For those who don't know, Vringo (VRNG) is an IP company currently in litigation with Google (GOOG), Microsoft (MSFT), and ZTE. Google has been the main focus thus far, and has been discussed in detail here and here. There have been possible decimal place errors, laches disagreements, possible new trials, and a very long wait (still ongoing) for the judge to rule on the forward royalty rate. However, VRNG did have a jury rule that its patents are valid and infringed upon, which gives it an edge as it now sues Microsoft's Bing search engine. Clearly Microsoft agrees, as Vringo and Microsoft are now in settlement discussions. As we all wait for the judge to rule in the Google case, I think it is important to analyze what sort of settlement may be reached against Microsoft. Will it only be $50 million? Or maybe $1 billion? Will it add $1 or $5 to the stock price? How can somebody possibly buy or sell Vringo on this new development without first taking the time to at least value the settlement? There are numerous variables at play that could vary wildly, but through the following analysis, I hope to give a reasonable range of expectations as well as my personal opinion.
Before I begin, I want to list a few assumptions that I will be making, which I don't believe are too controversial:
- The settlement will be in the form of a one-time payment that includes both past and future damages. No running royalties (the patents expire in 2016 anyway).
- Bing began in mid-2009, the patents end in mid-2016 -- this is a 7 year period.
- There will be no laches issue since Bing began within the past 6 years.
- The patents will only apply to U.S. Revenues.
- Lawyers' fees will be 20% and taxes are 35%
Now that the assumptions are over with, there are three main factors to calculating the settlement amount: Applicable Revenues, Royalty Rate and Settlement Negotiations.
There are two methods of estimating the applicable revenues. The first is to look through Microsoft's quarterly SEC filings and estimate the portion that is U.S.-based. The second is to look at the total U.S. market size and break out Microsoft's market share. Both give relatively similar numbers (fortunately).
Firstly, let's look through Microsoft's quarterly filings. Microsoft breaks out its search revenues in its 10-k under the header of Online Services Division (OSD).
The above chart shows Microsoft's OSD revenues since Bing's inception (from SEC filings). They have been averaging approximately a 15% growth rate per year, but I am going to conservatively assume only a 10% growth rate, which gives us the following chart detailing annual revenues from 2009 through 2016:
This amounts to a grand total of $23.37 billion. The biggest issue with this data is that it includes global revenues, not just U.S., and Microsoft does not break it out geographically. From the suit against Google, we know that Google's U.S. revenues account for about 50% of total revenues. We also know that Bing is significantly more competitive in the U.S. than it is globally, and therefore we can assume that approximately 75% of Bing's revenue is from the U.S. This lowers our total revenue base from $23B to approximately $17.53 billion. Note that this includes both Bing's revenues and the amount that it receives from Yahoo, since Yahoo is powered by Bing (which hits Microsoft as revenue and is then paid out to Yahoo).
The second method is to look at the total U.S. search advertising size.
The above chart shows that total U.S. search advertising is estimated at $19.76B in 2013. From Microsoft's most recent 10-k, we know that they have approximately 26% of the U.S. market through Bing and Yahoo combined (approximately 14% and 12%, respectively). This amounts to $5.14B in revenues per year. However, there are many reports that state that Microsoft actually only receives around half of the revenue per ad as Google, and therefore, I will conservatively cut this number in half to $2.57B for 2013. Applying this same 13% rate to each year, we come to a total of $17.4 billion in total revenues, which is very similar to the $17.5B mentioned above.
Therefore, I believe that the appropriate amount of applicable revenues is $17.5B
Now we must determine the appropriate rate to apply to these revenues. Against Google, Vringo claimed that it was owed 3.5% of 20%-40% of Google's U.S. revenues. The idea was that it had shown that when Google switched its algorithm to the new algorithm, which infringed on Vringo's patents, there was an immediate and noticeable jump in revenues of approximately 20%-40%. In general, Vringo argued that it was focusing on the low end of this range so as to appear less greedy. However, we have no idea what sort of damages it is claiming against Microsoft, and therefore, I think it is reasonable to use the "3.5% of 20% of revenues" damages claimed from Google as a starting point.
Applying this to the $17.5B, we would come to an estimate of $123 million. I believe that this is a reasonable "low-end" of the range that both companies might have in mind when they enter settlement negotiations. Why is this just the low end? Because Bing started using Vringo's patents from the very beginning, and therefore, it isn't completely unreasonable to assume that damages should be applied to 3.5% of 100% of Bing's revenues. This would, of course, invoke the Entire Market Value theory, which brings up its own issues. In order for the Entire Market Value rule to apply, VRNG would have to be a practicing entity (it isn't) and be claiming to have essentially invented search (it didn't). Therefore, I think that 100% is much too high, while 20% serves as a reasonable floor. So where should the ceiling be? While Bing started using Vringo's patents from the beginning, Yahoo (YHOO) didn't switch over to Bing's services until the end of 2010, so we can attempt to look at its revenues to see if there is a noticeable 20%, 50%, or even 80% jump in revenues. Below is Yahoo's net search revenues by quarter, starting in 2008:
At first glance, it is quite obvious that Yahoo was in trouble and it is easy to see why it began working with Microsoft in early 2010. However, since Bing was fully integrated starting at the end of 2010, revenues not only stopped its decline, but began to grow once again. This is despite continuing to lose market share. Therefore, I don't think it would be unheard of for Vringo to argue that it deserves 3.5% of 75% of the total revenue, which would amount to a total settlement of $460 million. We now have a range of somewhere between $123 million and $460 million.
Going into the settlement, Vringo might be arguing for $460 million, whereas Microsoft argues for zero, and they eventually meet somewhere in the middle (or even below) at around $150-$200 million. However, Vringo once again has a small edge here in the form of Willful Infringement. In 2003, one of Microsoft's own patents was rejected due to prior art from Vringo's patents (link). This proves that Microsoft was well aware of Vringo's patents and could cause the judge to double or even triple the damages. Given this, the true range of damages is from $123 million to $1.38 billion on the very high side. Since this is still pre-trial, Microsoft will have a lot of bargaining power, and I think it will eventually settle in the $300-$400 million range, which is what it would have to pay if Vringo won 3.5% of 20% of revenues, tripled for willful infringement, thus allowing Microsoft to save the risk of having to pay damages on more than 20% of revenues. Another way to look at this is to say that Microsoft is only paying damages on 3.5% of 60% of revenues, and saves the risk of paying more than 60% as well as paying any additional multiple for willful infringement.
So what does a $300-$400 million win for Vringo mean? This is a gross valuation, and after lawyer's fees and taxes, it will only amount to $150-$200 million, or about $1.30 to $1.70 per share on a fully diluted basis. Given that Vringo's valuations never really reflected the Microsoft suit, I wouldn't be surprised to see the stock jump $1-$1.50 on this news, perhaps higher with short covering.
If you have any questions, please use the comments section below. I know that many people will think my numbers are too low, but if that is the case, then simply treat them as conservative. If, on the other hand, you believe they are significantly too high, please let me know why and what your calculations are. As I mentioned in the beginning, there are numerous variables at work here that could have drastically different valuations. I estimated numbers where needed, and it is very possible that I am completely wrong. However, to my knowledge, there is no other solid attempt at estimating the value of a MSFT settlement, so I hope to use this analysis as a starting point.