Are Non Practicing Entity Patent Holders Significantly Undervalued?

| About: Great Elm (GEC)

The mobile patent wars appear like they will continue unabatedly. The cost of prosecuting, monitoring and litigating patents will also continue at a high rate, considering the recent $30 million jury award granted to Vringo (VRNG) in its litigation against Google (NASDAQ:GOOG) et. al. (of which Google was sanctioned $15.8 million based on a running royalty rate of 3.5% on net sales) related to certain advertising search technology. The stakes are high, due to the total size of the mobile market, rich margins and the number of patents awarded to innovators.

But to say the stakes are high in the patent damages world would be an understatement. In August 2012, a jury awarded $1.05 billion in patent damages to Apple (NASDAQ:AAPL) in the Samsung (OTC:SSNLF) matter, the second largest patent damages award ever. The presiding judge, though, subsequently reduced the award by $450 million. The judge ruled that the jury had erroneously calculated damages. In addition, the judge indicated that a new trial would need to be set to try damages covering post-judgment (August 2012) sales.

Introduction to Patent Damages:

Patent damages are generally predicated on two types of damages: (1) lost profits (of which price erosion could be a factor) and (2) reasonable royalties. The former is calculated by estimating the portion of offending sales that would have been sold by the plaintiff-patentee and multiplied by the patentee's incremental profit margin. In a market with more than two suppliers (the patentee and the infringer), the hypothetical market shares need to be adjusted to estimate what portion of the offending sales the plaintiff would have captured, and what portion non-infringing competitors would have captured. For the remaining units not captured by the patentee in a lost profits analysis (i.e., those that would not have been made by the plaintiff, but by other competitors), Title 35, Section 284 of the United States Code indicates that no less than a reasonable royalty shall be levied for the use of the invention by the infringer. Because incremental profit margins and unit sale prices are high on smartphones, both lost profits and reasonable royalties can yield large damages figures. When multiplied by the growing and large total size of the smartphone market, it's easy to see how damages amounts can easily reach into the hundreds of millions of dollars range.

Need more evidence as to the value of patents? When Google purchased Motorola Mobility in August 2011 for $12.5 billion, pundits conjectured that an important strategic consideration was the treasure trove of 17,000 patents it acquired in the deal in addition to the handset device business. The Google acquisition came just 6 weeks after a consortium of buyers including Apple, BlackBerry (NASDAQ:BBRY), Ericsson (NASDAQ:ERIC), EMC (EMC) and Sony (NYSE:SNE) purchased some 6,000 patents related to wireless, data networking, optical, voice and internet functionalities for mobile phones from the defunct Nortel Networks (equating to a purchase price of $750,000 per patent).

The quid pro quo acquisition clearly indicates that patents are used not only to exclude others from using proprietary ideas, but also as a defensive measure should the patent-holder get sued by a competitor. The situation is not unlike the US and Soviet Union nuclear warhead arms race during the Cold War: a bigger stockpile of weapons is seen as a deterrent from an offensive action.

Escalating Patent Wars:

The mobile patent war stakes are obviously high based on the damages figures issued by juries over the years. Consider the following: In 2012 alone, there were 18 jury awards over $10 million; 8 over $50 million; 5 over $100 million; 3 over $350 million; and 2 over $1 billion. [Note: some of these cases, including the Apple vs. Samsung matter, have been vacated or remanded for a retrial on damages.] Those are significant numbers nonetheless, collectively amounting to $3.04 billion in damage awards.

And the direct cost of litigating patents is astronomical too. A study conducted my academics James Bessen and Michael Meuer placed the figure at $29 billion annually, and that's just covering the legal fees spent and licenses entered into to defend against so-called non-practicing entities (NPEs), pejoratively known as patent trolls. Some, however, would suggest that NPEs help drive innovation by determining the highest and best use of the property rights, including finding appropriate licensees for the proprietary technology.

With so much at stake including exorbitant jury awards and costly patent license agreements covering future sales, it is understandable why manufacturers faced with a patent suit defend themselves vigorously. So, because patents apparently carry a lot of value, are there any pure play patent investments out there?

An Interesting Patent Play:

Absent any sweeping reform to patent and patent damages law, Unwired Planet (UPIP) appears to be an interesting play on the mobile patent war battlefield. Valued at some $200 million, Unwired Planet has an interesting history. It traces its history to 1994, and after a number of strategic acquisitions, it changed its name to during the boom, then to Openwave Systems where it directed its efforts towards "development and delivery of mobile and fixed broadband software infrastructure to a global base of communication service providers." [Source: Unwired Planet 2012 Annual Report] It is the creator of the Wireless Application Protocol ("WAP"), which is the foundation for mobile internet capabilities.

Recently, Unwired Planet refocused its business strategy, disposed of its product businesses and related manufacturing facilities, moved its headquarters to Reno, Nevada, reduced its workforce to 19 employees and announced it would refocus its business to protect and commercialize its intellectual property assets, "now solely focused on a multi-pronged intellectual property strategy that includes, among other things, licensing and, when necessary, litigation to protect the value of its patent portfolio."

Unwired Planet had $62.5 million in cash and equivalents as of December 31, 2012, and a low burn rate, estimated by management to be between $7 million and $12.5 million per quarter, as it pursues its new intellectual property licensing and enforcement strategy. The opportunity, though, is large. 4G smartphone shipments are expected to increase at a 53.5% [PDF] compound annual growth rate ("CAGR") through 2016. According to IDC, the global market for connected devices is expected to increase to almost $800 billion in 2016. Should Unwired Planet capture even a small portion of the addressable and licensable market, the stock will be exceedingly cheap at $200 million.

To further effectuate the change towards its stated intellectual property strategy, in January 2013, Unwired Planet and Ericsson announced a deal whereby Unwired Planet acquired 2,185 patents (and 100 more per year from 2014 through 2018) from Ericsson in return for future royalty sharing (no cash upfront). The announcement served as a catalyst for the stock, up some 85% so far in 2013. In particular, the royalty share to Ericsson is as follows:

  • 20% of royalties up to $100 million;
  • 50% of royalties on sales between $100 million $500 million;
  • 70% of royalties over $500 million.

Let's say, for example, that Unwired Planet successfully closes licensing arrangements having a total value of $1 billion in royalties. Ericsson's share of those royalties would be $20 million on the first tranche, $200 million on the second tranche; and $350 million on the third tranche, collectively $570 million, leaving $430 million for Unwired Planet in this hypothetical. What's more, Unwired Planet would not owe any taxes on that income (more on that below).

The agreement with Ericsson also requires Unwired Planet to set minimum agreed royalty rates on certain patents, if the rate goes below those thresholds, the revenue share increases to Ericsson. Ericsson also received a fully paid-up license to the transferred patents as part of the deal. Additionally, Unwired Planet has agreed to license certain key patents to potential licensees at a fair, reasonable and non-discriminatory basis ("FRAND"), in order to avoid certain anti-trust allegations in the marketplace. For technologies that are considered industry standards, licensors must abide by FRAND, or else risk government regulatory issues.

Net Operating Loss (NOL) carryforwards:

As part of Unwired Planet's lengthy history of operating losses, it has accrued $1.6 billion in federal income tax NOLs and $600 million of state income tax NOLs. The company warns in its filings though, that Section 382 of the Internal Revenue Code indicates that if there is an "ownership change," then the NOL benefit may be limited. However, management implemented a Tax Benefits Preservation Agreement, or a "poison pill" on January 28, 2012, whereby certain preferred stock purchase rights were attached to common shares trading as of January 29, 2012 in order to make sure an acquiring entity does not frustrate the "ownership change" provision in Section 382 of the Internal Revenue Code. The goal is to allow shareholders of record to acquire certain preferred shares to maintain the ownership structure.


The first risk, of course, is management's ability to license its patent portfolio to a diverse group of mobile device consumer electronics manufacturers and telecommunication service providers. Because Unwired Planet recently decided to pursue this strategy, there may be some growing pains as they attempt to sign up licensees. It does, however, count Microsoft (NASDAQ:MSFT) as a licensee. That's not a bad start.

The second risk is the expense of monitoring, policing and litigating its patent portfolio. While highly capitalized manufacturers such as Apple and Google have the ample resources to defend themselves (whether it's a good use of capital is the subject of another debate), Unwired Planet has considerably less maneuvering room in which to pay legal fees. However, NPEs generally have smaller legal costs relative to defendants who perform substantial discovery.

The third risk is the limited lives of the patent portfolio. Management indicated that some of the Unwired Planet portfolio will begin to expire in 2015, with a material portion of the portfolio expiring between 2017 and 2019. While the additional patents acquired from Ericsson, including the 400 due over the course of the next few years, should extend the life of its assets; however, investors should perform due diligence on the patent portfolio to understand which are the key patents and their expiration dates.

The fourth risk is dilution to current shareholders. While the company has reduced its cash burn rate, there is still a potential for dilution, should management burn through its cash and marketable securities. In line with that concern, management filed an S-3 ("shelf filing") on March 11, 2013, allowing management to issue $50 million in new common or preferred equity and warrants (or about 25% of the current market capitalization).

The fifth risk relates to transition at the management level. Former CEO Michael Mulica recently announced he is leaving the company. Unwired Planet will need to find a suitable replacement, with significant experience in commercializing and defending intellectual property rights.


Investors should proceed with caution and do the requisite due diligence. While there appears to be significant upside to the Unwired Planet story should they sign up licensees or prevail in their patent litigation matters, there are certainly many risks involved. In fact, the company decided to vacate its International Trade Commission Section 337 Investigation against BlackBerry and Apple because the Administrative Law Judge ("ALJ") did not construe certain claim constructions in Unwired Planet's favor. Rather, Unwired Planet is pursuing these claims in a concurrent litigation against the same parties, concerning the same patents-in-suit in Delaware Federal Court.

In addition, there are many opaque details under the Unwired Planet hood, including the NOL provisions that investors should be keenly aware of before committing capital.

Should investors decide to invest in this unique pure play on the growth of the mobile phone market, they might also consider a signing up for updates at the International Trade Commission ("ITC) and a subscription to Law360 to actively monitor the dockets for updates on Unwired Planet's patent litigation efforts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.