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INTERDIGITAL, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) 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 Form 10-K. Business InterDigital designs and develops advanced technologies that enable and enhance wireless communications and capabilities. Since our founding in 1972, we have designed and developed a wide range of innovations that are used in digital cellular and wireless products and networks, including 2G, 3G, 4G and IEEE 802-related products and networks. We are a leading contributor of intellectual property to the wireless communications industry. 29-------------------------------------------------------------------------------- Table of Contents Given our long history and focus on advanced research and development, InterDigital has amassed one of the most significant patent portfolios in the wireless industry. As of December 31, 2012, InterDigital's wholly owned subsidiaries held a portfolio of over 19,000 patents and patent applications related to the fundamental technologies that enable wireless communications. In that portfolio are a number of patents and patent applications that we believe are or may be essential or may become essential to cellular and other wireless standards, including the 2G, 3G, 4G and the IEEE 802 suite of standards. That portfolio has largely been built through internal development, supplemented by joint development projects with other companies as well as select patent acquisitions. Products incorporating our patented inventions include: mobile devices, such as cellular phones, tablets, notebook computers and wireless personal digital assistants; wireless infrastructure equipment, such as base stations; and components, dongles and modules for wireless devices. InterDigital derives revenues primarily from patent licensing and sales, technology solutions licensing and sales and engineering services. In 2012, 2011 and 2010, our total revenues were $663.1 million, $301.7 million and $394.5 million, respectively. In 2012, we recorded $384.0 million of revenue related to the sale of less than ten percent of our patent portfolio. Our patent licensing revenues in 2012, 2011 and 2010 were $276.6 million, $295.3 million and $370.2 million, respectively. In 2012, the amortization of fixed-fee royalty payments accounted for approximately 49% of our patent licensing revenues. These fixed-fee revenues are not affected by the related licensees' success in the market or the general economic climate. The majority of the remaining portion of our patent licensing revenue is variable in nature due to the per-unit structure of the related license agreements. Approximately 82% of this per-unit, variable portion for 2012 related to sales by two of our licensees with concentrations in the smartphone market and our collection of 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 the sales performance of these licensees. Strategic Alternatives Review and Expansion of Business Strategy On July 19, 2011, we announced that our Board of Directors had initiated a process to explore and evaluate potential strategic alternatives for the company, including a sale or other transaction. We announced on January 23, 2012, that our Board of Directors had concluded its review of strategic alternatives for the company and determined that it was in the best interests of the company and its shareholders to execute on the company's business plan and to expand the plan to include patent sales and patent licensing partnerships as additional vehicles to generate revenue. On October 23, 2012, we announced a further expansion of our business strategy by enhancing our technology sourcing and establishing a business unit, InterDigital Solutions, dedicated to monetizing the company's market-ready technologies and research capabilities. For additional information regarding the company's business strategy, see Part I, Item 1, of this Form 10-K. Repositioning On October 23, 2012, we announced that, as part of our ongoing expense management, we had initiated a voluntary early retirement program ("VERP"). In connection with the VERP, we incurred a related repositioning charge of $12.5 million in 2012. During 2012, cash payments of $1.4 million were made for severance and related costs associated with the VERP. We have accrued $11.1 million for severance and related costs at the balance sheet date. The $12.5 million charge is included within the repositioning line of our Consolidated Statements of Income. Approximately 60 employees elected to participate in the VERP across our locations, the majority of whose last day was December 15, 2012. The majority of the charge recorded in 2012 represents cash obligations associated with severance. We expect to recognize an additional $1.0 million to $2.0 million charge related to the VERP in 2013. All of the severance and related costs are scheduled to be paid within twelve months of the balance sheet date. We did not incur any repositioning charges during 2011 or 2010. Patent Sales On June 18, 2012, we announced that certain of our subsidiaries had entered into a definitive agreement to sell approximately 1,700 patents and patent applications, including approximately 160 issued U.S. patents and approximately 40 U.S. patent applications, to Intel Corporation for $375.0 million. The sale agreement involved patents primarily related to 3G, LTE and 802.11 technologies. Upon completion of the transaction in third quarter 2012, we recognized $375.0 million as patent sales revenue and $15.6 million as patent sales expense, which was recorded within the patent administration and licensing line on our Consolidated Statements of Income. Included in the patent sales expense was the remaining net book value of the patents sold, as well as commissions and legal and accounting services fees paid in conjunction with the sale. We intend to pursue additional patent sale opportunities as part of our expanded strategy. However, we are unable to predict the timing and magnitude of any such sales due to the unpredictable nature of the sales cycle for such transactions. 30-------------------------------------------------------------------------------- Table of Contents Patent License Agreements In fourth quarter 2012, we entered into an agreement that extends the term of our worldwide, non-exclusive, royalty-bearing patent license agreement with BlackBerry. In addition to extending the patent license agreement for a multi-year period, the parties agreed to amend the patent license to add coverage for 4G products, including LTE and LTE-Advanced products. Also in fourth quarter 2012, we entered into a patent license agreement with Sony that covers Sony's sale of 3G and 4G products. Additionally, during 2012, we entered into new or expanded patent license agreements with u-blox AG, Cinterion Wireless Modules GmbH, Sierra Wireless, Inc., Acer Inc., Pantech Co. Ltd., Wistron Corporation and Quanta Computers, Inc. These agreements cover various wireless modules for consumer electronics and M2M devices, including handsets, wireless modules, computers and tablets designed to operate in accordance with 4G wireless technologies, LTE, LTE-Advanced and WiMax standards, in addition to 2G and 3G wireless technologies. Expiration of Patent License Agreement with Samsung In 2012, we recognized the remaining $102.7 million of revenue associated with the 2009 Samsung PLA. The 2009 Samsung PLA covered the sale of single-mode terminal units and infrastructure designed to operate in accordance with TDMA-based 2G standards, which portion of the license became paid up in 2010, and the sale of terminal units and infrastructure designed to operate in accordance with 3G standards through 2012. Pursuant to the 2009 Samsung PLA, Samsung paid InterDigital $400.0 million in four equal installments over an 18-month period. Samsung paid the first two $100.0 million installments in 2009. We received the third and fourth $100.0 million installments in January 2010 and July 2010, respectively. Upon expiration of the 2009 Samsung PLA, Samsung retained its paid-up license to sell single-mode terminal units and infrastructure designed to operate in accordance with TDMA-based 2G standards and became unlicensed as to all other products covered under the agreement. In January 2013, we filed a complaint with the USITC against Samsung and seven other respondents, alleging that they engaged in unfair trade practices by selling for importation into the United States, importing into the United States and/or selling after importation into the United States certain 3G and 4G wireless devices that infringe up to seven of InterDigital's U.S. patents. Patent Licensing Royalties Patent licensing royalties in 2012 of $276.6 million decreased 6% from the prior year. This $18.7 million year-over-year decrease in patent licensing royalties was primarily driven by a decrease in royalties from our Japanese per-unit licensees and lower shipments from our per-unit licensees with concentrations in the smartphone market. Refer to "Results of Operations -- 2012 Compared with 2011" for further discussion of our 2012 revenue. Technology Solutions and Engineering Services We are engaged in arbitration to determine whether royalties are owed on specific product classes pursuant to one of our technology solutions agreements. As of December 31, 2012 and December 31, 2011, we have deferred related revenue of $44.3 million and $29.7 million, respectively. These amounts have either been collected or recorded in accounts receivable on their respective balance sheet dates. During fourth quarter 2012, we entered into an agreement with Convida Wireless, our joint venture with Sony Corporation of America, to provide M2M research and platform development. Work under this agreement commenced during first quarter 2013. USITC Proceedings Samsung, Nokia, Huawei and ZTE 2013 USITC Proceeding (337-TA-868) and Related Delaware District Court Proceedings On January 2, 2013, the company's wholly owned subsidiaries InterDigital Communications, Inc., InterDigital Technology Corporation, IPR Licensing, Inc. and InterDigital Holdings, Inc. filed a complaint with the USITC against Samsung Electronics Co., Ltd., Samsung Electronics America, Inc. and Samsung Telecommunications America, LLC, Nokia Corporation and Nokia Inc., Huawei Technologies Co., Ltd., Huawei Device USA, Inc. and FutureWei Technologies, Inc. d/b/a 31-------------------------------------------------------------------------------- Table of Contents Huawei Technologies (USA) and ZTE Corporation and ZTE (USA) Inc. (collectively, the "337-TA-868 Respondents"), alleging violations of Section 337 of the Tariff Act of 1930 in that they engaged in unfair trade practices by selling for importation into the United States, importing into the United States and/or selling after importation into the United States certain 3G and 4G wireless devices (including WCDMA-, cdma2000- and LTE-capable mobile phones, USB sticks, mobile hotspots, laptop computers and tablets and components of such devices) that infringe one or more of up to seven of InterDigital's U.S. patents. The complaint also extends to certain WCDMA and cdma2000 devices incorporating WiFi functionality. InterDigital's complaint with the USITC seeks an exclusion order that would bar from entry into the United States infringing 3G or 4G wireless devices (and components), including LTE devices, that are imported by or on behalf of the 337-TA-868 Respondents, and also seeks a cease-and-desist order to bar further sales of infringing products that have already been imported into the United States. Certain of the asserted patents have been asserted against Nokia, Huawei and ZTE in earlier pending USITC proceedings (including the Nokia, Huawei and ZTE 2011 USITC Proceeding (337-TA-800) and the Nokia 2007 USITC Proceeding (337-TA-613), as set forth below) and therefore are not being asserted against those 337-TA-868 Respondents in this investigation. On February 6, 2013, the Administrative Law Judge ("ALJ") overseeing the proceeding issued an order setting a target date of June 4, 2014 for the Commission's final determination in the investigation, with the ALJ's Initial Determination on alleged violation due on February 4, 2014. On February 21, 2013, each 337-TA-868 Respondent filed their respective responses to the complaint. On February 21, 2013, Samsung moved for partial termination of the investigation as to six of the seven patents asserted against Samsung, alleging that Samsung was authorized to import the specific 3G or 4G devices that InterDigital relied on to form the basis of its complaint. InterDigital's opposition is due March 4, 2013. On February 22, 2013, Huawei and ZTE moved to stay the investigation pending their respective requests to the United States District Court for the District of Delaware to set a FRAND royalty rate for a license that covers the asserted patents, or in the alternative, until a Final Determination issues in the 337-TA-800 investigation. InterDigital's opposition is due March 4, 2013. On January 2, 2013, the company's wholly owned subsidiaries InterDigital Communications, Inc., InterDigital Technology Corporation, IPR Licensing, Inc. and InterDigital Holdings, Inc. filed four related district court actions in the Delaware District Court against the 337-TA-868 Respondents. These complaints allege that each of the defendants infringes the same patents with respect to the same products alleged in the complaint filed by InterDigital in USITC Proceeding (337-TA-868). The complaints seek permanent injunctions and compensatory damages in an amount to be determined, as well as enhanced damages based on willful infringement and recovery of reasonable attorneys' fees and costs. On January 24, 2013, Huawei filed its answer and counterclaims to InterDigital's complaint. Huawei asserted counterclaims for breach of contract, equitable estoppel, waiver of right to enjoin and declarations that InterDigital has not offered or granted Huawei licenses on FRAND terms, declarations seeking the determination of FRAND terms and declarations of noninfringement, invalidity and unenforceability of the asserted patents. In addition to the declaratory relief specified in its counterclaims, Huawei seeks specific performance of InterDigital's purported contracts with Huawei and standards-setting organizations, appropriate damages in an amount to be determined at trial, reasonable attorneys' fees and such other relief as the court may deem appropriate. On January 31, 2013, ZTE filed its answer and counterclaims to InterDigital's complaint; ZTE asserted counterclaims for breach of contract, equitable estoppel, waiver of right to enjoin and declarations that InterDigital has not offered ZTE licenses on FRAND terms, declarations seeking the determination of FRAND terms and declarations of noninfringement, invalidity and unenforceability. Nokia and Samsung have not yet responded to the complaints against them. In addition to the declaratory relief specified in its counterclaims, ZTE seeks specific performance of InterDigital's purported contracts with ZTE and standards-setting organizations, appropriate damages in an amount to be determined at trial, reasonable attorneys' fees and such other relief as the court may deem appropriate. On February 11, 2013, Huawei and ZTE filed motions to expedite discovery and trial on their FRAND-related counterclaims. Huawei seeks a schedule for discovery and trial on its FRAND-related counterclaims that would afford Huawei the opportunity to accept a FRAND license rate at the earliest opportunity, and in any case before December 28, 2013. ZTE seeks a trial on its FRAND-related counterclaims no later than November 2013. Nokia, Huawei and ZTE 2011 USITC Proceeding (337-TA-800) and Related Delaware District Court Proceeding On July 26, 2011, InterDigital's wholly owned subsidiaries InterDigital Communications, LLC (now InterDigital Communications, Inc.), InterDigital Technology Corporation and IPR Licensing, Inc. filed a complaint with the USITC against Nokia Corporation and Nokia Inc., Huawei Technologies Co., Ltd. and FutureWei Technologies, Inc. d/b/a Huawei Technologies (USA) and ZTE Corporation and ZTE (USA) Inc., alleging violations of Section 337 of the Tariff Act of 1930 in that they engaged in unfair trade practices by selling for importation into the United States, importing into the United States and/or selling after importation into the United States certain 3G wireless devices (including WCDMA- and cdma2000-capable mobile phones, USB sticks, mobile hotspots and tablets and components of such devices) that infringe seven of InterDigital's 32-------------------------------------------------------------------------------- Table of Contents U.S. patents. The action also extends to certain WCDMA and cdma2000 devices incorporating WiFi functionality. InterDigital's complaint with the USITC seeks an exclusion order that would bar from entry into the United States any infringing 3G wireless devices (and components) that are imported by or on behalf of the 337-TA-800 Respondents, and also seeks a cease-and-desist order to bar further sales of infringing products that have already been imported into the United States. On October 5, 2011, InterDigital filed a motion requesting that the USITC add LG Electronics, Inc., LG Electronics U.S.A., Inc. and LG Electronics Mobilecomm U.S.A., Inc. as 337-TA-800 Respondents to the complaint and investigation, and that the Commission add an additional patent to the complaint and investigation as well. On December 5, 2011, the ALJ overseeing the proceeding granted this motion and, on December 21, 2011, the Commission determined not to review the ALJ's determination, thus adding the LG entities as 337-TA-800 Respondents and including allegations of infringement of the additional patent. On January 20, 2012, LG filed a motion to terminate the investigation as it relates to the LG entities, alleging that there is an arbitrable dispute. The ALJ granted LG's motion on June 4, 2012. On July 6, 2012, the Commission determined not to review the ALJ's order, and the investigation was terminated as to LG. On August 27, 2012, InterDigital filed a petition for review of the ALJ's order in the Federal Circuit. On September 14, 2012, the Federal Circuit granted LG's motion to intervene. On October 23, 2012, InterDigital filed its opening brief. Responsive briefs were filed on January 22, 2013, and InterDigital's reply brief was filed on February 8, 2013. The Federal Circuit has scheduled oral argument for April 4, 2013. On the same date that we filed USITC Proceeding (337-TA-800), we filed a parallel action in the United States District Court for the District of Delaware against the 337-TA-800 Respondents alleging infringement of the same asserted patents identified in USITC Proceeding (337-TA-800). The Delaware District Court complaint seeks a permanent injunction and compensatory damages in an amount to be determined, as well as enhanced damages based on willful infringement, and recovery of reasonable attorneys' fees and costs. On September 23, 2011, the defendants in the Delaware District Court complaint filed a motion to stay the Delaware District Court action pending the parallel proceedings in the USITC. Because the USITC has instituted USITC Proceeding (337-TA-800), the defendants have a statutory right to a mandatory stay of the Delaware District Court proceeding pending a final determination in the USITC. On October 3, 2011, InterDigital amended the Delaware District Court complaint, adding LG as a defendant and adding the same additional patent that InterDigital requested be added to USITC Proceeding (337-TA-800). On October 11, 2011, the Delaware District Court granted the defendants' motion to stay. On March 21, 2012, InterDigital filed an unopposed motion requesting that the Commission add newly formed entity Huawei Device USA, Inc. as a 337-TA-800 Respondent. On April 11, 2012, the ALJ granted this motion and, on May 1, 2012, the Commission determined not to review the ALJ's determination, thus adding Huawei Device USA, Inc. as a 337-TA-800 Respondent. On July 20, 2012, in an effort to streamline the evidentiary hearing and narrow the remaining issues, InterDigital voluntarily moved to withdraw certain claims from the investigation, including all of the asserted claims from U.S. Patent No. 7,349,540. By doing so, InterDigital expressly reserved all arguments regarding the infringement, validity and enforceability of those claims. On July 24, 2012, the ALJ granted the motion. On August 8, 2012, the Commission determined not to review the ALJ's Initial Determination granting the motion to terminate the investigation as to the asserted claims of the '540 patent. On August 23, 2012, the parties jointly moved to extend the target date in view of certain outstanding discovery to be provided by the 337-TA-800 Respondents and third parties. On September 10, 2012, the ALJ granted the motion and issued an Initial Determination setting the evidentiary hearing for February 12, 2013 to February 22, 2013. The ALJ also set June 28, 2013 as the deadline for his Initial Determination as to violation and October 28, 2013 as the target date for the Commission's Final Determination in the investigation. On October 1, 2012, the Commission determined not to review the Initial Determination setting those deadlines, thereby adopting them. On January 2, 2013, in an effort to streamline the evidentiary hearing and narrow the remaining issues, InterDigital voluntarily moved to withdraw certain additional patent claims from the investigation. By doing so, InterDigital expressly reserved all arguments regarding the infringement, validity and enforceability of those claims. On January 3, 2013, the ALJ granted the motion. On January 23, 2013, the Commission determined not to review the ALJ's Initial Determination granting the motion to terminate the investigation as to those withdrawn patent claims. InterDigital continues to assert seven U.S. patents in this investigation. The ALJ held the evidentiary hearing from February 12, 2013 to February 21, 2013. The ALJ's final Initial Determination is due by June 28, 2013, and the target date for completion of the investigation is October 28, 2013. Nokia 2007 USITC Proceeding (337-TA-613), Related Delaware District Court Proceeding and Federal Circuit Appeal On August 1, 2012, the Federal Circuit issued its decision in InterDigital's appeal of the USITC's Final Determination in this proceeding, holding that the Commission had erred in interpreting the claim terms at issue and reversing the 33-------------------------------------------------------------------------------- Table of Contents Commission's finding of non-infringement. The Federal Circuit adopted InterDigital's interpretation of such claim terms and remanded the case back to the Commission for further proceedings. In addition, the Federal Circuit rejected Nokia's argument that InterDigital did not satisfy the domestic industry requirement. On September 17, 2012, Nokia filed a combined petition for rehearing by the panel or en banc with the Federal Circuit. On January 10, 2013, the Federal Circuit denied Nokia's petition. Nokia has until April 10, 2013 to petition the United States Supreme Court for a writ of certiorari. On January 17, 2013, the Federal Circuit issued its mandate remanding USITC Proceeding (337-TA-613) to the Commission for further proceedings. On February 4, 2013, the Commission issued an order requiring the parties to submit comments regarding what further proceedings must be conducted to comply with the Federal Circuit's August 1, 2012 judgment, including whether any issues should be remanded to an ALJ to be assigned to this investigation. Please see Part I, Item 3, of this Form 10-K for a fuller discussion of our USITC proceedings. Cash and Short-Term Investments At December 31, 2012, we had $577.3 million of cash and short-term investments and an additional $291.7 million of fixed or prepayments due under agreements signed, including $169.9 million recorded in accounts receivable as it is due within twelve months of the balance sheet date. A substantial portion of this balance relates to fixed and prepaid royalty payments we have received that relate to future sales of our licensees' products. As a result, our cash receipts from existing licenses subject to fixed and prepaid royalties will be reduced in future periods. During 2012, we recorded $472.7 million of cash receipts related to patent licensing, technology solutions agreements and patent sales as follows (in thousands): Cash In Fixed royalty payments $ 8,048 Current royalties and past sales 54,513 Prepaid royalties 12,816 Technology solutions 17,367 Patent Sales 380,000 $ 472,744 The $20.9 million of fixed-fee and prepaid royalty cash receipts, together with a $156.8 million accrual of accounts receivable related to scheduled prepaid royalties and fixed-fee payments, partially offset the $223.4 million in deferred revenue recognized, resulting in a net $19.9 million decrease in deferred revenue to $268.1 million at December 31, 2012. Approximately $84.7 million of our $268.1 million deferred revenue balance relates to fixed royalty payments that are scheduled to amortize as follows (in thousands): 2013 $ 62,031 2014 17,190 2015 2,027 2016 2,027 2017 1,459 Thereafter - $ 84,734 The remaining $183.4 million of deferred revenue primarily relates to prepaid royalties that will be recorded as revenue as our licensees report their sales of covered products and prepaid royalties that may be recorded as revenue upon the resolution of the arbitration related to one of our technology solutions agreements. Repurchase of Common Stock During 2012, we repurchased a cumulative total of 4.9 million shares of our common stock for an aggregate of $152.7 million under the 2009 Repurchase Program and the 2012 Repurchase Program, each as defined below. We made no share repurchases during 2011 or 2010. In March 2009, our Board of Directors authorized a $100.0 million share repurchase program (the "2009 Repurchase Program"). The company repurchased shares under the 2009 Repurchase Program through pre-arranged trading plans. During 2012, we repurchased 2.3 million shares under the 2009 Repurchase Program for $75.0 million. The 2009 Repurchase Program 34-------------------------------------------------------------------------------- Table of Contents was completed in second quarter 2012, bringing the cumulative repurchase total under the program to approximately 3.3 million shares at a cost of $100.0 million. In May 2012, our Board of Directors authorized a new share repurchase program, which was then expanded in June 2012 to increase the amount of the program from $100.0 million to $200.0 million (the "2012 Repurchase Program"). The company may repurchase shares under the 2012 Repurchase Program through open market purchases, pre-arranged trading plans or privately negotiated purchases. During 2012, we repurchased approximately2.6 million shares under the 2012 Repurchase Program for $77.7 million. From January 1, 2013 through February 25, 2013, we did not make any share repurchases under the 2012 Repurchase Program. Intellectual Property Rights Enforcement If we believe any party is required to license our patents in order to manufacture and sell certain products and such party refuses to do 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 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 2012, our intellectual property enforcement costs increased to $52.7 million from $23.7 million and $12.1 million in 2011 and 2010, respectively. The 2012 amount includes a $3.2 million increase to accrue for a litigation contingency related to the Huawei-China proceedings. This represented 42% of our 2012 total patent administration and licensing costs of $126.3 million. Intellectual property enforcement costs will vary depending upon activity levels, and it is likely they will continue to be a significant expense for us in the future. Comparability of Financial Results When comparing 2012 financial results against other periods, the following items should be taken into consideration: • Our 2012 revenue includes: $384.0 million of revenue associated with patent sales; and $26.2 million of past sales related to a new patent license agreement with Sony, new and amended agreements signed during 2012 and revenue associated with the audits of existing licensees. • Our 2012 operating expenses include: $16.7 million of expense related our 2012 patent sales; $12.5 million of expense associated with actions to reposition the company's operations; $4.4 million charge to increase the accrual rate under our Long-Term Compensation Program ("LTCP") for the program cycle ending December 31, 2012; and lower accrual rates as compared to 2011 for the remaining two active cycles under the LTCP; $4.5 million tax benefit for release of valuation allowances on DTA. 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 ("GAAP"), which require us to make estimates and assumptions that affect the amounts reported in both our consolidated financial statements and the accompanying notes. 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 Part II 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 revenue recognition, compensation and income taxes. If different assumptions were made or different conditions existed, our financial results could have been materially different. 35-------------------------------------------------------------------------------- Table of Contents Revenue Recognition We derive the vast 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 intellectual property enforcement. For agreements entered into or materially modified prior to 2011, 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 has often been recognized over the performance period. Beginning in January 2011, all new or materially modified agreements are being accounted for under the Financial Accounting Standards Board ("FASB") revenue recognition guidance, "Revenue Arrangements with Multiple Deliverables." This guidance requires consideration to be allocated to each element of an agreement that has stand alone value using the relative fair value method. 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) collectibility 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 the guidance for revenue arrangements with multiple deliverables and the guidance for 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 Past 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 past 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 collectibility is reasonably assured. Fixed-Fee Royalty Payments: These are 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 for specified products, under certain patents or patent claims, for sales in certain countries, or a combination thereof - in each case for a specified time period (including for the life of the patents licensed under the agreement). We recognize revenues related to Fixed-Fee Royalty 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: These are 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 typically 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: These are 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 are obligated to provide us with quarterly or semi-annual royalty reports that summarize their sales of covered products and their related royalty obligations to 36-------------------------------------------------------------------------------- Table of Contents us. We typically receive these royalty reports subsequent to the period in which our licensees' underlying sales occurred. As a result, it is impractical for us to recognize revenue in the period in which the underlying sales occur, and, in most cases, 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. Patent Sales During 2012, we expanded our business strategy of monetizing our intellectual property to include the sale of select patent assets. As patent sales executed under this expanded strategy represent a component of our ongoing major or central operations and activities, we will record the related proceeds as revenue. We will recognize the revenue when there is persuasive evidence of a sales arrangement, fees are fixed or determinable, delivery has occurred and collectibility is reasonably assured. These requirements are generally fulfilled upon closing of the patent sale transaction. Technology Solutions and Engineering Services Technology solutions revenue consists primarily of revenue from software licenses and engineering services. Software license revenues are recognized in accordance with the original and revised guidance for 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 the accounting guidance for 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 the accounting guidance for construction-type and certain production-type contracts on a straight-line basis, 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. Sony Agreement On December 21, 2012, we formed a joint venture with Sony Corporation of America to combine Sony's consumer electronics expertise with our wireless M2M and bandwidth management research. The joint venture, called Convida Wireless, will focus on driving new research in M2M wireless communications and other connectivity areas. Based on the terms of the agreement, the parties will contribute funding and resources for additional M2M research and platform development, which we will perform. Stephens Capital Partners LLC ("Stephens"), the principal investing affiliate of Stephens Inc., is a minority investor in Convida Wireless. Our agreement with Sony is a multiple-element arrangement that also includes a three-year license to our patents for Sony's sale of 3G and 4G products, effective January 1, 2013, and an amount for past sales. Under the arrangement, we expect to collect a total of $125.0 million of cash and have also acquired certain patents covering non-baseband technologies from Sony. We have estimated the value of the acquired patents to be $28.9 million. We estimated the fair value of patents by a combination of a discounted cash flow analysis (the income approach) and an analysis of comparable market transactions (the market approach). For the income approach, the inputs and assumptions used to develop this estimate were based on a market participant perspective and included estimates of projected royalties, discount rates, useful lives and income tax rates, among others. For the market approach, judgment was applied as to which market transactions were 37-------------------------------------------------------------------------------- Table of Contents most comparable to this transaction. These inputs and assumptions represent our best estimates at the time of the transaction. Changes in any number of these assumptions may have had a substantial impact on the estimated value of the acquired patents. In connection with this arrangement, we recognized $22.3 million of patent licensing revenue in fourth quarter 2012, and we expect to recognize $116.6 million of patent licensing revenue, using the straight-line method, over the three-year term of the patent license. The remaining $15.0 million represents funding toward M2M research and platform development. Convida Wireless is a variable interest entity. Based on our provision of M2M research and platform development services to Convida Wireless, we have determined that we are the primary beneficiary for accounting purposes and must consolidate Convida Wireless. Because Convida Wireless had no operations in 2012, the consolidation of Convida Wireless had no impact on our financial statements as of December 31, 2012, and there was no income or loss to allocate to interests held by other parties. The agreement is a multiple-element arrangement for accounting purposes. As discussed in our revenue recognition policy footnote, we identified each element of the arrangement and determined when those elements should be recognized. Using the accounting guidance from multiple-element revenue arrangements, we allocated the consideration to each element for accounting purposes using our best estimate of selling price for each element. The development of a number of these inputs and assumptions in the model requires a significant amount of management judgment and is based upon a number of factors, including the selection of industry comparables, market growth rates and other relevant factors. Changes in any number of these assumptions may have had a substantial impact on the fair value as assigned to each element for accounting purposes. These inputs and assumptions represent management's best estimates at the time of the transaction. The impact that a five percent change in each of the following key estimates would have had on fourth quarter 2012 revenue and pretax income is summarized in the following table (in millions): Change in estimate + 5% - 5% Value of patents acquired $ 1.4 $ (1.4 ) Allocation between past and future royalties $ (7.0 ) $ 7.0 Compensation Programs We use a variety of compensation programs to both attract and retain employees, and to more closely align employee compensation with company performance. These programs include, but are not limited to, short-term incentive awards tied to performance goals and cash awards to inventors for filed patent applications and patent issuances, as well as, prior to 2010, restricted stock unit ("RSU") awards for non-managers and the LTCP for managers, which included both time-based and performance-based RSUs and a performance-based cash incentive component. Prior to 2010, LTCP awards would alternate annually between RSU and cash cycles, each of which generally covered a three-year period and could overlap with another cycle by as many as two years. In fourth quarter 2010, the LTCP was amended to, among other things, increase the relative proportion of performance-based compensation for executives and managers, extend participation to all employees, and eliminate alternating RSU and cash cycles. Effective with the cycle that began on January 1, 2010 through December 31, 2012, executives and managers received 25% of their LTCP participation in the form of time-based RSUs that vest in full at the end of the respective three-year cycle and the remaining 75% in the form of performance-based awards granted under the long-term incentive plan ("LTIP") component of the LTCP. LTIP performance-based awards may be paid out in the form of cash, equity or any combination thereof, as determined by the Compensation Committee of the Board of Directors. Where the form of payment has not been determined at the beginning of the cycle, as is the case of Cycle 5, Cycle 6 and Cycle 7 (each as defined below), the LTIP payment is assumed to be 100% cash for accounting purposes. All employees below manager level received 100% of their LTCP participation in the form of time-based RSUs that vest in full at the end of the respective three-year cycle. The following LTCP cycles were active for all or some portion of the three years ended December 31, 2012: • Cash Cycle 3: A long-term performance-based cash incentive covering the period January 1, 2008 through December 31, 2010; • RSU Cycle 4: Time-based and performance-based RSUs granted on January 1, 2009, with a target vest date of January 1, 2012; • Cycle 5: Time-based RSUs granted on November 1, 2010, which vested on January 1, 2013, and a long-term performance-based incentive covering the period from January 1, 2010 through December 31, 2012; 38-------------------------------------------------------------------------------- Table of Contents • Cycle 6: Time-based RSUs granted on January 1, 2011, which vest on January 1, 2014, and a long-term performance-based incentive covering the period from January 1, 2011 through December 31, 2013; and • Cycle 7: Time-based RSUs granted on January 1, 2012, which vest on January 1, 2015, and a long-term performance-based incentive covering the period from January 1, 2012 through December 31, 2014. ______________________________________ Note: The long-term performance-based incentives for each of Cycle 6 and Cycle 7 were converted into performance-based RSUs on January 18, 2013. As the conversion occurred after December 31, 2012, these cycles were accounted for as cash awards during 2011 and 2012. We recognized share-based compensation expense of $6.5 million, $8.1 million and $5.8 million in 2012, 2011 and 2010, respectively. Included in 2011 is a charge of $1.3 million to increase the accrual rate for the performance-based RSU grant under RDU Cycle 4 from 0% to 31% based on the final payout associated with this grant. We also recognized $8.3 million, $1.8 million and $11.2 million of compensation expense in 2012, 2011 and 2010, respectively, related to the performance-based cash incentive under our LTCP. In 2012, performance-based cash incentive cost of $8.3 million includes a charge of $4.4 million to increase the accrual rate for Cycle 5 from the previously estimated payout of 50% to the actual payout of 100%. The increase in the incentive payout from 50% to 100% was driven by the company's success in achieving a number of key goals, including the execution of strategic patent sales and the signing of new or amended 4G patent license agreements, after we had reduced the accrual rate to 50% in 2011. In 2011, performance-based cash incentive cost of $1.8 million is net of a reduction of $5.7 million to decrease the accrual rates for Cycle 5 and Cycle 6 from 100% to 50%. This reduction was driven by the impact of our strategic alternatives review process on the timing of license agreements and includes a $1.9 million adjustment to amounts accrued through December 31, 2010. In 2010, the performance-based cash incentive cost includes a charge of $3.3 million to increase the accrual rate for Cash Cycle 3 from the previously estimated payout of 50% to the actual payout of 86%. The increase in the incentive payout from 50% to 86% was driven by the company's success in achieving a number of key goals, including the signing of five new or amended 3G patent license agreements, after we had reduced the accrual rate to 50% in third quarter 2009. At December 31, 2012, accrued compensation expense associated with the LTCP's performance-based incentives was based on estimated payouts of 100%, 50% and 0% for Cycle 5, Cycle 6 and Cycle 7, respectively. Under both the current and immediately prior versions of the program, 100% achievement of the goals set by the Compensation Committee of the Board of Directors results in a 100% payout of the performance-based incentive target amounts. For each 1% change above or below 100% achievement, the payout is adjusted by 2.5 percentage points, with a maximum payout under the current program of 200%, a maximum payout of 225% under the current program and no payout under either program for performance that falls below 80% achievement. The following table provides examples of the performance-based incentive payout that would be earned based on various levels of goal achievement: Payout Scenarios Under Current LTCP Program Goal Achievement Payout less than 80% - % 80% 50 % 100% 100 % 120% 150 %140% or greater (current program maximum) 200 % 150% or greater (prior program maximum) 225 % If we had assumed that goal achievement for Cycle 6 would be either 100% or less than 50%, we would have accrued $3.8 million more or less, respectively, of related compensation expense through December 31, 2012. If we had assumed that goal achievement for Cycle 7 would be 100% or 50%, we would have accrued $3.2 million or $1.6 million, respectively, of related compensation expense through December 31, 2012. For LTCP RSU cycles that began prior to 2010, executives received 50% of their RSU grant as performance-based RSUs and 50% as time-based RSUs, and the company's managers received 25% of their RSU grant as performance-based RSUs and 75% as time-based RSUs. 39-------------------------------------------------------------------------------- Table of Contents Under the prior LTCP program, 100% achievement of the goals set by the Compensation Committee of the Board of Directors resulted in a 100% payout of the performance-based RSU incentive target amounts. For each 1% change above or below 100% achievement, the RSU payout was adjusted by 4 percentage points, with a maximum payout of 300%. For performance that fell below 80% achievement, no payout would occur. The following table provides examples of the performance-based RSU payout that would have been earned based on various levels of goal achievement: Payout Scenarios Under Prior LTCP Program Goal Achievement Payout less than 80% - % 80% 20 % 100% 100 % 120% 180 % 150% or greater 300 % Income Taxes Income taxes are accounted for under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the Consolidated Statement of Income in the period that includes the enactment date. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets if management has determined that it is more likely than not that such assets will not be realized. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. We are subject to examinations by the Internal Revenue Service ("IRS") and other taxing jurisdictions on various tax matters, including challenges to various positions we assert in our filings. In the event that the IRS or another taxing jurisdiction levies an assessment in the future, it is possible the assessment could have a material adverse effect on our consolidated financial condition or results of operations. The financial statement recognition of the benefit for a tax position is dependent upon the benefit being more likely than not to be sustainable upon audit by the applicable tax authority. If this threshold is met, the tax benefit is then measured and recognized at the largest amount that is greater than 50 percent likely of being realized upon ultimate settlement. In the event that the IRS or another taxing jurisdiction levies an assessment in the future, it is possible the assessment could have a material adverse effect on our consolidated financial condition or results of operations. During fourth quarter 2009, we completed a study to assess the company's ability to utilize foreign tax credit carryovers into the tax year 2006. As a result of the study, we amended our United States federal income tax returns for the periods 1999 - 2005 to reclassify $29.3 million of foreign tax payments we made during those periods from deductions to foreign tax credits. We also amended our federal tax returns for the periods 2006 - 2008 to utilize the resulting tax credits. When we completed the study, we established a basis to support amending the returns and estimated that the maximum incremental benefit would be $19.1 million. We recognized a net benefit of $16.4 million after establishing a $2.7 million reserve for related tax contingencies. In 2011, we recorded an additional tax benefit of $8.3 million to eliminate this $2.7 million reserve and other tax contingencies and recognize interest income on the associated refund. Between 2006 and 2012, we paid approximately $145.8 million in foreign taxes for which we have claimed foreign tax credits against our U.S. tax obligations. It is possible that as a result of tax treaty procedures, the U.S. government may reach an agreement with the related foreign governments that will result in a partial refund of foreign taxes paid with a related reduction in our foreign tax credits. Due to both foreign currency fluctuations and differences in the interest rate charged by the U.S. government compared to the interest rates, if any, used by the foreign governments, any such agreement could result in interest expense and/or foreign currency gain or loss. 40-------------------------------------------------------------------------------- Table of Contents New Accounting Guidance Accounting Standards Updates: Fair Value Measurements: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS In May 2011, the FASB issued authoritative guidance that is more closely aligned with the fair value measurement and disclosure guidance issued by the International Accounting Standards Board ("IASB"). The issuance of this standard results in global fair value measurement and disclosure guidance that minimizes the differences between U.S. GAAP and International Financial Reporting Standards. Many of the changes in the final standard represent clarifications to existing guidance, while some changes related to the valuation premise and the application of premiums and discounts and new required disclosures are more significant. This guidance is effective for interim and annual periods beginning after December 15, 2011. We adopted this guidance effective January 1, 2012; however, the adoption of this guidance does not have a significant impact on the company's financial statements or related disclosures. Accounting Standards Updates: Presentation of Comprehensive Income In June 2011, the FASB issued authoritative guidance requiring most entities to present items of net income and other comprehensive income either in one continuous statement, referred to as the statement of comprehensive income, or in two separate, but consecutive, statements of net income and other comprehensive income. The option to present items of other comprehensive income in the statement of changes in equity was eliminated. This guidance is effective for interim and annual periods beginning after December 15, 2011. We adopted this guidance effective January 1, 2012. We have chosen to present items of net income and other comprehensive income in two separate but consecutive statements. On December 23, 2011, the FASB issued an amendment to the new standard on comprehensive income to defer the requirement to measure and present reclassification adjustments from accumulated other comprehensive income to net income by income statement line item in net income and also in other comprehensive income. The deferred requirement would have called for the measurement and presentation in net income of items previously recognized in other comprehensive income. In February 2013, the FASB issued final guidance on the presentation of reclassifications out of other comprehensive income. The amendments require an entity to provide information about the amounts reclassified out of other comprehensive income by component. In addition, an entity is required to present, either on the face of the income statement or in a footnote, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income, only if the amount reclassified is required by GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under GAAP that provide detail about those amounts. This amendment is effective for interim and fiscal years beginning after December 15, 2012. The amended standard will not impact the Company's financial position or results of operations. Legal Proceedings We are routinely involved in disputes associated with enforcement and licensing activities regarding our intellectual property, including litigations and other proceedings. These litigations and other proceedings are important means to enforce our intellectual property rights. We are a party to other disputes and legal actions not related to our intellectual property, but also arising in the ordinary course of our business. Refer to Part I, Item 3, of this Form 10-K for a description of our material legal proceedings. FINANCIAL POSITION, LIQUIDITY AND CAPITAL REQUIREMENTS Our primary sources of liquidity are cash, cash equivalents and short-term investments, as well as cash generated from operations. We have the ability to obtain additional liquidity through debt and equity financings. Based on our past performance and current expectations, we believe our available sources of funds, including cash, cash equivalents and short-term investments and cash generated from our operations, will be sufficient to finance our operations, capital requirements, debt obligations and existing stock repurchase and dividend programs in the next twelve months. On April 4, 2011, we completed an offering of $230.0 million in aggregate principal amount of 2.50% Senior Convertible Notes due 2016 (the "Notes"). The net proceeds from the offering were approximately $222.0 million, after deducting the initial purchaser's discount and offering expenses. A portion of the net proceeds of the offering were used to fund the cost of the convertible note hedge transactions entered into in connection with the offering of the Notes. Refer to Note 6, "Obligations," in the Notes to Condensed Consolidated Financial Statements included in Part II, Item 8, of this Form 10-K for a more detailed discussion of the Notes. 41-------------------------------------------------------------------------------- Table of Contents On June 18, 2012, we announced that certain of our subsidiaries had entered into a definitive agreement to sell approximately 1,700 patents to Intel Corporation for $375.0 million in cash. Upon the closing of the transaction in third quarter 2012, we received $375.0 million of cash and recorded this amount as revenue. Driven by this transaction, we made an estimated federal tax payment of approximately $104.0 million in fourth quarter 2012. We have and expect to continue to use the net proceeds discussed above for general corporate purposes, which may include, among other things: acquisitions of intellectual property-related assets or businesses or securities in such businesses, capital expenditures, payment of cash dividends, funding of our existing stock repurchase program and working capital. Cash, cash equivalents and short-term investments At December 31, 2012 and December 31, 2011, we had the following amounts of cash, cash equivalents and short-term investments (in thousands): Increase / December 31, 2012 December 31, 2011 (Decrease) Cash and cash equivalents $ 349,843 $ 342,211 $ 7,632 Short-term investments 227,436 335,783 (108,347 ) Total cash and cash equivalents and short-term investments $ 577,279 $ 677,994 $ (100,715 ) The decrease in cash, cash equivalents and short-term investments was primarily attributable to the cost of repurchasing of common stock of $152.7 million, dividend payments of $83.1 million and $47.4 million in capital investments, which were partially offset by $177.6 million of cash provided by operating activities. Cash flows from operations We generated or used the following cash flows from our operating activities in 2012 and 2011 (in thousands): For the Year Ended December 31, Increase / 2012 2011 (Decrease) Cash flows provided (used in) by operating activities $ 177,608 $ (34,338 ) $ 211,946 The positive operating cash flow during 2012 was derived principally from cash receipts of $472.7 million from patent sales and patent license and technology solutions agreements. We received $380.0 million of patent sales payments, $67.3 million of per-unit royalty payments, including past sales, current royalties and prepayments, from existing customers and new licensees and $8.0 million of fixed-fee payments. Cash receipts from our technology solutions agreements totaled $17.4 million, primarily related to royalties and other license fees associated with our SlimChip modem core. These cash receipts and other changes in working capital were partially offset by cash operating expenses (operating expenses less depreciation of fixed assets, amortization of patents, non-cash cost of patent sales, non-cash compensation, accretion of debt discount and amortization of financing costs) of $191.5 million, cash payments for short-term and long-term incentive compensation of $10.3 million, estimated federal tax payments of $110.5 million and cash payments for foreign source withholding taxes of $3.6 million. Cash used in operating activities during 2011 included cash operating expenses (operating expenses less depreciation of fixed assets, amortization of patents, non-cash compensation, accretion of debt discount, impairment of long-term investments and amortization of financing costs) of $126.9 million, cash payments for short-term and long-term incentive compensation accrued in prior periods of $20.1 million and tax payments of $36.6 million. These items were partially offset by $128.3 million of cash receipts from patent license and technology solutions agreements, tax refunds and other changes in working capital. We received $34.0 million of fixed-fee payments and $65.4 million of per-unit royalty payments, including past sales and prepayments, from existing licensees and a new licensee. Cash receipts from our technology solutions agreements totaled $28.9 million, primarily related to royalties and other license fees associated with our SlimChip modem core. In addition, we received $19.5 million in tax refunds, including interest income, as a result of amendments of previously filed tax returns. Working capital We believe that working capital, adjusted to exclude cash, cash equivalents, short-term investments and current deferred revenue provides additional information about non-cash assets and liabilities that might affect our near-term liquidity. 42-------------------------------------------------------------------------------- Table of Contents While we believe cash and short-term investments are important measures of our liquidity, the remaining components of our current assets and current liabilities, with the exception of deferred revenue, could affect our near-term liquidity and/or cash flow. We have no material obligations associated with our deferred revenue, and the amortization of deferred revenue has no impact on our future liquidity and or cash flow. Our adjusted working capital, a non-GAAP financial measure, reconciles to working capital, the most directly comparable GAAP financial measure, at December 31, 2012 and December 31, 2011 (in thousands) as follows: December 31, 2012 December 31, 2011 Increase / (Decrease) Current assets $ 814,347 $ 768,887 $ 45,460 Less: current liabilities 172,913 173,153 (240 ) Working capital 641,434 595,734 45,700 Subtract: Cash and cash equivalents 349,843 342,211 7,632 Short-term investments 227,436 335,783 (108,347 ) Add: Current deferred revenue 106,305 134,087 (27,782 ) Adjusted working capital $ 170,460 $ 51,827 $ 118,633 The $118.6 million increase in adjusted working capital in 2012 compared to 2011 is primarily attributable to a $132.8 million increase in accounts receivable related to new and recently renewed its patent license agreements and a $21.4 million increase in prepaid expenses and other current assets primarily related to tax receivables. These increases were partially offset by increases to accrued compensation and other accrued expenses, primarily due to the LTCP performance cycle that ended December 31, 2012 and the accrued repositioning charge, respectively. Additionally, a decrease in deferred tax assets of $17.0 million primarily related to timing differences in the recognition of deferred revenue for book and tax purposes helped offset the increases discussed above. Cash used in or provided by investing and financing activities We generated net cash in investing activities of $63.0 million in 2012 and used $41.2 million in 2011. We sold $110.4 million of short-term marketable securities, net of purchases in 2012, and we purchased $10.1 million of short-term marketable securities, net of sales, in 2011. This increase in net sales was driven by higher cash needs primarily associated with our stock repurchase program and our cash dividends. Purchases of property and equipment decreased to $3.6 million in 2012 from $3.8 million in 2011 primarily due to a lower level of investments in new and existing facilities. Investment costs associated with capitalized patent costs and acquisition of patent costs increased to $43.8 million in 2012 from $27.2 million in 2011, primarily due to investments in patent acquisitions in 2012. Net cash used in financing activities decreased by $435.2 million in 2012 primarily due to our issuance of the Notes and related transactions in second quarter 2011 as well as our repurchases of common stock of $152.7 million and dividends paid of $83.1 million in 2012. Other Our combined short-term and long-term deferred revenue balance at December 31, 2012 was approximately $268.1 million, a decrease of $19.9 million from December 31, 2011. We have no material obligations associated with such deferred revenue. The decrease in deferred revenue was primarily due to $223.4 million of deferred revenue recognized, partially offset by a gross increase in deferred revenue of $174.6 million. This deferred revenue recognized was comprised of $135.1 million of amortized fixed-fee royalty payments and $88.4 million in past sales and per-unit exhaustion of prepaid royalties (based upon royalty reports provided by our licensees). The gross increase in deferred revenue of $174.6 million primarily related to cash received or due from patent licensees and technology solutions customers. Of the $174.6 million, $14.5 million relates to the technology solutions agreement arbitration discussed above in the "Overview" section. Based on current license agreements, we expect the amortization of fixed-fee royalty payments to reduce the December 31, 2012 deferred revenue balance of $268.1 million by $62.0 million over the next twelve months. Additional reductions to deferred revenue will be dependent upon the level of per-unit royalties our licensees report against prepaid balances or arbitration rulings. 43-------------------------------------------------------------------------------- Table of Contents Contractual Obligations On April 4, 2011, InterDigital entered into an indenture (the "Indenture"), by and between the company and The Bank of New York Mellon Trust Company, N.A., as trustee, pursuant to which the $230.0 million in Notes were issued. The Notes bear interest at a rate of 2.50% per year, payable in cash on March 15 and September 15 of each year, commencing September 15, 2011. The Notes will mature on March 15, 2016, unless earlier converted or repurchased. For more information on the Notes, see Note 6, "Obligations," in the Notes to Consolidated Financial Statements included in Part II, Item 8, of this Form 10-K. The following table summarizes our contractual obligations as of December 31, 2012 (in millions): Payments Due by Period Less Than Total 1 year 1-3 Years 3-5 Years Thereafter2.50% Senior Convertible Notes due 2016 $ 230.0 $ - $ - $ 230.0 $ - Contractual interest payments on Notes 20.2 5.8 11.5 2.9 - Operating lease obligations 16.9 2.4 4.5 3.9 6.1 Purchase obligations (a) 11.3 11.3 - - - Total contractual obligations $ 278.4 $ 19.5 $ 16.0 $ 236.8 $ 6.1 _______________________________________ (a) Purchase obligations consist of agreements to purchase good and services that are legally binding on us, as well as accounts payable. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements as defined by Item 303(a)(4) of Regulation S-K. RESULTS OF OPERATIONS 2012 Compared with 2011 Revenues The following table compares 2012 revenues to 2011 revenues (in millions): For the Year Ended December 31, 2012 2011 (Decrease)/Increase Per-unit royalty revenue $ 115.3 $ 146.5 $ (31.2 ) (21 )% Fixed-fee amortized royalty revenue 135.1 135.2 (0.1 ) - % Current patent royalties 250.4 281.7 (31.3 ) (11 )% Past sales 26.2 13.6 12.6 93 % Total patent licensing royalties 276.6 295.3 (18.7 ) (6 )% Patent Sales 384.0 - 384.0 100 % Technology solutions revenue 2.5 6.4 (3.9 ) (61 )% Total revenue $ 663.1 $ 301.7 $ 361.4 120 % Total revenue increased $361.4 million in 2012, primarily attributable to patent sales. Not including patent sales revenue, total revenue decreased $22.6 million. This decrease is primarily attributable to a $31.3 million decrease in current patent licensing royalties, which was partially offset by a $12.6 million increase in past sales revenue. Per-unit royalty revenue decreased $31.2 million, the majority of which was due to lower shipments from our Japanese per-unit licensees and our licensees with concentrations in the smartphone market. Royalties from past sales totaled $26.2 million in 2012, primarily related to the signing of new or amended license agreements and the resolution of audits of existing licensees. Royalties from 44-------------------------------------------------------------------------------- Table of Contents past sales totaled $13.6 million in 2011, primarily related to the resolution of audits of existing licensees. The decrease in technology solutions revenue was due to lower royalties recognized in connection with our SlimChip modem IP business. In 2012 and 2011, 72% and 59% of our total revenues, respectively, were attributable to companies that individually accounted for 10% or more of our total revenues. In 2012 and 2011, the following customers accounted for 10% or more of our total revenues: For the Year Ended December 31, 2012 2011 Intel Corporation 57% < 10% Samsung Electronics Company, Ltd. 15% 34% BlackBerry < 10% 14% HTC Corporation < 10% 11% Operating Expenses The following table summarizes the change in operating expenses by category (in millions): For the Year Ended December 31, 2012 2011 Increase/(Decrease)Patent administration and licensing $ 126.3 $ 71.7 $ 54.6 76 % Development 67.9 63.8 4.1 6 % Selling, general and administrative 37.4 31.5 5.9 19 % Repositioning 12.5 - 12.5 100 % Total operating expenses $ 244.1 $ 167.0 $ 77.1 46 % Operating expenses increased 46% to $244.1 million in 2012 from $167.0 million in 2011. Not including $12.5 million in repositioning charges in 2012, operating expenses would have increased 39%. The $77.1 million increase in total operating expenses was primarily due to increases/(decreases) in the following items (in millions): Increase/ (Decrease) Intellectual property enforcement and non-patent litigation $ 31.2 Cost of patent sales 16.7 Personnel-related costs 6.8 Long-term compensation 5.0 Litigation contingency 3.2 Depreciation and amortization 2.6 Patent maintenance and evaluation 1.4 Other (0.8 ) Strategic alternatives evaluation process costs (1.5 ) Total increase in operating expenses excluding repositioning charges 64.6 Repositioning charge 12.5 Total increase in operating expenses $ 77.1 Intellectual property enforcement and non-patent litigation costs increased $31.2 million primarily due to costs associated with the USITC actions initiated in second half 2011 and January 2013, the ongoing arbitration proceeding related to one of our technology solutions agreements, and various arbitrations with our existing licensees. We recognized $16.7 million of expense associated with patent sales. Included in this amount was the remaining net book value of patents sold, as well as commissions and legal and accounting services fees paid in conjunction with the sales. Personnel-related costs grew $6.8 million primarily due to increased personnel levels and merit increases. Long-term compensation increased $5.0 million, primarily due to a $4.4 million charge to increase the accrual rate on our LTCP cycle ended December 31, 2012, and a net $4.4 45-------------------------------------------------------------------------------- Table of Contents million reduction to the accrual rates on our active cycles in 2011. This increase was partially offset by lower accrual rates on the remaining two active cycles under the LTCP in 2012 as compared to 2011. In 2012 we recorded a litigation contingency related to our Huawei China proceedings. Patent amortization increased $3.1 million due to increases in the number of patent applications filed in recent years and patent acquisitions made during 2012, and was partially offset by decreases in depreciation of $0.5 million. The increase in patent maintenance and patent evaluation costs was primarily related to due diligence associated with both patent acquisition and patent sale opportunities. Costs associated with our strategic alternatives evaluation process decreased $1.5 million due to the company exiting the process in first quarter 2012. Patent administration and licensing expense: The increase in patent administration and licensing expense primarily resulted from the above-noted increases in intellectual property enforcement, cost of patent sales, personnel-related costs, patent amortization and patent maintenance and evaluation. Development expense: The increase in development expense was primarily attributable to the above-noted increase in personnel-related costs and long-term compensation. Selling, general and administrative expense: The increase in selling, general and administrative expense was primarily attributable to the above-noted increases in non-patent litigation, personnel-related costs and long-term compensation. These increases were partially offset by the above-noted decrease in costs associated with the strategic alternatives process. Repositioning expense: As part of our ongoing expense management, we initiated a voluntary early retirement program ("VERP") in September 2012. Approximately 60 employees elected to participate in the VERP across our 5 locations. We incurred a charge of $12.5 million in 2012. Other (Expense) Income The following table compares 2012 other (expense) income to 2011 other (expense) income (in millions): For the Year Ended December 31, 2012 2011 (Decrease)/Increase Interest expense $ (14.9 ) $ (10.9 ) $ (4.0 ) 37 % Other (0.2 ) (1.8 ) 1.6 (89 )% Investment income 4.7 2.6 2.1 81 % $ (10.4 ) $ (10.1 ) $ (0.3 ) 3 % The change between periods primarily resulted from the recognition of an additional $3.7 million of interest expense associated with the Notes, due to the Notes being outstanding for the full year in 2012 compared to only nine months in 2011. This change was partially offset by higher returns on our investment balances in 2012 and a decrease in other expense due to $1.6 million of investment impairments recorded in 2011. Income Taxes In 2012, our effective tax rate was approximately 33.5% based on the statutory federal tax rate net of discrete foreign taxes and a $6.7 million benefit related to the reversal of a valuation allowances against deferred taxes. During 2011, our effective tax rate was approximately 28.2% based on the statutory federal tax rate net of discrete foreign taxes, a $6.8 million benefit related to the reversal of a previously accrued liability for tax contingencies and its related interest and $1.5 million of after-tax interest income related to a tax refund. 2011 Compared with 2010 Revenues The following table compares 2011 revenues to 2010 revenues (in millions): 46-------------------------------------------------------------------------------- Table of Contents For the Year Ended December 31, 2011 2010 Increase/ (Decrease) Fixed-fee amortized royalty revenue $ 135.2 $ 195.8 $ (60.6 ) (31 )% Per-unit royalty revenue 146.5 133.1 13.4 10 % Current patent royalties 281.7 328.9 (47.2 ) (14 )% Past sales 13.6 41.3 (27.7 ) (67 )% Total patent licensing royalties 295.3 370.2 (74.9 ) (20 )% Technology solutions revenue 6.4 24.3 (17.9 ) (74 )% Total revenue $ 301.7 $ 394.5 $ (92.8 ) (24 )% The $92.8 million decrease in total revenue was primarily attributable to a $74.9 million decrease in patent licensing royalties. Of this decrease in patent licensing royalties, $60.6 million was attributable to a decrease in fixed-fee amortized royalty revenue. This decrease was primarily driven by the expiration of the 3G portion of our patent license agreement with LG at the end of 2010. The $27.7 million decrease in past sales revenue was due to the signing of a patent license agreement with Casio Hitachi Mobile Communications Co., Ltd., the resolution of a routine audit and the renewal of a patent license agreement, each in 2010. Royalties from past sales totaled $13.6 million in 2011, primarily related to the resolution of audits of existing licensees. Per-unit royalty revenue increased $25.6 million due to strong sales from licensees with concentrations in smartphones, partly offset by a $12.7 million decrease in royalties from our Japanese licensees as a result of lower shipments. The decrease in technology solutions revenue was due to the elimination of $14.1 million of revenue under technology solutions agreements that concluded in 2010. The remaining decrease was due to lower royalties recognized in connection with our SlimChip modem IP as a result of the ongoing arbitration proceeding related to one of our technology solutions agreements. In 2011 and 2010, 59% and 41% of our total revenues, respectively, were attributable to companies that individually accounted for 10% or more of our total revenues. In 2011 and 2010, the following licensees accounted for 10% or more of our total revenues: For the Year Ended December 31, 2011 2010 Samsung Electronics Company, Ltd. 34% 26% BlackBerry 14% < 10% HTC Corporation 11% < 10% LG Electronics, Inc. 0% 15% Operating Expenses The following table summarizes the change in operating expenses by category (in millions): For the Year Ended December 31, 2011 2010 Increase/(Decrease) Patent administration and licensing $ 71.7 $ 58.9 $ 12.8 22 % Development 63.8 71.5 (7.7 ) (11 )% Selling, general and administrative 31.5 28.3 3.2 11 % Repositioning - - - - % Total operating expenses $ 167.0 $ 158.7 $ 8.3 5 % The $8.3 million increase in operating expenses was primarily due to net changes in the following items (in millions): 47-------------------------------------------------------------------------------- Table of Contents Increase/ (Decrease) Intellectual property enforcement and non-patent litigation $ 14.0 Personnel-related costs 6.0 Strategic alternatives evaluation process costs 2.1 Depreciation and amortization 1.6 Consulting services 1.3 Other 0.6 Engineering software, equipment and maintenance 0.5 Sublicense fees (7.5 ) Long-term compensation (7.0 ) Commissions (3.3 ) Total increase in operating expenses $ 8.3 Intellectual property enforcement and non-patent litigation costs increased $14.0 million primarily due to costs associated with USITC Proceeding (337-TA-868). Personnel-related costs grew $6.0 million primarily due to increased personnel levels within our patents, licensing and advanced research groups. Costs associated with our strategic alternatives evaluation process contributed $2.1 million to the operating expense increase. Depreciation and patent amortization increased $1.6 million due to higher levels of capitalized patent costs in recent years. Consulting services and engineering software, equipment and maintenance increased $1.8 million primarily due to the initiation of new development projects in 2011. The decrease in sublicense fees was as a result of technology solutions agreements that concluded in 2010. The $7.0 million decrease in long-term compensation was primarily due to a $5.7 million reduction to the accrual rates on Cycles 5 and 6 of the LTCP in 2011, a $1.3 million increase to the accrual rate on RSU Cycle 4 in 2011 and a $3.3 million charge, in 2010, to increase our accrual rate for Cash Cycle 3. The $3.3 million decrease in commission expense was primarily driven by the decline in revenue in 2011. Patent administration and licensing expense: The increase in patent administration and licensing expense primarily resulted from the above-noted increases in intellectual property enforcement, personnel-related costs and patent amortization. These increases were partially offset by the above-noted decrease in commissions, as well as a decrease in consulting services due to lower levels of patent due diligence. The decrease in long-term compensation costs further offset the previously mentioned increases. Development expense: The decrease in development expense was primarily attributable to the above-noted decreases in sublicense fees related to technology solutions agreements that concluded in 2010 and long-term compensation costs. These decreases were partially offset by the above-noted increases in personnel-related costs, as well as increases in consulting services and engineering software, equipment and maintenance attributable to the initiation of new research and development projects in 2011. Selling, general and administrative expense: The increase in selling, general and administrative expense was primarily attributable to the above-noted increases in costs associated with our strategic alternatives evaluation process and non-patent litigation costs, which was related to the previously discussed arbitration proceeding related to one of our technology solutions agreements. These increases were partially offset by a decrease in long-term compensation costs. Other (Expense) Income The following table compares 2011 other (expense) income to 2010 other (expense) income (in millions): For the Year Ended December 31, 2011 2010 (Decrease)/Increase Interest expense $ (10.9 ) $ (0.1 ) $ (10.8 ) 10,800 % Other (1.8 ) 0.3 (2.1 ) (700 )% Investment income 2.6 2.4 0.2 8 % $ (10.1 ) $ 2.6 $ (12.7 ) (488 )% The change between periods primarily resulted from the recognition of $10.9 million of interest expense associated with the Notes and the recognition of a $1.6 million charge for investment impairment in 2011. 48-------------------------------------------------------------------------------- Table of Contents Income Taxes In 2011, our effective tax rate was approximately 28.2% based on the statutory federal tax rate net of discrete foreign taxes, a $6.8 million benefit related to the reversal of a previously accrued liability for tax contingencies and its related interest and $1.5 million of after-tax interest income related to a tax refund. During 2010, our effective tax rate was approximately 35.6% based on the statutory federal tax rate net of discrete foreign taxes. STATEMENT PURSUANT TO THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 - FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Such statements include certain information in "Part I, Item 1. Business" and "Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" and other information regarding our current beliefs, plans and expectations, including without limitation the matters set forth below. Words such as "anticipate," "estimate," "expect," "project," "intend," "plan," "forecast," "believe," "could," "would," "should," "if," "may," "might," "future," "target," "goal," "trend," "seek to," "will continue," "predict," "likely," "in the event," variations of any such words or similar expressions contained herein are intended to identify such forward-looking statements. Forward-looking statements in this Annual Report on Form 10-K include, without limitation, statements regarding: (i) Our expectation that the technologies in which we are engaged in advanced research will improve the wireless user's experience and enable the delivery of a broad array of information and services; (ii) Our objective to continue to be a leading designer and developer of technology solutions for the wireless industry; (iii) Our plans for executing on our business strategy, including our plans to pursue additional patent sales and patent licensing partnerships, enhance our technology sourcing and commercialize our market-ready technologies and research capabilities; (iv) Our belief that our portfolio includes a number of patents and patent applications that are or may be essential or may become essential to cellular and other wireless standards, including 2G, 3G, 4G and the IEEE 802 suite of standards, and that companies making, importing, using or selling products compliant with these standards require a license under our patents and will require licenses under patents that may issue from our pending patent applications; (v) The anticipated continued growth in sales of advanced wireless products and services and continued proliferation of converged devices; (vi) The predicted increases in global wireless subscriptions, worldwide handset shipments, including shipments of 3G and 4G phones, shipments of media tablets with wireless connectivity and IEEE 802.11 semiconductor shipments over the next several years; (vii) Factors driving the continued growth of advanced wireless products and services sales over the next five years; (viii) The types of licensing arrangements and various royalty structure models that we anticipate using under our future license agreements; (ix) The possible outcome of audits of our license agreements when underreporting or underpayment is revealed; (x) Our plan to continue to pay a quarterly cash dividend on our common stock at the rate set forth in our current dividend policy; (xi) Our current plans to preserve a significant portion of our cash, cash equivalents and short-term investments to finance our business in the near future; (xii) Our ability to obtain additional liquidity through debt and equity financings; (xiii) Our belief that our available sources of funds will be sufficient to finance our operations, capital requirements, debt obligations and existing stock repurchase and dividend programs in the next twelve months; (xiv) The potential effects of new accounting standards on our financial statements or results of operations; (xv) The expected amortization of fixed-fee royalty payments over the next twelve months to reduce our deferred revenue balance; 49-------------------------------------------------------------------------------- Table of Contents (xvi) The expected timing, outcome and impact of our various litigation and administrative matters; and (xii) Our belief that it is more likely than not that the company will successfully sustain its separate company reporting in connection with our New York State audit described in Note 11 to the Consolidated Financial Statements. Although the forward-looking statements in this Form 10-K reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements concerning our business, results of operations and financial condition are inherently subject to risks and uncertainties. We caution readers that actual results and outcomes could differ materially from those expressed in or anticipated by such forward-looking statements due to a variety of factors, including, without limitation, the following: (i) unanticipated difficulties or delays related to the further development of our technologies; (ii) the failure of the markets for our technologies to materialize to the extent or at the rate that we expect; (iii) changes in the company's plans, strategy or initiatives; (iv) the challenges related to entering into new and renewed patent license agreements and unanticipated delays, difficulties or acceleration in the negotiation and execution of patent license agreements; (v) our ability to leverage our strategic relationships and secure new patent license and technology solutions agreements on acceptable terms; (vi) the impact of current trends in the industry that could result in reductions in and/or caps on royalty rates under new patent license agreements; (vii) changes in the market share and sales performance of our primary licensees, delays in product shipments of our licensees and timely receipt and final reviews of quarterly royalty reports from our customers and related matters; (viii) the timing and/or outcome of our various litigation, arbitration or administrative proceedings, including any awards or judgments relating to such proceedings, additional legal proceedings, changes in the schedules or costs associated with legal proceedings or adverse rulings in such legal proceedings; (ix) the impact of potential patent legislation, USPTO rule changes and international patent rule changes on our patent prosecution and licensing strategies; (x) the timing and/or outcome of any state or federal tax examinations or audits, changes in tax laws and the resulting impact on our tax assets and liabilities; (xi) the effects of any dispositions, acquisitions or other strategic transactions by the company; (xii) decreased liquidity in the capital markets; and (xiii) unanticipated increases in the company's cash needs or decreases in available cash. You should carefully consider these factors as well as the risks and uncertainties outlined in greater detail in Part I, Item 1A, in this Form 10-K before making any investment decision with respect to our common stock. These factors, individually or in the aggregate, may cause our actual results to differ materially from our expected and historical results. You should understand that it is not possible to predict or identify all such factors. In addition, you should not place undue reliance on the forward-looking statements contained herein, which are made only as of the date of this Form 10-K. We undertake no obligation to revise or update publicly any forward-looking statement for any reason, except as otherwise required by law. |