than 130 companies worldwide that hold 5G patents and contribute to the standard. But the top 10, which include Qualcomm, Samsung, and Interdigital account for more than three quarters of the 5G patent families, over time what's become clear is that Interdigital is not fighting this battle alone.

26:39We can shift back to the revenue point on an agreement with the likes of Apple. You see the seven year renewal 15 % higher comparing that to what has happened to Apple smartphone sales over that same period It is an increasingly small percentage of their sales from your perspective the upfront fixed fee Could certainly benefit if we're to see the mobile market decline But seems like it would have been a net negative in that growth of the market where you had so many more units being sold I'm just curious just in terms of the fee, the contract structure, if there's conversation around that ever changing, if you think it is the right model, it does stand out to me where you have this period of time where the market is growing substantially, they might not be able to get a meaningful percentage of that growth.

27:32So I think any negotiated outcome, if it's a good agreement, will reflect the business preferences of the parties in the negotiation. It turns out that for various reasons, device manufacturers tend to prefer fixed pricing models. It gives them a level of certainty. And interdigital, quite frankly, is a small company. So if they were to have variable agreements, they would then be in a position of auditing sales, auditing unit sales, and doing sort of royalty audits on their customers. What that would do is create sort of a administrative nightmare and be sort of an adversarial relationship with their key partners.

28:20So they have almost exclusively agreed to fix price. It's also really much easier for inter -digital to run its business thinking forward. What are we investing for R &D? What are we likely to spend on our patents and potential litigation? and then what is our revenue going to look like? So in many ways, we think better model than a variable price model would be. But there's a trade -off, right? And there's a risk on both sides. Interdigital is also very secretive about its contracts. Obviously, for competitive reasons. The Apple contract is public. And if you were to look at a $500 smartphone phone that has both 3G, 4G as well as Lyre lists and HVC, which is the video technology.

29:11Interdigital probably earns $1 .15 on a fully loaded $500 smartphone. Over the last 20 to 22, they probably renewed 99 % of their recurring revenue. They signed 30 new licenses over the last three years with a contract value of $2 .5 billion. They had this churning point. They really needed to fight to get recognition for their standards. And now they have moved almost to a new phase where their standards and their engineers are not just world -class but known in the industry to be world -class. An important part of Interdigital today is the management team. The CEO is a guy by the name of Lerinchin, who came to Interdigital in 2021.

30:06From Qualcomm, he at Qualcomm was the head of licensing. And he has been a big part of the spark that has helped Interdigital renew existing licenses, advocate for its technology and sign many new licenses. at the same time, he's also enhanced the shareholder friendliness of the capital allocation. As I mentioned, there was a period where in its history of being a public company where interdigital was very misunderstood. Liren has an MBA, a law degree, and I think himself has personally 28 or so patents in the US and over 100 worldwide, he really has focused on improving not just the shareholder -friendly aspect of the capital allocation approach, but also communicating better with shareholders and working to make this a company that can be more easily understood.

31:08It's one of those swords that can swing in both directions where management teams, you focused on the business, but some ability to tell what is a complicated story is useful and certainly when that extends into the industry as you mentioned, having that advocation being on so many different committees, I think for something like this and seems incredibly important. One thing I wanted to touch on was his background being head of licensing at Qualcomm. Seems like that backlog number is quite big just in terms of contract value. you mentioned there's some volatility in the revenue streamer in the earnings stream for the business.