Acacia Research: Patience Required, But Earnings Could Explode

| About: Acacia Research (ACTG)

Acacia Research (NASDAQ:ACTG), a licensor, developer, acquirer and enforcer of patents, has reached an inflection point. The company posted its second highest revenue number ever, and 50% year over year growth, when they reported their fourth quarter earnings on February 19th. 2009 looks even more promising for Acacia as they begin the year with the most licensing opportunities in company history, according to CEO Paul R. Ryan. Additionally, Acacia’s business model enables it to thrive in today’s difficult environment as companies increasingly look to squeeze more dollars out of their technology by monetizing their patents through enforcement. During times of heightened patent enforcement, potential infringers are much quicker to enter into licensing agreements rather than risk considerable legal fees and court awarded judgments. The current business environment has set the stage for ACTG to have a breakout year in 2009.

Acacia Research has stabilized its cost structure at $48 million on an annual basis. Assuming their gross margin stays at the historical level of 43%, any increase in revenue will flow directly to the bottom line. While operations costs should be stable in the near term, Acacia has grown its active patent portfolio to total just over 100 and was generating revenue from licensing agreements on 48 of them by the end of 2008. At the beginning of 2008, ACTG was only generating revenue from 28 licensing agreements. To provide some financial perspective, licensing rev generated $18.3 million in revenue in Q4 ’08 vs. $12 million in Q4 ’07. Management did not provide guidance for 2009 but noted that they expect growth in licensing revenue and patent portfolio acquisition.

Let’s take a look at the balance sheet. No major issues appear to be lurking here since ACTG has zero debt and $1.65 in cash. The forward P/E has declined to 7, which is around levels not seen in years. Management has demonstrated that ACTG’s business model does not call for borrowing to stimulate growth, but rather has built up a decent cash reserve that can be used to make strategic investments in promising patent portfolios even as most businesses rush to cut costs or limit cash burn.

The last time ACTG’s stock sank to these levels insiders stepped up and started buying. From the middle of August ’08 to the middle of December ’08, insiders bought 199,759 shares as the stock dropped from $4.18 to the mid-$2 range. All but 24,000 of these shares were bought when the stock dropped below the $3 mark. Using the momentum of the insider buying, the stock rallied from $1.87 on 11/21/08 to $3.80 on 1/7/09.

Almost on cue, President Richard L. Harris bought 40,000 shares last week in the $2.60-$2.70 price range. Could this be the start to another insider buying spree?

Other potential catalysts should come into play in 2009. In Q4, Acacia’s trial against Verizon (NYSE:VZ) over wireless emergency services technology (E911) is scheduled to begin. A settlement for this case could occur at any time and generate around $100 million. Three other major cases are slated to go to trial in 2010, which could also bring about settlements in 2009, but investors should focus on the Verizon case for now.

With major cases pending, an advantageous business environment, and a strong start to the first quarter the stage could be set for a few major upside surprises in earnings over the next few quarters. I believe revenues could ramp up toward $100 million in the next year or two, which would cause earnings to explode due to ACTG’s fixed cost structure of $48 million a year. On the negative side, there are patent-related expenses and non-cash option charges each quarter that will skew the long-term potential earnings power of Acacia. Quarterly results are also very uneven and impossible to predict. Patience will be required with this being a long-term trade for my accounts.

Disclosure: The author is currently long this stock.