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Edited Transcript of IDCC earnings conference call or presentation 27-Apr-17 2:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 InterDigital Inc Earnings Call

KING OF PRUSSIA May 3, 2017 (Thomson StreetEvents) -- Edited Transcript of InterDigital Inc earnings conference call or presentation Thursday, April 27, 2017 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Patrick Van de Wille

InterDigital, Inc. - Chief Communications Officer

* Richard J. Brezski

InterDigital, Inc. - CFO

* William J. Merritt

InterDigital, Inc. - CEO, President and Director

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Conference Call Participants

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* Charles L. Anderson

Dougherty & Company LLC, Research Division - VP and Senior Research Analyst

* Eric Christian Wold

B. Riley & Co., LLC, Research Division - Senior Equity Analyst

* Matthew Galinko

Sidoti & Company, LLC - Research Analyst

* Nikhil Dixit

Barclays PLC, Research Division - Research Analyst

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Presentation

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Operator [1]

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Good day, and welcome to the InterDigital First Quarter 2017 Earnings Call. Please note that today's conference is being recorded. At this time, I'd like to turn the conference over to Patrick Van de Wille. Please go ahead, sir.

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Patrick Van de Wille, InterDigital, Inc. - Chief Communications Officer [2]

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Thank you, Emelia. And good morning, everybody. Welcome to InterDigital's First Quarter 2017 Earnings Conference Call. With me this morning are Bill Merritt, our President and CEO; and Rich Brezski, our CFO. Consistent with last quarter's call, we'll 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 published this morning as well as those detailed in our annual report on Form 10-K for the year ended December 31, 2016, and from time to time in 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, pro forma operating expenses, non-GAAP net income and non-GAAP diluted EPS. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our first quarter 2017 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 Q1 2017. With that taken care of, I'll turn the call over to Bill.

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William J. Merritt, InterDigital, Inc. - CEO, President and Director [3]

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Thank you, Patrick. And good morning, everyone, and thank you for joining us on the call today. As you saw from the press release this morning, the company delivered a very solid quarter, driven by our strong base of licensees that includes the 3 top sellers of smartphones: Apple, Samsung and Huawei. The strong results on our top line combined with the continued efforts to control our cost resulted in substantial profitability. We also ended the quarter with a very strong balance sheet that provides us with significant opportunities of doing the business in smart ways.

Rich will go through the numbers in more detail in his remarks. I wanted to spend just a couple of minutes today talking about the status of our licensing activities, where we are on 5G research, how the IoT opportunity is shaping up and our continuing thoughts around M&A.

On the licensing front, we have an active dialogue going on -- ongoing with the remaining key unlicensed companies including LG, Lenovo, ZTE and Xiaomi. We remain patient in our approach understanding that each of these customers faces different challenges within their respective businesses. We talk to our customers about a wide range of options, including the transfer of patents, joint research and access to our technology platforms and the like with some of the discussions greatly enhanced by our acquisition of Hillcrest Labs. That said, we and they also understand the potential for litigation in our industry in situations where the discussions do not get to where they need to be.

In this regard, we are buoyed by a recent decision in the U.K. on how to apply FRAND principles. The decision involves Huawei and Unwired Planet, with one of the issues being under what conditions an injunction should issue for the infringement of standard-essential patents.

While like any decisions, there are parts we may agree with and other parts we may not, overall, there are many favorable aspects of that decision. And in particular, as to how the court handled the question I just mentioned. In a nutshell, the court determined in this case, a case which involves standard-essential patents that were found to be valid and infringed, that an injunction should be granted. Importantly, the judge considered that the manufacturer should have agreed to take a worldwide license to the patent holder's standard-essential patent and that the manufacturer's insistence on a U.K. only portfolio license was not FRAND.

This is a very important conclusion. In reaching this decision, the judge recognized that requiring the patent holder to bring suit in jurisdiction after jurisdiction was fundamentally unfair to the patent holder. Indeed the original patent holder, the innovator, had willingly offered its technology solutions to the standard body, which operates on a worldwide basis to enable the manufacturers to sell phones on a worldwide basis. The technology access substantially lowered the barrier for entry for new market participants, allowing them to rapidly enter the market and grow market share. Indeed, that is the beauty of a worldwide standards process. It opens up the worldwide market to a large number of competitors to the benefit of manufacturers and consumers.

Given the benefits that accrue to manufacturers and consumers alike, it only follows that the innovators who enable this market be treated fairly. Requiring that the manufacturer implementing such a standard take a license on a worldwide basis to access this important and exciting technology is a very logical and fair result.

While this is a lower court decision, it is nonetheless very meaningful and represents, I believe, the pendulum's beginning to swing back to the middle on patent rights. It puts unwilling licensees on notice that patent holders may now have an effective and efficient means by which to secure worldwide licenses with manufacturers on fair terms. This is an extremely important development and can serve as encouragement to unlicensed companies to negotiate the terms of a license on a good faith and arm's length basis versus running the risk of a court setting the rate for them. That said, don't construe this as suggesting court proceedings are more necessary. To the contrary, the fact that courts can be effective in bringing closure to licensing issues on fair and balanced terms can actually have the opposite effect. It may make both parties act more reasonably, avoid litigation and fashion their own result.

Moving on to our 5G research efforts. We continue to play a very important role in the development of this new, very crucial standard. As we have discussed before, the 5G standard as a development will not only supercharge the services we get on current devices, it will enable brand new services for massive machine communications, to mission-critical services like autonomous vehicles.

It's a very exciting development effort, and InterDigital is in the thick of it. InterDigital leadership is reflected in the fact that we have over a dozen key leadership positions within the standards bodies working on 5G designs. We were also one of the 4 companies that were asked to present our 5G technology at the headline demo event on the main stage at the Mobile World Congress in Barcelona, the most important annual trade show for the industry.

We also demonstrated a host of 5G-related technologies in our booth at the show and hosted a significant number of visitors who sought us out. And we continue to be one of the few companies with its design proposals for a new radio, critical for 5G, being actively considered for inclusion in the standard.

As for the IoT opportunity we are pursuing, we continue to build our brand, channel partners and sales pipeline. For smart meter applications, we are now partnered with CA, a leading technology solutions provider to the utility market, to bring our IoT platforms to this market (inaudible). We are partnered with HARMAN for smart buildings. And we continue to have our direct customer connection with Sony and others. These efforts continue to be supported by the recognition that our offerings are receiving in the marketplace in terms of nominations, awards and wins on funded research out of the U.K.

We continue to be optimistic that we will see quality revenue from the business this year that, while small at the onset, could ramp over time in a meaningful way.

As previously discussed at our Investor Day in September 2016, we estimated that in 5 years, the revenue from this opportunity combined with the revenue we expect from the Avanci IoT licensing platform could be in the $75 million to $100 million range with a substantial portion of that revenue dropping to the bottom line as we have only a small amount of incremental cost associated with these activities.

Lastly, we continue to be very focused on exploring the opportunity for inorganic growth, which is one reason why we have maintained a strong balance sheet. With our large installed base of handset customers, we see an opportunity to acquire additional pervasive technologies that we can offer to our licensee base at economical prices.

We also believe that licensing businesses benefit from scale generally. As a result, moreso than any time in our history, we see the opportunity to make value-driving external investments. We intend to explore them, but with a rigor and financial discipline that you have become used to seeing with the company.

In sum, we've done a great job of building a very strong business that we love. And there is more value to create, be assured we are determined to do so. With that, let me turn the call over to Rich.

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Richard J. Brezski, InterDigital, Inc. - CFO [4]

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Thanks, Bill. As Bill discussed, the addition of our recent license agreements with Huawei and Apple provide us with a stable platform to pursue further growth. That stability is reflected in the overall shift in the proportion of fixed fee versus per-unit revenues over the last 12 months.

In first quarter 2016, per-unit royalties accounted for 72% of our current patent royalty revenue, with the remaining 28% coming from fixed-fee agreements. In first quarter 2017, that ratio has inverted with 82% of our current patent royalty revenue coming from fixed-fee agreements and per-unit royalties contributing just 18%.

This year-over-year shift in revenue mix also reflects the seasonality that used to exist in our business related to the Apple supply chain. Up until this year, our first quarter revenue was impacted by Apple's calendar fourth quarter sales, traditionally, the first full quarter of sales following the annual iPhone launch.

Per unit contributions from the Apple ecosystem would then trend down over our second and third quarters. Now with Apple under a fixed-fee agreement, we expect regular revenue contributions from Apple based on straight-line revenue recognition under that fixed-fee agreement.

Our pro forma operating expenses for the quarter were up a little bit on a year-over-year basis. This increase was expected due to our December 2016 acquisition of Hillcrest Labs. Of note, we recognized a tax benefit of $11.8 million in the first quarter associated with the vesting of share-based compensation. This benefit reflects the increase in the value of share-based compensation at best, which is the basis for our tax deduction as compared to the value at grant, which is the basis for our book expense.

Prior to January of this year, such differences were recorded as an adjustment to equity. But as a result of our adoption of new accounting standards that became effective this year, such changes now run through the P&L when the underlying shares vest.

During the quarter, we recognized about $1 million of share-based compensation expense associated with a fourth quarter 2016 retention grant to Hillcrest employees. The expense of this grant is recognized on an accelerated basis, and like all share-based compensation, we exclude it from our non-GAAP diluted EPS in our financial metrics.

We also recognized about $1 million of amortization expense related to intangible assets we acquired from Hillcrest with most of that value being associated with patents covering Hillcrest's sensor fusion innovations. We have not excluded any acquisition-related amortization from our non-GAAP diluted EPS.

We note that this practice is a bit different from our peers and is an outgrowth of our accounting policy to capitalize the cost associated with filing patents. With that, I'll turn it back over to Patrick.

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Patrick Van de Wille, InterDigital, Inc. - Chief Communications Officer [5]

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Thanks very much, Rich. Emelia, we'll open the call for questions, please.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And we'll go first to Eric Wold from B. Riley.

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Eric Christian Wold, B. Riley & Co., LLC, Research Division - Senior Equity Analyst [2]

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Few questions. I guess, two kind of quick housekeeping ones, first. I guess, one, anything unusual in the Q1 operating expenses, post Hillcrest, anything unusual in there, either direction or is that what we see in Q1, is that a relatively good run rate for the remainder of the year or, I guess, kind of assuming normal trends?

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William J. Merritt, InterDigital, Inc. - CEO, President and Director [3]

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Yes, Eric. I don't think there is anything highly unusual in there. That said, our level of investment is going to fluctuate a little bit quarter-to-quarter. You know that we're not intently focused on quarterly results, but making long-term investments that drive value. So we want to make sure that we operate -- manage our expenses. I guess, we did have the trade show in Barcelona, so that does tend to add to first quarter expenses. The only other thing that I'd note is the benefit rate is a little bit higher in the beginning of the year and trends down, but they are the normal seasonal things that we see every first quarter.

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Eric Christian Wold, B. Riley & Co., LLC, Research Division - Senior Equity Analyst [4]

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Okay. Is the thought still that you will be able to recognize the remaining past sales payment from Huawei in Q2?

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William J. Merritt, InterDigital, Inc. - CEO, President and Director [5]

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Yes, that's right. That's all based on the timing of the final patent transfer from Huawei and that's anticipated to be in the second quarter.

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Eric Christian Wold, B. Riley & Co., LLC, Research Division - Senior Equity Analyst [6]

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Okay. I think, kind of a larger question. Update us now that you've had Hillcrest Labs in there for a few months, and maybe kind of if you'll dig a little bit deeper. Maybe, talk about what's transpired into the combining efforts between the 2 teams, discussions with their customers about potentially going deeper with technologies? And then also, as you've looked at some of the other areas they were in, the areas you had not been in before, any of those seem increasingly more attractive now, as you kind of, maybe, go -- would go deeper and later than they previously thought?

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William J. Merritt, InterDigital, Inc. - CEO, President and Director [7]

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Sure. So I'd sort of break it into 3 pieces, right? So there's sort of the Hillcrest organic brand that they were operating on. So -- they continue to have solid customer discussions. They've got engagements with LG, Samsung and others on that. So that process continues. The second piece is where that process intersects with our customer base. So one of the reasons that -- another reason we acquired them is not -- is in addition to having their own set of customers, some of their customers overlap with ours and it gives us a broader set of tools and we're talking with some of the unlicensed parties in terms of other things that we can do together. And that has been a very productive dialogue gone on with folks in terms of trying to create more a bundled solution.

And then the third piece is, well you mentioned is, it's now talking about where the two organizations can go together, particularly from a technology development standpoint. Sensors and sensor fusion is a very critical part of the go-forward technology landscape. There is a lot of intersection with wireless in that -- in all that. And so we're involved in a strategic planning process with them now to come up with the next great thing that Hillcrest can do leveraging its capabilities, but also bringing our strength into that as well. So far, it's doing exactly what we wanted it to do. So -- and that -- we hope that to be the continuing process with it.

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Eric Christian Wold, B. Riley & Co., LLC, Research Division - Senior Equity Analyst [8]

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Perfect, and then final question for me. You continue to progress towards 5G. Remind us, which -- or if you don't want to name specific customers maybe kind of what percentage of customers or licensees, if any, really have any consideration for 5G in their agreements even or not generally now, but kind of have contemplation in the agreements for when 5G comes out? Or is that all incremental down the road to those discussions?

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William J. Merritt, InterDigital, Inc. - CEO, President and Director [9]

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I'd say for the most part, it's not in agreements today. There is -- obviously, a 5G device would be backwards compatible to 2G and 3G and 4G. And so if it's a running royalty, for example, you would still get royalties on that product. If it's -- even though the product itself may not be fully licensed at that point. I think some of the longer-term agreements at least address 5G in some respects. And so, I think my guess is as we look at agreements that we would do this year and next year, 5G is going to become more of, it was like the prior generations of technology starts to bleed into agreements on a more consistent basis given that the launch of 5G services is not too far out.

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Operator [10]

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(Operator Instructions) And we'll go next to Charlie Anderson from Dougherty & Company.

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Charles L. Anderson, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [11]

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Bill, I noted in the script that you named a few unlicensed OEMs. I don't know if I remember you doing that in the past, maybe LG. I wonder if that was because you're maybe at a more advanced state than you had been previously. And then, kind of what you see as the triggers there? I know you mentioned there is -- everyone has sort of a different road map and different opportunities. Any additional color on that would be great. Then I have got a follow-up.

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William J. Merritt, InterDigital, Inc. - CEO, President and Director [12]

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Sure. So no particular reason I think I put it in the script other than I think it's something we've said before. We think about the rest of the market to license. It's not 100 companies, right? It's a relatively small number of companies that we've got to focus on. So I think that's a positive. I do think that each one presents a different set of facts that we need to deal with. And so while there are some aspects of resolution of one that can bleed into the others, as well as some aspects of resolutions of Huawei and Apple that bleed into all of them. We do need to and we always are very flexible in terms of how we approach licensees.

And the other part of my discussion was around the U.K. case, and as I said, I think that if you think about licensing as needing to be a strong rope, most rope is made up of a bunch of individual twines, right? And so the twines are how strong is your portfolio, how strong is your research, how strong are the tools you have. I think one of those twines needs to be an effective enforcement system. And I think that we're seeing more positive developments on that front.

And I think the result of that is actually less enforcement at the end of the day, because people start to view that as sort of an unnecessary exercise, because it's going to -- if it's going to end up with a fair and balanced result, at the end of the day, people would rather negotiate that themselves. So hopefully, that will be the effect of the U.K. decision. You can be assured that that's something we chat about now with all of our licensees in terms of an alternative and perhaps not a preferred alternative, just working it out on our own.

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Charles L. Anderson, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [13]

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Great. And then as it relates to IoT, you mentioned, a trickle of revenue this year. Is that in reference to something coming in from Avanci or your own efforts? And then just generally, any color on how Avanci is going so far?

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William J. Merritt, InterDigital, Inc. - CEO, President and Director [14]

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So it would be both. Certainly, the way Avanci is structured, I think, when that begins to slow, I think, it's certainly that it would be of that quality revenue that I talked about. And I think it's also very scalable. We can just continue to be encouraged by their level of activity that they are having and the quality of the discussions that they're having. We don't have perfect visibility in everything that they're doing since they are an independent group, but I know the person very well. And we chat on a regular basis, and I'm very comfortable with what they're doing.

Another component would be our own activity and that would be on the software side. And the expectation there is things will come in through the channel partners that we have whether it's CA or HARMAN, we may have a little bit of direct customer involvement as well. But again, the metric there is we're looking for customer engagement and that we see as scaling over time. And certainly, those are the opportunities that are on the table right now. We just have to see if we can close on those.

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Charles L. Anderson, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [15]

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Great, actually, just one more quick one, big jump in the AR balance. I wonder when you see that converting into cash?

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Richard J. Brezski, InterDigital, Inc. - CFO [16]

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Yes, so Charlie, our policy is to recognize receivables as they cross the 12 months from being due. So basically anything that's sitting in account receivables it's all current and due within 12 months.

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Operator [17]

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And we'll go next to Matthew Galinko from Sidoti.

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Matthew Galinko, Sidoti & Company, LLC - Research Analyst [18]

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First question would be, can you flesh out a little bit more the mechanics from your view of why players would behave a little more rationally if courts are more accommodative to patent holders? I guess, I kind of understand that if you're licensing FRAND, but insofar as portion of your portfolio which doesn't fit in that structure, so just maybe broadly and then more specifically to you, how do the mechanics work in your view?

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William J. Merritt, InterDigital, Inc. - CEO, President and Director [19]

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Yes. So good question. So if you think about what InterDigital has been talking about and what we've actually been doing from a licensing perspective, our position over the last number of years has been pretty straightforward, which is either you can choose to negotiate a license agreement directly with us or if we cannot come to a fair result that everyone likes, then we are more than happy to arbitrate the terms of that license and have somebody else determine what a fair license would be. With the -- the key part of that being, it needs to be worldwide, the license.

I think for a while we were sort of a lone voice out there on this. And -- but oddly, it seemed to me to be the most rational way to approach this issue, which is we enable worldwide competitors or competition, manufacturers benefit on a worldwide basis. We willingly give our technology to use on a worldwide basis. So why shouldn't the resolution be on a worldwide basis. But recognizing that, it may not be on terms that we or shouldn't be on terms that we dictate. It will be on terms that are fair and if we can't come up with things that are fair on a bilateral negotiation, let's arbitrate.

I think what I liked about the U.K. decision is it was essentially a validation event, not so much the arbitration piece, but the worldwide nature of things and as long as you've offered fair rates, you should be entitled to an injunction. I think that -- so the reason I think that, that now will be very helpful in license negotiations is that becomes the backstop of the negotiation, which is you tell people if you don't want to agree to what we're putting forward, we can either go to arbitration or if you want, we can go to the U.K and get it resolved there and that path has already been cut.

And over the years, I've found that, as I said, once you have an effective enforcement means out there, folks are not really inclined to go down that path. And we don't want to go down that path. We'd rather negotiate on fair terms. And so I think, certainly, for the FRAND-related patents, it balances the risk, levels the playing field, I think that's enough metaphors. And then, I think provides an environment for a more arm's length negotiation.

If your second question is what about non-FRAND-related patents, yeah, to some extent, at least the way we approach the world, it may not be different in the sense that you may not have the same FRAND overlay on top of those patents. But I don't think that immediately takes you to, and therefore, you can charge an unreasonable amount of money for that; at least that's not where it would take us. So I think, you may have less regulatory rigmarole to get to the same result, which is, look if you want a license and you want to agree to our terms, fine. Or if you want a license and you want to arbitrate it, fine, we'll agree to that too. But if you don't want to do either of those, then we should be able to stop your shipments, that's only fair.

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Operator [20]

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And we'll go next to Darrin Peller from Barclays.

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Nikhil Dixit, Barclays PLC, Research Division - Research Analyst [21]

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This is Nikhil Dixit on for Darrin. I'm jumping on a little late, so I apologize if this has been covered already. But on the technology solutions front, I was curious as to the uptick in revenues there in the quarter, this is kind of like the second time we've seen that. And is it similar -- is it driven by similar factors to what you called out last quarter? And how should we think about the sustainability of that going forward?

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Richard J. Brezski, InterDigital, Inc. - CFO [22]

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Yes, so Nikhil that is driven by royalties we collect under a protocol stack agreement, that's been in place for some time. And really on a go-forward basis, it's going to be driven by underlying sales. In addition, we had Hillcrest on board first quarter of this year, well, since the very end of December. So it really wasn't much of an impact at all in fourth quarter, but is additive to that line in the current quarter.

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Nikhil Dixit, Barclays PLC, Research Division - Research Analyst [23]

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Got it. Understood. And then, on OpEx, going forward, it seems like expense leverage at least came in pretty strong in the quarter. What are some of the kind of initiatives you're enacting there? And how should we think about expense growth going forward?

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Richard J. Brezski, InterDigital, Inc. - CFO [24]

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Yes, I wouldn't say that there is any initiatives. There is no signs on the walls or anything like that. It's really just the same kind of expense management that we've been applying over the years here. The belief is that we make a very strong investment in research and development. And that's been continuous over the years. And we want to make sure that we're not overspending in other areas. Only enough to make sure that we can harvest the fruits of that investment.

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Operator [25]

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With no further questions in the queue, I'd like to turn it back over to you gentlemen for any additional or closing remarks.

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Patrick Van de Wille, InterDigital, Inc. - Chief Communications Officer [26]

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Thank you, Emelia, and thank you, everybody, for joining us today. Looking forward to talking to you next quarter. Thanks very much.

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Operator [27]

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Ladies and gentlemen, that does conclude our conference for today. Thank you so much for your participation. You may now disconnect.