John Amster founded RPX Corporation (RPXC) in July 2008 as a subscription business which mitigates patent lawsuit risk for companies. At $17.49, the company is valued at 2.5x tangible book value and 4.5x trailing EBITDA. The company’s capital returns are solid (15.8% ROE with no adjustment for an overcapitalized balance sheet) and its earnings are growing.  To make maters more interesting, consider the following:

1. RPXC generated $100 million of cash (after tax) from operations during Q1 2013. Subtracting capital expenditures, they netted $80 million cash during the quarter– not bad for a company with an $888 million market capitalization.

2. RPXC is a unique business which may become a quasi monopsony for portions of the secondary patent market; at its current valuation, this represents a free option on future growth.

Kleiner Perkins Caufield & Byers and Charles River Ventures financed RPXC’s start-up. The company initially sold 9.065 million shares to the public on 5/4/2011 at $19 each (9x 2010 EBITDA).  They issued an additional 1.4 million shares in a follow-on offering on 9/16/2011 for $20.49 each. The following table summarizes RPXC’s insider stock ownership.

RPXC Insider Ownership

The table shows that venture firms still own 42% of RPXC’s shares – this represents an overhang to the share price.  Mitigating this is what appears to be RPXC’s modest valuation. For instance, note that RPXC sold 105,708 shares to venture board members during April 2011 (prior to the public offering) at $14.19 per share – roughly the same price we can buy shares today and 33% below the IPO price. We suspect that the venture firms are unlikely to sell their shares at current prices, especially in light of RPXC’s demonstrated earnings growth and cash generation capability (i.e., the IPO valued the company at 9x EBITDA and it currently trades at 3.4x EBITDA).

Business

RPXC sells subscriptions to companies that want to reduce their exposure to lawsuits brought by non-practicing entities (NPEs, also known as “patent trolls”). RPXC mitigates subscriber exposure to patent lawsuits by acquiring patents and patent rights, then issuing licenses for these patents to their subscribers. This is an interesting business for the following three reasons:

1. NPE lawsuits are an increasing expense and distraction for companies. The number of NPE lawsuits increased from 145 in 2001 to 2,923 in 2012.

There are a number of explanations for the growth in NPE lawsuits, e.g., being an NPE can be lucrative. The large increase in the number of patents issued over the last half-decade likely contributes to the increased litigation.  For instance, 250,000 patents were issued in 2012, up from 150,000 patents in 2005.

Regardless of the reason(s), lawsuits brought by NPEs are a growing problem for companies. The following table summarizes the number of lawsuits brought by NPEs against the most pursued companies since 2008.  

NPE Lawsuits / Year

Note that retailers and telecom companies are also featured in this list – we conclude that NPE lawsuits are a growing problem (see next table for the costs associated with NPE lawsuits).

2. There is a great deal of inefficiency in the patent market; much of this inefficiency accrues to NPEs and their attorneys at the expense of inventors and companies (practicing entities). The following table summarizes the cost of NPE litigation since 2008.

NPE Settlements Since 2008 (000)

The table shows that NPE’s were able to extract $10.9 billion of value from target companies in exchange for patent licenses during 2012, up from $5.3 billion in 2008: this is definitely a growing market. The data also indicate that, of the $10.9 billion, $5 billion went to legal fees – one could conclude that this is an inefficient market!  There is also inefficiency in the $5.9 billion of settlements – the NPEs aren’t the inventors and they aren’t volunteers.

3. RPXC is able to close a portion of this inefficiency while generating earnings for its shareholders. It does this by acquiring patents that are of interest to its subscribers, either from inventors or from NPEs. It then grants licenses to these patents to all its subscribers. When RPXC buys patents directly from inventors or from practicing companies holding the patents, RPXC eliminates the legal costs plus the NPE’s margin from the transaction.  When RPXC buys patents from an NPE, RPXC is able to eliminate the legal costs – either way, RPXC and its subscribers win.

At this point, there is one member-owned organization, Allied Security Trust, which performs a similar service as RPXC.  Allied Security Trust’s ownership structure makes it well suited to acquire patents that it is able to get its ten members  to agree to purchase, but we infer that its decision making process is slower than that of RPXC. So far, there seems to be room for both organizations in this market.

How good of a business?

RPXC was founded in July 2008 and taken public in May 2011, so there is not a great deal of operating history. Here are the company’s capital returns, sans adjustment, since 2010.

RPXC Capital Returns

Note that the company’s returns deteriorated in 2011 – this was due to the large influx of cash the business received from the IPO.  Given that cash represents 32% of the company’s current market capitalization and the company is a growing start-up, its returns are phenomenal. The story gets better. Consider the following two characteristics of RPXC’s business:

1. GAAP earnings tend to understate RPXC’s cash generating potential. For example, during Q1 2013, RPXC produced GAAP earnings of $14.7 million, up from $8 million during Q1 2012: not too shabby.  However, defining free cash flow as GAAP earnings + depreciation & amortization – capital expenditures, the business produced $18.2 million of free cash flow, up from $12.8 million during Q1 2012.  But this isn’t what really happened to their cash balance: during Q1 2013, RPXC produced $100.2 million of cash, net of taxes.  Part of the explanation for this is a large structured transaction RPXC coordinated, on behalf of its clients, during Q4 2012 which depressed Q4 2012 cash flow and increased Q1 2013.  But adjusting for this and subtracting capital expenditures during the quarter, RPXC produced about $50 million during Q1. The reason for the disparity between GAAP earnings and actual cash flow is that RPXC recognizes subscription revenue over the life of its contracts and its COGS is almost entirely patent amortization costs, which are recognized on a straight-line basis over the estimated useful life of their patents (generally 24-60 months). As they add subscribers, however, their cash flow increases faster than one would conclude from their GAAP earnings. It is important to note, however, while cash flow may be extraordinary in any given quarter, it is lumpier than earnings.     

Cash Flow Summary since 2008

2. As RPXC adds subscribers and builds its patent portfolio, it increases barriers from potential competitors. This is because each new client and each new patent transaction improves the company’s understanding of the patent market, an understanding that is not available to any one of its clients, the NPEs or others wishing to compete with RPXC. Each new patent that RPXC acquires makes the company’s subscription that much more valuable to clients. One can conceive of a situation in which RPXC becomes so integral to the patent market that they become a monopsony for large portions of the secondary patent market. At its current valuation, we are not asked to pay for this optionality.

Conclusion

RPXC is building a unique business which generates high returns on capital and is increasing subscribers, GAAP earnings and cash flow. The company’s balance sheet is overcapitalized and the business may be purchased for 3.4x trailing EBITDA (less than you would pay to acquire your neighborhood dry cleaner).  We conclude that RPXC is an Absolute Value.

Patent and NPE Industry Background

The U.S. Patent and Trademark Office issued 253,000 utility patents in 2012, up from 225,000 in 2011. The cost of obtaining a patent is generally between $10,000 and $15,000. Patents provide exclusive rights to the patent owner, usually for a period of 20 years. Patents are negative rights – if a patent owner thinks that someone is infringing on an owned patent, the owner must negotiate an agreement with the infringer and, if that fails, sue the infringer. Inventors wishing to enforce their patents against large companies are at a disadvantage, so an industry of intermediaries has evolved called non-practicing entities (NPE’s). NPE’s typically partner with inventors and/or purchase patents from inventors with the intention of enforcing the patent rights against companies that may be infringing on the patents.  The following is a list of the largest NPE’s.