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A reader recently suggested I take a look at RPX Corporation (RPXC).  Coincidentally, the next day, Union Square Research Group tweeted out a link to an article about their biggest competitor.  After that, I decided I had to take a closer look at them.

The Patent Market

The market for the purchase and sale of patents, patent rights and other related intellectual property (collectively the “patent market”) is inefficient and adversarial.  A difference in perceived value of patents and lack of signals often causes participants to ignore the market and gravitate towards litigation.  The courts are horribly inefficient and horribly expensive as a substitute for a free market.  RPX described this sorry state of affairs in the 2012 10-K:  “We believe the process by which value is transferred from users to owners of patents lacks key attributes of more developed markets, such as an open exchange to execute transactions, transparent pricing information and broadly accepted standard contract terms. Because an orderly and efficient market for the exchange of patent value has yet to develop, this transfer of value is currently driven by litigation or the threat of litigation. Patent litigation today is a multi-billion dollar industry.”[1]

A sea change occurred in the patent market over the past 15 years due to the rise of non-practicing entities (NPEs).  NPEs are more commonly known by the pejorative term “patent troll.”  In fairness, the two terms are not synonymous.  NPEs do not create or sell products or services, but instead exist to monetize patents through licensing and litigation.  Some NPEs obtain patents through their own research and development efforts, while others accumulate patents through acquisitions.  NPEs have become a major factor in the patent market and an important source of liquidity for patent owners.

While most if not all NPEs use litigation as part of their strategy, a subset of NPEs own patents with the sole intention of engaging in patent enforcement litigation.  This litigation is often seen as unduly aggressive and abusive.  They hope that threat of a big lawsuit settlement is serious enough to extract a payment from the other party.  Such companies are classic “patent trolls.”

I remain agnostic on the NPE / patent troll dichotomy, but I am interested in the impact they are having on the marketplace.  That impact has been considerable.  Corresponding with the rise of NPEs/patent trolls has been an explosion in patent enforcement litigation.  RPX estimates that the cost (defense costs plus settlements) of litigation in 2012 alone was $11 billion.  RPX has identified 1,000 unique NPE plaintiffs since 2005. (See Charts 1 and 2)

Chart 1 (click to expand)

RPX1

Chart 2 (click to expand)

RPX2

In response, a number of different business models have emerged to capitalize on the poorly functioning patent market. Here is an overview of some of the major business models:

1.  Offensive Aggregators – Offensive aggregators purchase large amounts of patents in the hopes of generating licensing revenue.  If licensing talks break down, they will resort to litigation.[2]  In a typical arrangement, the offensive aggregator will acquire a patent portfolio or acquire rights to a patent portfolio, and in exchange, the original patent portfolio owner receives (i) an upfront payment for the purchase of the patent portfolio or patent portfolio rights, or (ii) a percentage of the offensive aggregator’s net recoveries from the licensing and enforcement of the patent portfolio, or (iii) a combination of the two.  Two of the biggest offensive aggregators are Intellectual Ventures (privately held) and Acacia Research (ACTG).  Mass aggregators operate on a scale and at a level of sophistication and complexity that would have been unimaginable a decade ago. They have taken the strategies pioneered by a prior generation of NPEs and changed them into some of the cleverest strategies yet seen in the intellectual property rights field.  According to a report prepared by RPX, Acacia was second among all NPEs with 1,276 parties sued in the last five years.

Intellectual Ventures, founded in 2000, was the first to bring an investing mindset to the patent market on a broad scale.  IV’s business model, revolutionary at the time, was to acquire patents and then seek royalties from companies that wanted to use them.  Per Reuters, Intellectual Ventures to-date has raised about $6 billion and acquired 70,000 patents and other intellectual property assets.  The company has run into cash flow problems of late.  It has curtailed new patent acquisitions and is trying to raise $3 billion.  Many early backers, including MSFT and GOOG, are no longer investing in IV due to IV’s increased propensity for litigation in the past 3 years.  Fund returns have also been disappointing.  The IV investor presentation reviewed by Reuters shows that at the end of last year the average rate of return for IV’s 2003 fund was 16.2% while the 2008 fund stood at 2.5%.

2.  IP Advisory – Unlike Offensive Aggregators which purchase patents, IP advisory firms do not take ownership of the patents.  Instead, they help their clients create a strategy for monetizing their patents.  Among the strategies pursued could be a sale to an NPE or litigation.  IP advisory firms can be hired on a contingency basis.  The advisory work can range from mere consulting to a full-service IP management partnership.  Privately held IP Navigation is one example of a patent monetization consulting firm.  According to the same RPX report as cited above, IP Navigation led all NPEs with 1,638 parties sued in the last five years.  IP Navigation will even pay clients for the exclusive rights to monetize their patents.

3.  Patent Brokers – Patent brokers match buyers and sellers for the sale of patents and other intellectual property assets. Privately held ICAP Patent Brokerage is one example.

4.  Hybrids – Hybrid firms combine aspects of the three models listed above.  Hybrids provide advisory services, brokerage services, litigation support and licensing support.   Their objective is to help IP owners monetize their IP.   They themselves do not take ownership of the IP.  ThinkFire is one example of a hybrid.  Another company, Wi-LAN (WILN) represents another twist on the hybrid concept.  In addition to the business lines mentioned above, Wi-LAN also conducts R&D for its own benefits and patents its self-developed technology.

5.  Defensive Aggregators – Defensive aggregators purchase potentially troublesome patents to shield their clients from patent infringement lawsuits.  The clients pay an annual subscription fee and in return get a license to use all of the firms patents.  In sharp contrast to offensive aggregators, they make no other attempt to monetize their portfolio and pledge to not sue clients or even non-subscribers.  In this way, the defensive aggregator reduces its clients’ legal expenses and replaces unpredictable litigation results with a consistent subscription fee.

RPX’s Business Model

RPX is the leading defensive aggregator.  RPX was incorporated in 2008 with major venture capital backing and went public in 2009 with the goal of helping “companies reduce patent-related risk and expense.”  Just prior to founding the company, John Amster was Intellectual Ventures’ general manager of strategic acquisitions and vice president of licensing.  They approach NPEs who have initiated or contemplated litigation against their clients and negotiate the acquisition of the patent at issue.  RPX then licenses the patents to their clients to protect them from patent infringement claims.    As of December 31, 2012, RPX had spent a total of $620 million on 120 patent acquisitions, including $220 million contributed by clients.  Annual subscription fees run from $75,000 to $7 million per year and is tied to the client’s revenue or operating income.

Alignment of interest is essential to the RPX business model. Crucially, RPX pledges not to sue clients or even non-subscribers.   “Our approach is purely defensive; every RPX client receives a license to the patents we acquire and we never assert these patents.  All of our efforts are designed to reduce patent risk and drive down patent litigation costs.”

One question that immediately comes to mind is, how do you avoid the free rider problem?  That is, why would a potential client ever subscribe to the RPX service if they can get the same benefit by standing on the sideline?  Management thinks they have the problem solved.  They rarely buy 100% of the rights associated with a patent.  Instead, they buy limited rights to only protect their clients.  Further, when RPX sells patents, only current subscribers are granted a perpetual license to the sold patents.  In this way, they leave the threat of litigation out there.  According to RPX, “in nearly a third of our transactions, we acquire rights only for our clients, and we have already begun to sell patents. Those joining later may not get the full benefit of licensing to our broad portfolio that our earlier clients enjoy.”

As you can see, RPX is quite a bit more complicated than the staid candy companies and truck rental companies I typically analyze.

Results

To date, RPX has spent $700 million on patent acquisitions.  They have signed up 157 clients, including many of the biggest names in tech.  Average subscription term is 2.8 years and they have a 90%+ renewal rate.  Revenue has increased at an astoanishing 90% CAGR since 2008, although it dipped in 2012.  But, is it sustainable?

Is There A Moat?

Its premature to look at quantitative evidence of a moat.  The company is still growing and has not yet hit critical mass.  Operating margins have gone from 15% in 2009 to 31% in 2012.  If margins continue to expand, it would certainly be evidence of a moat.  ROIC[3] is relatively low at 13% in 2012 but is also growing.  There does not seem to be a great deal of pricing power, a key characteristic of a wide moat company, as subscription fees simply increase with the CPI.  But, this at least shows some ability to raise prices.  Nevertheless, the company does disclose in their SEC filings that they do grant clients discounts and other contractual incentives.  There is no detail on how widespread this discounting is.

More disturbingly, another characteristic of wide moat companies we focus on, market share stability, is impossible to determine.  As described above, the patent market is in a state of flux.  It is impossible to determine which of the competing business models will emerge triumphant from this morass.  At one time, the conventional wisdom was that Intellectual Ventures was a behemoth that would dominate the marketplace and threatened American innovation.  Now, Intellectual Ventures is struggling to raise money.  I simply don’t understand the market or where it is headed well enough to determine if there is a moat now or whether there will be one eventually.

RPX’s hope is to create a working patent marketplace where patent owners and users could meet and arrange deals.  It would be much more transparent than the current, barely functioning market and would not rely on costly litigation.  RPX would buy the patents themselves, buy the patents in a partnership with other companies, or simply structure the transaction and earn a fee.

If it works and they hit critical mass, RPX could be a lot like Ebay.  Just as Ebay created an electronic marketplace for all types of goods, RPX will have created a marketplace for the purchase and sale of patents.  If this happens, the network effect will kick in.  The more patent buyers come to RPX, the more sellers will be attracted to it and so forth and so on.  In this way, the more people used their service, the more attractive it became.  This is a very powerful moat.  One key distinction between RPX and Ebay, is that in most cases RPX actually purchases the patents rather than just acting as an intermediary.  Ebay earns a small amount of money per transaction.  RPX has to actually shell out large amounts of money to purchase the patents themselves (more on this below).

Notably, the company recognizes the nature of their moat. In the 2012 10-K, they wrote:  “Because each acquisition of a patent asset may create value for more than one client, we believe our acquisitions of patent assets create a network effect: expanding our portfolio of patent assets results in greater patent risk mitigation for our clients, which we believe leads to greater opportunities to retain and grow our membership base In simple terms, the business is driven by portfolio growth, which leads to revenue-producing licensing programs (that hold dozens of patents and agreements), which then turn into licensing revenue.

There is some evidence that the company is starting to generate scale.  According to RPX, their patent purchases in 2012 represented approximately 10% of all open market activity.

Competition

RPX faces a great deal of competition for both clients and patents.

The bulk of RPX’s competition for clients still comes from traditional intellectual property management approaches.  Most technology companies have in-house departments to deal with IP through licensing and cross-licensing arrangements, patent purchases, and litigation.  As a result, RPX must spend considerable resources educating existing and prospective clients on the potential benefits of their services and the value and cost savings it may provide.

The other competitors are the emerging business models discussed above.

Risks Related to the Business and Industry

There are a number of risks.

  1. The RPX business has a number of characteristics similar to that of a traditional asset manager.  Essentially, growth in AUM – in the form of patent assets – is the key leading indicator to future revenue growth and margin expansion as scale is achieved.  But for traditional asset managers investing in equities or bonds, I have some ability to assess their proficiency in selecting assets for investment.  Here, I have no ability to assess whether management is buying high quality patents at an attractive price.  This is a bit of a blind pool.
  2. Free Cash Flow:  Well over 100% of cash flow from operations goes right back into purchasing patents.  While they have a lot of cash on the balance sheet, last year for the first time cash spent on patent purchases was greater than cash generated from operations. There was $91 million of CFOA and $116 million spent on patents.  They have never paid a dividend or bought back shares[4].  Management claims they will hit an inflection point where patent purchases will level off while subscriber fees will increase.  Their model is to grow revenue at 13-19% and keep patent purchases flat.  Perhaps, but this remains to be seen.  (See Chart 3)
  3. High Amount of Stock Compensation Expense:  In 2012, RPX had 125 employees and had $10.3MM of stock based compensation.  This works out to $82K per employee.  Diluted shares outstanding have gone from 2M in 2009 to 52M in 2012.  Enough said.
  4. Policy Risk:  Tech companies are pushing Congress to make it harder to sue for patent infringement. One proposal would make it easier for defendants to recoup legal fees if they fight a patent lawsuit and win.  This would largely take away RPX’s reason for being.
  5. Expenses are growing almost as fast as revenue.  Since 2009, SG&A has increased at 74% CAGR versus 82% CAGR for revenue.  They are sinking a lot of money into growth and its not clear whether it will be profitable growth.
  6. Vesting Period Reduces Incentive to Renew Membership:  RPX’s subscription agreement include a vesting provision which converts client short term licenses to perpetual licenses.  Vesting occurs on a delayed, rolling basis as long as the company remains a client.  Therefore, the longer you are a client the more patents for which you are granted a perpetual license.  However, if clients feel they have vested in all relevant patents, they lose any incentive to renew their subscription.

Chart 3 (Click to expand)

RPX3

Valuation

The business model of RPX and its competitors is quite attractive – scalable, capital-light and high-return/margin.  The subscription/deferred revenue model also bring some predictability to the revenue flow.  Further, the valuation is reasonable. More than 25% of the market cap is cash (per the June 2013 balance sheet).

But valuing this company brings to mind the old Buffett line about valuing Internet companies:  “If I was teaching a class at business school, on the final exam I would pass out the information on an Internet company and ask each student to value it. Anybody that gave me an answer, I’d flunk.”  This is a brand new company with a very limited track record and an innovative business model.  I never even look at companies without at least a 10 year record.  It is difficult if not impossible to project future earnings.  Its growing really fast, but it remains to be seen whether their model works.  The market for patent risk management solutions is new and it is uncertain whether these solutions will achieve and sustain high levels of demand and market acceptance.  I believe that RPX has a more favorable business model because of the alignment of their interests and their clients (in other words, they won’t sue anybody), but the better product doesn’t always win.

RPX will not be added to our watch list.


[1] I am not in the habit of lifting quotes from 10-Ks, but RPX’s is unusually well-written.

[2] I can understand the attractiveness of this approach.  In his 2012 letter to shareholders, the CEO of Wi-LAN, one of the companies discussed herein, claims to have a 5X ROI on litigation.

[3] ROIC is defined here as EBIT / Current Assets-Current Liabilities + Net Fixed Assets.

[4] This capital allocation history is in sharp contrast with Wi-LAN’s announced policy which is to spend 40% of cash flow on dividends, 40% on patent purchases and 20% on share buyback.  I wish all companies were this transparent.