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Form 10-K for INTERDIGITAL, INC.
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2-Mar-2009
Annual Report
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
OVERVIEW
The following discussion should be read in conjunction with the Selected Financial Data, the Consolidated Financial Statements and the notes thereto contained in this document. Please refer to the Glossary of Terms immediately following the Table of Contents for a listing and detailed description of the various technical, industry and other defined terms that are used in this Form 10-K.
Samsung Settlement
On January 14, 2009, we entered into a patent license agreement (the "2009 Samsung PLA") with Samsung Electronics Co., Ltd. ("Samsung") covering Samsung's affiliates, including Samsung Electronics America, Inc. The agreement supersedes the terms of the binding term sheet signed in November 2008 by such parties and provides for the termination of the 1996 patent license agreement between us. Under the terms of the agreement, Samsung has agreed to pay us $400.0 million in four equal installments over an 18-month period to resolve the outstanding arbitration disputes involving Samsung's sale of 2G products, as well as the patent disputes over Samsung's sales of 3G products. Following our January 30, 2009 receipt of Samsung's first payment, the parties moved to end all litigation and arbitration proceedings ongoing between them as more fully discussed in Item 3 of Part I of this Form 10-K.
Under the terms of the 2009 Samsung PLA, we have granted Samsung a royalty-bearing license covering Samsung's sale of 3G products (including products built under both the WCDMA and cdma2000 standards and certain of their related extensions) through 2012 and a license covering Samsung's sale of 2G single-mode TDMA-based products that will become paid-up in 2010.
We will recognize the revenue associated with the agreement ratably from January 14, 2009 through the expiration of the agreement on December 31, 2012. The total amount of revenue recognized will include approximately $7.0 million of deferred revenue from our 1996 patent license agreement. Beginning in first quarter 2009, and in accordance with our accounting policies, we will recognize within our accounts receivable all payments due from Samsung within twelve months of our balance sheet date.
Our 2008 operating expenses include a fourth quarter 2008 charge of $9.4 million to increase our accrual for a performance-based cash incentive under our Long Term Compensation Program (LTCP) from the previously estimated payout of 100% to the actual payout of 175%. The increase in the incentive payout was driven by the Company's success in a number of key goals including signing LG Electronics, Inc. ("LG") and Samsung, two of the top five cellular handset OEMs, to 3G licensing agreements. These licenses helped increase our share of the 3G market under license from approximately 20% to approximately 50%, and drove substantial positive operating cash flow over the period. SlimChip
In October 2008, we announced that, due to the rapidly changing landscape of suppliers and customers of digital baseband technology, we were evaluating a number of options for the modem portion of our business. These options could include an acquisition or partnership to achieve the appropriate scale needed to succeed in the market, or the disposition of the modem product portion of our business through a sale or closure. We continue to evaluate these options, and while we have had substantive discussions with potential counterparties, we have not made a final determination of the most appropriate option to pursue. A final decision could occur as early as the first quarter 2009. The ultimate outcome of this evaluation and pursuit of an option could result in an impairment of long-lived assets related to the modem business. The assets that could be affected include all or a significant portion of our intangible assets, which totaled $22.7 million and $22.9 million, net of accumulated amortization, at December 31, 2008 and 2007, respectively, and a significant portion of our property and equipment, which totaled $21.0 million and $24.6 million, net of accumulated depreciation, at December 31, 2008 and 2007. While a disposition of the modem portion of our business could create significant long-term cost savings and improved cash flow, it could also produce a near-term repositioning charge and a significant reduction to our technology solutions revenue, which contributed $12.0 million, $3.4 million and $6.9 million of revenue at December 31, 2008, 2007 and 2006, respectively.
As a result of our October 2008 announcement, we evaluated the carrying value of our long-lived assets associated with the modem business in accordance with SFAS No. 144. We concluded that there was no impairment at December 31, 2008. Business
We design and develop advanced digital wireless technologies for use in digital cellular and wireless IEEE 802 -related products. We actively participate in and contribute our technology solutions to worldwide organizations responsible for the development and approval of Standards to which digital cellular and IEEE 802 -compliant products are built, and our contributions are regularly incorporated into such Standards. We offer licenses to our patents to equipment producers that manufacture, use and sell digital cellular and IEEE 802 -related products. In addition, we offer for license or sale our SlimChip family of mobile broadband modem solutions (which includes modem IP know-how, baseband ICs, embedded modules and Reference Platforms) to mobile device manufacturers, semiconductor companies and other
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equipment producers that manufacture, use and sell digital cellular products. We have built our suite of technology and patent offerings through independent development, joint development with other companies and selected acquisitions.
Our goal is to derive revenue on every 3G mobile device sold, either in the form of patent licensing revenues, product related revenues, or a combination of these elements. In recent years, our patent license agreements have contributed the majority of our cash flow and revenues. Including agreements signed in first quarter 2009, we now derive revenue from approximately one-half of all 3G mobile devices sold worldwide, up from approximately one-third at the beginning of 2008.
In 2008, 2007 and 2006 our total revenues were $228.5 million, $234.2 million and $480.5 million, respectively, and our recurring revenues were $219.1 million, $219.5 million and $213.1 million, respectively. Recurring patent licensing revenue made up at least 95% of our total recurring revenues in each period.
In 2008, the amortization of fixed fee royalty payments accounted for approximately 40% of our recurring patent licensing revenues. Due to the nature of the revenue recognition, these fixed fee revenues are not affected by the related licensees' success in the market or the general economic climate. The remaining portion of our recurring patent licensing revenue is variable in nature due to the per unit nature of the related license agreements. Approximately three-fourths of this per unit variable portion for 2008 related to sales of product by Japanese licensees for whom the majority of the sales are within Japan. As a result, our per unit variable patent license royalties have been, and will continue to be, largely influenced by sales within the Japanese cellular market.
We expect that the proportion of our recurring patent licensing revenues resulting from fixed fee payments will increase in early 2009 upon our recognition of revenue associated with our new agreement with Samsung. Under that agreement, effective January 2009, Samsung will make payments totaling $400.0 million over the next 18 months.
Industry Overview
Our future revenues and cash flows are dependent, in large part, on industry-wide sales of wireless products. Over the course of the last ten years, the cellular communications industry has experienced rapid growth worldwide. Total worldwide cellular wireless communications subscriptions rose from slightly more than 320 million at the end of 1998 to approximately 4.0 billion at the end of 2008. In several countries, mobile telephones now outnumber fixed-line telephones. Market analysts expect that the aggregate number of global wireless subscriptions could exceed 5.6 billion in 2013. In June 2008, Strategy Analytics, Inc. forecasted 1.4 billion total handset sales for 2009. Recently, Strategy Analytics, Inc. lowered their forecast for 2009 handset sales by 20%. The following table includes the recent forecast for 2009 and the June 2008 forecast for 2010 through 2013, the latest forecast available for that period.
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(1) Source: Strategy Analytics, Inc. December 2008. Global Handset Shipment Forecast by Quarter for 2009 (2007 through 2009). Strategy Analytics, Inc. June 2008. Global Handset Sales Historical and Forecast 2003-2013 (2010 through 2013).
(2) Includes: WCDMA/HSPA, LTE, and TD-SCDMA.
(3) Includes: cdma2000 and its evolutions, such as EV-DO.
(4) Includes: GSM/GPRS/EDGE and Analog, iDEN, TDMA, PHS and PDC.
The growth in new cellular subscribers, combined with existing customers choosing to replace their mobile phones, helped fuel the growth of mobile phone sales from approximately 168 million units in 1998 to almost 1.2 billion units in 2008. We believe the combination
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of a broad subscriber base, continued technological change and the growing dependence on the Internet, e-mail and other digital media sets the stage for continued growth in the sales of advanced wireless products and services over the next five years. While recent market forces and a global economic downturn may contribute to a decline in total handset sales for 2009, analysts continue to predict that the shift to advanced 3G devices will continue to increase sales in that category. For these same reasons, shipments of 3G-enabled phones, which represented approximately 25% of the market in 2007, are predicted to increase to approximately 80% of the market by 2013. Moreover, recent advances in 3G technologies that support devices offering higher data rates have met with rapid consumer uptake.
In addition to the advances in digital cellular technologies, the industry has also made significant advances in non-cellular wireless technologies. In particular, IEEE 802.11 WLAN has gained momentum in recent years as a wireless broadband solution in the home and office and in public areas. IEEE 802.11 technology offers high-speed data connectivity through unlicensed spectra within a relatively modest operating range. Since its introduction in 1998, semiconductor shipments of products built to the IEEE 802.11 Standard have shipped nearly 1 billion units cumulatively through 2008. Analysts forecast that these cumulative shipments may reach 4 billion by 2012. In addition, the IEEE wireless Standards bodies are creating sets of Standards to enable higher data rates, provide coverage over longer distances and enable roaming. These Standards are establishing technical specifications for high data rates, such as IEEE 802.16 (WiMAX), as well as technology specifications to enable seamless handoff between different air interfaces (IEEE 802.21).
Repurchase of Common Stock
In 2006, our Board of Directors authorized the repurchase of up to $350.0 million of our outstanding common stock (the "2006 Repurchase Program"). In October 2007, our Board of Directors authorized a $100.0 million share repurchase program (the "2007 Repurchase Program"). The Company could repurchase shares under the programs through open market purchases, pre-arranged trading plans or privately negotiated purchases. During 2006, we repurchased approximately 6.5 million shares of common stock for $192.4 million. At December 31, 2006, we accrued accounts payable of approximately $7.6 million associated with our obligation to settle late December repurchases. We completed the 2006 Repurchase Program in first half 2007 through the repurchase of an additional 4.8 million shares of common stock for $157.6 million in 2007. Under the October 2007 authorization in 2007, we repurchased approximately 1.0 million shares of common stock for $18.5 million. At December 31, 2007, we accrued accounts payable of approximately $0.8 million associated with our obligation to settle late December repurchases. During 2008, we completed the 2007 Repurchase Program through the repurchase of 3.8 million shares of common stock for $81.5 million.
Intellectual Property Rights Enforcement From time to time, if we believe any party is required to license our patents in order to manufacture and sell certain digital cellular products and such party has not done so, we may institute legal action against them. This legal action typically takes the form of a patent infringement lawsuit or an administrative proceeding such as a Section 337 proceeding before the U.S. International Trade Commission ("USITC"). In addition, we and our licensees, in the normal course of business, might seek to resolve disagreements between the parties with respect to the rights and obligations of the parties under the applicable license agreement through arbitration or litigation.
In 2008, our patent litigation and arbitration costs decreased to $34.0 million from $38.6 million in 2007. This represented 58% of our 2008 total patent administration and licensing costs of $58.9 million. Patent litigation and administration costs will vary depending upon activity levels and it is likely they will continue to be a significant expense for us in the future. Development
Our investments in the development of advanced digital wireless technologies and related products include maintaining a highly specialized engineering team and providing that team with the equipment and advanced software platforms necessary to support the development of technologies. Over each of the last three years, our cost of development has ranged between 45% and 52% of our total operating expense, exclusive of non-recurring contingency accruals and repositioning charges. The largest portion of our cost of development has been personnel costs.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our consolidated financial statements are based on the selection and application of accounting principles, generally accepted in the United States of America, which require us to make estimates and assumptions that affect the amounts reported in both our consolidated financial statements and the accompanying notes thereto. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from these estimates and any such differences may be material to the financial statements. Our significant accounting policies are described in Note 2 to our consolidated financial statements and are included in Item 8 of this Form 10-K. We believe the accounting policies that are of particular importance to the portrayal of our financial condition and results and that may involve a higher degree of complexity and judgment in their application compared to others are those relating to patents, contingencies, revenue recognition, compensation and income taxes. If different assumptions were made or different conditions had existed, our financial results could have been materially different.
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Patents
We capitalize external costs, such as filing fees and associated attorney fees, incurred to obtain issued patents and patent license rights. We expense costs associated with maintaining and defending patents subsequent to their issuance. We amortize capitalized patent costs on a straight-line basis over ten years, which represents the estimated useful lives of the patents. The ten year estimated useful life of internally generated patents is based on our assessment of such factors as the integrated nature of the portfolios being licensed, the overall makeup of the portfolio over time and the length of license agreements for such patents. The estimated useful lives of acquired patents and patent rights, however, have and will continue to be based on separate analyses related to each acquisition and may differ from the estimated useful lives of internally generated patents. The average estimated useful life of acquired patents used thus far has been 15 years. We assess the potential impairment to all capitalized net patent costs when events or changes in circumstances indicate that the carrying amount of our patent portfolio may not be recoverable. Amortization expense related to capitalized patent costs was $11.9 million, $9.3 million and $7.8 million in 2008, 2007 and 2006, respectively. As of December 31, 2008 and 2007, we had capitalized gross patent costs of $159.7 million and $132.1 million, respectively, which were offset by accumulated amortization of $56.9 million and $45.0 million, respectively. The weighted average estimated useful life of our capitalized patent costs at December 31, 2008 and 2007 was 10.9 years and 11.0 years, respectively. Contingencies
We recognize contingent assets and liabilities in accordance with Statement of Financial Accounting Standards (SFAS) No. 5 Accounting for Contingencies. We do not include expected legal fees to defend ourselves in our accruals for contingent liabilities; we expense such legal fees in the periods in which the related services are provided.
In second quarter 2007, we recorded a $16.6 million charge to increase a $3.4 million contingent liability to $20.0 million. Subsequently we have accrued post judgment interest expense of $1.8 million ($1.1 million during 2008) and reported such interest expense within the interest and investment income, net, line within our Consolidated Statements of Income. This contingency relates to an arbitration with Federal over an insurance reimbursement agreement. In second quarter 2008, InterDigital deposited $23.0 million with the Clerk of the Court, an amount sufficient to secure Federal's judgment and anticipated interest until decision by the Court of Appeals.
In fourth quarter 2007, we accrued $7.8 million for the potential reimbursement of legal fees associated with our UKII matter with Nokia. During 2008, we recognized a credit of $3.9 million associated with the reduction of this accrual in connection with the resolution of the Nokia UK matters. Revenue Recognition
We derive the majority of our revenue from patent licensing. The timing and amount of revenue recognized from each licensee depends upon a variety of factors, including the specific terms of each agreement and the nature of the deliverables and obligations. Such agreements are often complex and include multiple elements. These agreements can include, without limitation, elements related to the settlement of past patent infringement liabilities, up-front and non-refundable license fees for the use of patents and/or know-how, patent and/or know-how licensing royalties on covered products sold by licensees, cross licensing terms between us and other parties, the compensation structure and ownership of intellectual property rights associated with contractual technology development arrangements, advanced payments and fees for service arrangements, and settlement of outstanding patent litigation. Due to the inherent difficulty in establishing reliable, verifiable and objectively determinable evidence of the fair value of the separate elements of these agreements, the total revenue resulting from such agreements may sometimes be recognized over the performance period. In other circumstances, such as those agreements involving consideration for past and expected future patent royalty obligations, after consideration of the particular facts and circumstances, the appropriate recording of revenue between periods may require the use of judgment. In all cases, revenue is only recognized after all of the following criteria are met: (1) written agreements have been executed; (2) delivery of technology or intellectual property rights has occurred or services have been rendered; (3) fees are fixed or determinable; and (4) collectability of fees is reasonably assured.
We establish a receivable for payments expected to be received within twelve months from the balance sheet date based on the terms in the license. Our reporting of such payments often results in an increase to both accounts receivable and deferred revenue. Deferred revenue associated with fixed fee royalty payments is classified on the balance sheet as short-term when it is scheduled to be amortized within twelve months from the balance sheet date. All other deferred revenue is classified as long-term, as amounts to be recognized over the next twelve months are not known. Patent License Agreements
Upon signing a patent license agreement, we provide the licensee permission to use our patented inventions in specific applications. We account for patent license agreements in accordance with Emerging Issue Task Force (EITF) No. 00-21 Revenue Arrangements with Multiple Deliverables and Staff Accounting Bulletin (SAB) No. 104 Revenue Recognition. We have elected to utilize the leased-based model for revenue recognition, with revenue being recognized over the expected period of benefit to the licensee. Under our patent license agreements, we typically receive one or a combination of the following forms of payment as consideration for permitting our licensees to use our patented inventions in their applications and products:
Consideration for Prior Sales: Consideration related to a licensee's product sales from prior periods may result from a negotiated agreement with a licensee that utilized our patented inventions prior to signing a patent license agreement with us or from the resolution of a disagreement or arbitration with a licensee over the specific terms of an existing license agreement. We may also receive consideration for prior sales in connection with the settlement of patent litigation where there was no prior patent license agreement. In each of these cases, we record the consideration as revenue when we have obtained a signed agreement, identified a fixed or determinable price and determined that collectability is reasonably assured.
Fixed Fee Royalty Payments: Up-front, non-refundable royalty payments that fulfill the licensee's obligations to us under a patent license agreement, for a specified time period or for the term of the agreement. We recognize revenues related to Fixed Fee Royalty
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Payments on a straight-line basis over the effective term of the license. We utilize the straight-line method because we cannot reliably predict in which periods, within the term of a license, the licensee will benefit from the use of our patented inventions.
Prepayments: Up-front, non-refundable royalty payments towards a licensee's future obligations to us related to its expected sales of covered products in future periods. Our licensees' obligations to pay royalties extend beyond the exhaustion of their Prepayment balance. Once a licensee exhausts its Prepayment balance, we may provide them with the opportunity to make another Prepayment toward future sales or it will be required to make Current Royalty Payments. Current Royalty Payments: Royalty payments covering a licensee's obligations to us related to its sales of covered products in the current contractual reporting period.
Licensees that either owe us Current Royalty Payments or have Prepayment balances provide us with quarterly or semi-annual royalty reports that summarize their sales of covered products and their related royalty obligations to us. We typically receive these royalty reports subsequent to the period in which our licensees' underlying sales occurred. We recognize revenue in the period in which the royalty report is received and other revenue recognition criteria are met due to the fact that without royalty reports from our licensees, our visibility into our licensees sales is very limited.
The exhaustion of Prepayments and Current Royalty Payments are often calculated based on related per-unit sales of covered products. From time to time, licensees will not report revenues in the proper period, most often due to legal disputes; when this occurs, the timing and comparability of royalty revenue could be affected.
In cases where we receive objective, verifiable evidence that a licensee has discontinued sales of products covered under a patent license agreement with us, we recognize any related deferred revenue balance in the period that we receive such evidence.
During 2007, we recognized revenue of $5.2 million related to unpaid patent licensee royalties. We based our recognition of this revenue on royalty reports received, despite the fact that the licensee had expressed its belief that it did not have a current payment obligation. We believed that we were entitled to these royalty payments and the eventual collection of these amounts was reasonably assured; we subsequently collected these amounts in 2008. Technology Solutions Revenue
Technology solutions revenue consists primarily of revenue from software licenses and engineering services. Software license revenues are recognized in accordance with the American Institute of Certified Public Accountants Statement of Position (SOP) 97-2 Software Revenue Recognition and SOP 98-9 Modification of SOP 97-2, Software Revenue Recognition. When the arrangement with a customer includes significant production, modification or customization of the software, we recognize the related revenue using the percentage-of-completion method in accordance with SOP 81-1 Accounting for Performance of Construction-Type and Certain Production-Type Contracts. Under this method, revenue and profit are recognized throughout the term of the contract, based on actual labor costs incurred to date as a percentage of the total estimated labor costs related to the contract. Changes in estimates for revenues, costs and profits are recognized in the period in which they are determinable. When such estimates indicate that costs will exceed future revenues and a loss on the contract exists, a provision for the entire loss is recognized at that time.
We recognize revenues associated with engineering service arrangements that are outside the scope of SOP 81-1 on a straight-line basis under SAB No. 104, unless evidence suggests that the revenue is earned in a different pattern, over the contractual term of the arrangement or the expected period during which those specified services will be performed, whichever is longer. In such cases we often recognize revenue using proportional performance and measure the progress of our performance based on the relationship between incurred labor hours and total estimated labor hours or other measures of progress, if available. Our most significant cost has been labor and we believe both labor hours and labor cost provide a measure of the progress of our services. The effect of changes to total estimated contract costs is recognized in the period such changes are determined.
When technology solutions agreements include royalty payments, we recognize revenue from the royalty payments using the same methods described above under our policy for recognizing revenue from patent license agreements. Deferred Charges
From time-to-time, we use sales agents to assist us in our licensing activities. In such cases, we may pay a commission. The commission rate varies from agreement to agreement. Commissions are normally paid shortly after our receipt of cash payments associated with the patent license agreements.
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We defer recognition of commission expense related to both Prepayments and Fixed Fee Royalty Payments and amortize these expenses in proportion to our recognition of the related revenue. In 2008, 2007 and 2006, we paid cash commissions of approximately $0.1 million, $1.7 million and $18.8 million and recognized commission expense of $4.7 million, $4.7 million, and $8.4 million, respectively, as part of patent administration and licensing expense. At December 31, 2008, 2007 and 2006 we had deferred commission expense of approximately $3.4 million, $4.1 million and $4.1 million, respectively, . . . |
