InterDigital Can Supercharge Your Portfolio

In these dire days during which the S&P 500 has lost all its 2011 gains, it's easy to think that all stocks go down. But that's not true. Wednesday, InterDigital (NASDAQ: IDCC), a $3.3 billion (market capitalization) holding company for 1,300 U.S. and 7,500 non-U.S. wireless telecom patents, popped almost 14%. Is it too late to join the InterDigital party?

For insight into that question, it helps to understand why its stock was up so much. InterDigital is in the middle of a bidding war that could result in a sale of the company for a cool $5 billion -- 52% higher than its current value, according to Bloomberg. The bidders include Samsung, Apple (NASDAQ: AAPL), and Google (NASDAQ: GOOG).

The intensity of this bidding war is heightened by patent litigation between Apple and Samsung. Since some of InterDigital's patents are used in Apple's iPhone and Google's Android, Apple's April 2011 lawsuit alleging that Samsung's Galaxy uses Apple's patents could be a factor in this bidding war. That's because if Samsung could acquire InterDigital, it might be able to use its ownership of the relevant patents to strengthen its position in the Apple litigation.

Since July 18, the day before InterDigital announced it was putting itself up for sale, its shares have risen 73%. If a sale does not go through, its shares will plunge; but if the company does find a buyer willing to pay $5 billion, they could gain another 52%.

To consider whether to buy InterDigital shares, it helps to consider whether the company would be a good investment if the acquisition rumors did not pan out. Here are two reasons to consider investing in the stock:

• Low valuation. InterDigital's price to earnings to growth of 0.64 (where a PEG of 1.0 is considered fairly priced) means it is cheap. It currently has a P/E of 29.6 and is expected to grow 46.4% to $3.05 in 2012.
• Many expectations-beating earnings reports. InterDigital has beaten analysts’ expectations in three of the last five reporting periods. In its 2011 second quarter, InterDigital reported $0.37 in adjusted EPS -- a penny above analysts' expectations. Although revenues were down and patent litigation expenses rose, InterDigital did benefit from rapid smartphone revenue growth -- offset by the impact of the Japan earthquake.

There are two reasons to avoid InterDigital:

• Not earning its cost of capital. InterDigital is earning slightly less than its cost of capital – and it’s deteriorating rapidly. How so? It produced positive EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In the first six months of 2011, InterDigital’s EVA momentum was a whopping -23%, based on first six months' 2010 annualized revenue of $414 million, and EVA that fell from $97 million annualizing the first six months of 2010 to ($0.4) million annualizing the first six months of 2011, using a 10% weighted average cost of capital.
• Falling sales and profits but stronger balance sheet. InterDigital has been shrinking. Its $395 million in revenues have fallen at an average rate of 5% over the last five years while its net income of $154 million has declined at a 10% annual rate over that period -- yielding a very high 39% net profit margin. It has virtually no debt and its cash has grown quickly at 19.7% annual rate from $264 million (2006) to $542 million (2010).

InterDigital is an extremely profitable company but the plunge in revenues suggests that it does not have or want to spend the cash required to enforce its patents, develop new ones and license those innovations to wireless industry participants.
If 2012 earnings projections are accurate, InterDigital stock is still under-valued. But since management has decided to put the company up for sale, it is sending a pretty clear message that shareholders would be better off if the company was acquired.

Given the deep cash positions of the bidders and their strong incentives to keep InterDigital out of the hands of rivals, I'd guess there's a better than 50% chance a deal will go through for a price near $5 billion -- 50% above its current value.

Investors willing to take that chance should consider buying InterDigital.