Background: RPXC isn’t a growth company. It has a somewhat difficult to understand business model. Its core business faces industry headwinds. Management’s prior capital allocation decisions have been questionable. RPX’s board recently fired the CEO and founder. Shares IPO’d in 2011 at $19 and have performed poorly especially compared to the RUT2K with the stock currently trading at $12.
Thesis: RPX shares have a favorable risk reward given the business has strong cash flow characteristics that I believe will be more persistent than investors believe and overtime the power of this cash flow combined with buybacks will create an attractive return for shareholders. Additionally, the different characteristics of RPX’s two segments and the cash on the balance sheet provide some degree of margin of safety for investors despite challenges in patent risk management.
Company description: segments
Patent Risk Management: ~75% of Revenue, 80% of consolidated EBITDA net of net patent spend (capitalized). Business features 40% EBITDA-NPS margins. This is a primarily subscription based business where RPX helps settle patent assertions on behalf of customers, many of which are large tech companies. Customers are typically on 1-3 year contracts with 90%+ renewal rates. Customers agree to pay RPX, and in turn RPX purchases patent portfolios from trolls and defensively.
Discovery Services: ~25% of revenue, 20% of EBITDA-nps (no NPS associated), 30% EBITDA margins
RPX entered this business with the acquisition of Inventus for $232m announced in December, 2015. The brain child of ex-CEO John Amster, investors at the time understandably didn’t appreciate the 12x EBITDA purchase price. The business did fairly well in 2016 and management is guiding to $22m in EBITDA in 2017 in this business and 5-18% revenue growth. There is some hope of cross selling discovery services to the patent risk management customers. Current RPX network customers spend over $500m in e-discovery per year so clearly there is some opportunity there. It seems reasonable to assume RPX can capture more of that pie over time although there is a question of how much and how quickly.
The core patent business has seen declining revenues. Some of this is due to customers getting acquired and either moving up a larger customer’s rate card or ceasing to contract with RPX completely. New customer signings have not been robust. Part of this is that the number of patent assertions is declining due to Alice and IPRs which have reduced nuisance claims. Additionally, the Supreme Court is considering jurisdictional reform in TC Heartland which creates the perception that perhaps prospective customers will not need RPX in the future. Congress has been considering venue reform although it is unlikely it gets done in near future given some of the current priorities in Washington. While RPX claims most of the decline in assertions is related to nuisance claims that fall below the significant that RPX deals with, clearly the environment has not been great for RPX and you can see it in the numbers.
While it is easy to focus on Silicon Valley’s desires to re-do the current patent system, there are other companies like Whirlpool that favor the current system. Interested investors can read Whirlpool’s Amicus brief related to the TC Heartland case. Also, defining with exactly a patent troll will be a difficult exercise. While not impossible I think a drastic change to the way patents work in the US will be a difficult process and RPX’s services will be needed despite changes on the margin in how the business is done.
The bull case on RPX rests on the fact that while on the margin jurisdictional reform could put a bit more pressure on the business in line with Alice and IPRs, fundamentally it will not change the need that customers have for RPX’s services. Management has levers on the cost side and the cross selling side to maintain cash flows in the face of these challenges.
Valuation: RPXC has a $600m market cap and a $500m TEV. In 2016, RPXC produced $66m in FCF (9x mkt cap) on $108m in EBITDA-NPS. The business is expected to produce $100m in EBITDA-NPS in 2017 (5x) and perhaps similar levels of cash flow although working capital tends to fluctuate a fair bit. Management is buying back stock aggressively having reduced the shares out from 55m as of 12/31/15 to 49m on 12/31/16. Expect 2017 FCF to be put into share repurchases and to see a similar share count reduction if the stock doesn’t significantly appreciate. If one assumes the cash flow power of the business remains north of $60m you could see a situation RPX generates $1.40 in FCF/share in 2018 with $2/share of net cash on the balance sheet. Assuming a 10x multiple + cash you can get a $16 stock for 33% upside, using 12.5x you would get close to a $20 stock. If tax reform occurs and taxes go to 20% you could add another $.25 of FCF to your estimate.
On the downside we can look at a sum of the parts valuation to get a sense of the implied valuation on the potentially challenged patent risk segment. If we assume $200m in value for the Discovery segment (9x EBITDA) and $30m less than management paid for the business before they grew it 30%+ and factor in $97m in net cash + $60m in expected 2017 FCF we get an implied valuation of $240m for the patent risk management segment in relationship to EBITDA-NPS of $80m (3x). It is my belief that in buying the subscription patent risk business at 3x cash ebitda investors are assuming a fair amount of revenue degradation. My view is that some degradation will likely occur, but that RPX has a bloated enough cost structure that they can mitigate a lot of the declines with cost cuts on the opex side and likely lower patent prices which would reduce NPS and maintain cash flows.
There have been reports RPXC may be acquired by a PE shop. I am not an ex-banker so I’ll let others speculate on this but I will say, in an environment where PE can get cheap debt, its possible someone could finance much of the 5x EBITDA-NPS with debt. Who knows, but cheap stocks do sometimes get acquired.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.