Summary
- I think the company remains wonderfully profitable. Although the capital structure has deteriorated, it remains very strong, and the dividend remains well covered.
- The problem is that the shares are neither cheap nor expensive at the moment. I've never regretted taking profits when I'm up 55%, so I'll sell half my stake today.
- I would have preferred that the company spend $200 million on a $6.74 special dividend than a buyback. Dividends can't be taken. Short term stock appreciation can be.
It's been just under 5 months since I bought InterDigital Inc. (IDCC) for $46.50, and a very short while later I was exercised on some short puts I had written with a strike of $50. The shares have returned about 55% since then, against a gain of 3.5% for the S&P 500. I really hate to come off like I'm bragging here, but I think I need to pause at this point to remind investors that I eschewed these same shares only three months prior when they were trading at $62.25. The narrative was as compelling in June as it was in September, but I insisted on only buying when the shares were cheap. Relying on the narrative alone would have resulted in a much worse outcome. This is why I recommend people pay much more attention to valuations than to stories. Apart from an update about InterDigital, I hope this article stands as yet further evidence of the power of simply buying great cash flow streams at low prices. Before continuing, I feel the need to confess to the fact that I just wrote a falsehood above. I wrote that "I really hate to come off like I'm bragging here", and that was a lie. I'm totally comfortable bragging.
Anyway, as I try to ignore that pesky voice in my head that's blathering something about "pride goeth before destruction" or whatever, I want to review this name again. After all, a stock trading at $71 is, by definition, a more risky investment than one that's trading at $50. So today I want to review the latest financial results, and review the valuation to determine whether or not it makes sense to buy more, hold, or take profits in this business. Additionally, the company has announced a buyback, and I want to offer some thoughts on that.
Welcome to the "thesis statement" portion of the article. I offer the gist of my arguments in the thesis statement for those people who want a little bit more than the bullet points and title, but have an understandably low tolerance for "Doyle mojo." I get it. InterDigital remains massively profitable, and I'm very happy to have had the opportunity to buy this wonderful business at such a great price earlier. The problem is that the shares are no longer cheap in my view, and I'm in the mood to preserve capital at the moment. For that reason, I'm going to sell off half of my stake this morning. In addition, since I'm of the view that the shares are no longer objectively cheap, I don't think the buyback is the best use of owner capital. Although there's little risk in the capital structure in my view, I'd have been happier if the company paid down some debt with this capital. I don't know if you've been keeping up with financial news, but interest rates have risen rapidly and relatively high given where they came from. Even more than debt reduction, I would prefer the company spend this $200 million on a $6.74 special dividend. That's the gist of my article in a nutshell. If you read on from here, that's on you. I don't want to read any complaints in the comments section about anything I write beyond this point that may offend. For instance, later in this article, I poke fun at fellow Canadians for being a bit drab. If that sort of thing bothers you, you should probably back away now.
Financial Snapshot
The financial results here have been rather good in my estimation. Specifically, revenue and net income for the first 9 months of 2022 were up by 8.7% and 83% (!) respectively. Additionally, things look even better when compared to the pre-pandemic period, with revenue and net income in 2022 being up by 64% and 754% respectively. The company remains very profitable, and the profits seem to be growing. Although the dividend has been flat for some time, these profits cover it well, given that the payout ratio is only about 52.5% as of the third quarter.
It's not all sunshine and lollipops at InterDigital, though. The level of indebtedness has exploded higher over the past year, rising from $421 million to $605 million. Although this is troubling on some level, interest payments have barely budged from the year ago period. More importantly, the company still has a cash hoard that dwarfs debt. Specifically, InterDigital has cash and short term investments of about $863 million on the balance sheet at the moment.
Given the sustainability of the dividend, and given the rock solid capital structure, I'm comfortable adding to my position at the right price.
InterDigital Financials (InterDigital investor relations)
The Stock
If you're one of my regular readers, you know exactly what time it is. It's time for me to point out, yet again, that "companies" and "stocks" are different things. It's also time for me to be a total "downer", as the young hippies say, because I remind investors that a great, solidly profitable company like this one can be a terrible investment at the wrong price.
Taking the first point first, the business generates revenue and profits, and the stock is a speculative instrument that gets traded around based on long term expectations about the business. Given that the financial statement valuation of the business is "backward looking" and the stock is a forecast about the distant future, there's an inevitable tension between the two. The tension is highlighted by the fact that the business designs, manufactures, and sells wireless technologies. The stock, on the other hand, is buffeted by a host of factors, some of which have nothing to do with those activities. One of the things that affects the performance of a given stock, for example, is the crowd's ever-changing views about the desirability of "stocks" as an asset class. There's no way to prove this definitively, as it's an obvious counterfactual, but a reasonable argument could be made to suggest that some portion of InterDigital's great return was boosted by the fact that people have been rather favorably disposed toward stocks over the past several months. Additionally, the stock has likely been boosted by the offer to repurchase shares.
That action has the potential to massively, and positively, impact the stock while reducing the strength of the capital structure. So this is why I consider the stock as a thing distinct from the business. The former is often a poor proxy for what's going on at the company, and I think it's possible to profitably exploit this disconnect. In my view, the only way to successfully trade stocks is to spot the discrepancies between what the crowd is assuming about a given company and subsequent results. I absolutely hate to bring it up again, but this is exactly how I managed to profit so handsomely from this investment over the recent past. I saw that investors were unreasonably pessimistic, so I bought. When the crowd is pessimistic, the shares are cheap, and cheap stocks are great because all of the potential bad news is already "priced in." In my previous piece, in case you've forgotten, I decided that the share price was compelling to me because the shares were trading at a price to sales ratio of about 3.02, and the dividend yield was exactly 3%. At the moment, the shares are about 60% more expensive and the yield has dropped by about 34%. I'm not a fan of paying more and getting less.
My regulars know that I think ratios can be instructive, but I also want to try to work out what the market is "thinking" about a given investment. If you read my stuff regularly, you know that the way I do this is by turning to the work of Professor Stephen Penman and his book "Accounting for Value" for this. In this book, Penman walks investors through how they can apply some pretty basic math to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in this formula. In case you find Penman's writing a bit opaque, you might want to try "Expectations Investing" by Mauboussin and Rappaport. These two have also introduced the idea of using the stock price itself as a source of information, and we can infer what the market is currently "expecting" about the future. Applying this approach to InterDigital at the moment suggests the market is assuming that this company will grow earnings at a rate of ~3.75% in perpetuity. I don't consider this to be too optimistic a forecast, but I will admit that the shares are no longer the "screaming buys" they were earlier. Since I'm in the mood to protect capital, I'm going to pare my stake here. I don't think the valuation is so egregious that I'm going to sell my entire stake, but I will certainly sell 700 of my shares, which represents half of my stake in this business.
Assessing the Buyback
I know some investors who are passionate advocates for buybacks. I know people who are equally passionate about why buybacks are a terrible waste of owner capital. Between the "fire" of one of these opinions and the "ice" of the other, I tend to be "lukewarm water", which is a stance that reflects a great Canadian tradition. I think buybacks are positive when the company pays a reasonable price for them, and I think they're a waste of money when the company overpays. Additionally, I want to judge the buyback in relation to alternatives available to the company, in this case paying down debt or paying a special dividend.
Given that I consider the shares to be neither cheap nor very expensive at the moment, my attitude about the buybacks could be summed up onomatopoeically as "meh." I'd prefer it if the company used this capital to de-risk the balance sheet.
Alternatively, if the company wants to return $ 200 million to shareholders, a special dividend would be most welcome. As of the latest 10-Q, there are currently 29,662,993 shares outstanding. Applying the skills quite brutally instilled to me by the good sisters at Holy Spirit School many decades ago, I have determined that if the company spent this same $200 million on a special dividend, that would work out to $6.74 per share. I would prefer that use of this capital most of all. As I've learned from decades of investing, no one's going to take from you the dividend you've just been paid. Returns from stock appreciation are a different type of return entirely, because what the market giveth, the market taketh awayeth.
For further details see:
Paring My Stake In InterDigital