This article discusses the investment imperatives of Vringo (VRNG) and Worlds Inc. (OTCQB:WDDD), two companies at very different stages in their litigation enterprises. Each is focused on a damages equation that they think would fairly compensate them for use of their technology. With Vringo in particular, we are afforded the opportunity to look back on months of litigation which may prove instructive to Worlds or any other companies embarking on such an enterprise.
VRINGO litigation: We are now at the stage (some 20 months after litigation began) where we expect to see Judge Raymond Jackson (JJ), from the district court of Norfolk, VA, finalize his post-trial rulings. Vringo received a favorable jury verdict against Google (GOOG) and its co-defendants on November 6, 2012. The decision on a running royalty to be paid Vringo is next on tap. Since the 822 motion has been fully briefed (for a few weeks now), we anticipate JJ's ruling at any time.
Our expectation is that JJ will order Google to pay an enhanced royalty rate based upon continuing infringement of patents that a jury found it to have infringed. This "enhancement" is due to the changed circumstances (jury verdict) of a "hypothetical negotiation" - factor #15 of the Georgia Pacific factors for determining appropriate damages in a patent case. Vringo has argued for an increase in the jury's recommendation of a 3.5% royalty that extends to 7%. Our thinking is that it will be somewhere in the 5-7% range on a base of some $15 billion and growing. $157-219M per year would not be a bad payday for Vringo.
The history of this litigation shows that investments in the patent infringement space are anything but straightforward. The most favorable time for those taking a long position in VRNG was the last several months of the pre-Markman time frame. The hearing was held on June 4, 2012 and the Markman order was issued June 19, 2012. Vringo closed at $4.15 the day of the hearing and reached a high of $5.45 the day of the order (providing an additional catalyst). The pre-hearing rise for Vringo was staggering. On June 4th, the day of the hearing, VRNG reached a high of $4.63 from a low of $1.60 on March 29, 2012, a 289% move.
VRNG data by YCharts
Vringo's Markman date market cap was a fraction of what many expected given a fairly clean victory at trial. As many now know, Vringo's victory was anything but clean. They lost hundreds of millions in past damages with the decision by Judge Jackson to grant Google's (GOOG) motion on laches. This was without a doubt the biggest single decision in the case, it set in motion a series of events that would prove damaging to VRNG's efforts (see jury verdict again). The second biggest decision will be Judge Jackson's pending ruling.
Vringo's experience is instructive in that once the Markman is over and the judge starts ruling (beginning with rulings on claim construction) the plot thickens and if investors are not paying close attention, moves made by the litigants or the court can wreak havoc on one's portfolio. Some investors take money off the table just prior to or even the day of the Markman hearing. Those with stronger beliefs or a higher risk tolerance will wait to hear how it went (we will be providing updates from Boston on the WDDD vs. Activision Blizzard Inc. (ATVI) Markman hearing and given that time may be limited, I will send them out via twitter from @edvact). Many will wait for the official Markman ruling and still others, given reasonably positive outcomes along the way, will elect to ride some or all of their investment into a trial or hold in hopes of a settlement.
Worlds litigation: There are 55 claims at issue in the Worlds Inc. vs. ATVI case covering five patents. In light of what happened to Vringo, must investors worry about a successful laches defense in the Worlds case? Nope. Worlds does not face the prospect of a laches defense as laches requires a longer period between the earliest date of constructive notice and the filing of an infringement suit. Anything greater than six years may be considered an unreasonable delay.
In Vringo's case, the Lang-Kosak '420 Patent was issued ten years prior to the filing of the complaint and the Lang-Kosak '664 Patent was issued seven years prior to the complaint. The date of constructive notice for Google cited by Vringo was in 2004, still over six years from when the complaint was filed. While time is only one of the elements that factor into a judge's decision, it is considered something of a prerequisite for even attempting a laches defense. The earliest constructive notice cited by Worlds of the patents in suit is February 20, 2007, the day the '690 patent was granted. The original complaint against Activision was filed on March 30, 2012. The patent statute states "no recovery shall be had for any infringement committed more than six years prior to the filing of the complaint or counterclaim for infringement in the action" (35 USC section 286). A successful laches defense, by way of differentiation, means that no damages will be awarded prior to the date of complaint but that fire-breathing dragon may be checked off the "unwelcome surprise" list here.
Worlds has claimed that the infringement by Activision has been willful. Under 35 USC section 284, if a jury finds that infringement has been willful, the judge may offer enhanced damages of up to 3X any jury award. Worlds CEO Thom Kidrin stated in a February interview that he had past discussions on a joint venture with Activision CEO Robert Kotick but that Mr. Kotick and Activision decided instead to willfully infringe.
Games in suit: World of Warcraft (WOW) launched in November 2004. Call of Duty (COD) launched in November 2006. Since we know the earliest date of constructive notice being asserted by Worlds is the grant date of the '690 patent, we review revenues from February 2007 forward.
Estimated damages (what Worlds is likely to seek):
To skip to the actual damages chart immediately click here. Background commentary follows below:
The two Activision game franchises in suit have accounted for $15.1b in revenue for Activision between 2007-2012, an average of about $2.5b a year. WOW $7.1b: (2007-2009: source: 3/1/10, 10-K p. 11, 42 & 2010-2012: source: 2/27/13, amended 10-K p. 11, 46) COD $8b: (2007-2012: source: 2/27/13, amended 10-K p.8).
Should this case make it to trial, it is likely to be scheduled sometime during the first half of 2014. We assume a final order by the court at the end of 2014. Each franchise released a new update toward the end of 2012 and we postulate that $3b is a reasonable total addition for these two games in 2013. 2014 remains flat (no growth). There is a bit of guesswork in trying to divine trial dates and final orders but the substantive points remain valid. To that end, over 90% of patent suits settle before trial (Georgetown law journal v. 99 p. 667) and we have some confidence in saying that Activision, should they lose this Markman, can ill afford to play the scorched earth game that Google (with seemingly unlimited funds) has played with Vringo.
A damages expert will need to decide to what portion of Activision's revenue a royalty number should be ascribed. After observing the VRNG trial firsthand I am reasonably convinced that Dr. Becker, Vringo's damages expert, could have settled on the high end of his apportionment (apportionment being the percent of the defendant's revenue that plaintiff feels is attributable to the patented invention) range (40%) and that is the number we would be discussing today instead of 20.9%. His apportionment went "unanswered" by Google other than to simply deride it as fantastical by utilizing "experts" quickly exposed on the stand as something short of expert by the litigation team from Dickstein Shapiro (plaintiff counsel). Quinn Emanuel, counsel for Google, seemed to fear that offering their own number might be seen as tacit admission of infringement, or if the number they offered departed too much to the downside from the norm, they would be viewed unfavorably.
45% Apportionment: We believe Worlds will seek an apportionment in the 40-55% range if its argument for implementation of the Entire Market Value Rule (EMVR) proves fruitless. Because the nature of the infringing element(s) are such in the Worlds case that they could be considered a central reason for game participation, absent EMVR (explained in detail here), we see an apportionment argument for 45% or better (of U.S. revenues which we approximate to be 50% of worldwide over the damages term).
The reason for this, and the reason we think too that an EMVR argument may prevail, is that the Worlds invention may well be compared to a 3-D theme park ride in which one feels like an active participant in the experience. While the "theme" of the rides may change, just as games do, we think any well-crafted survey would reveal that the "active participant" feature is the primary reason for participation, which sure sounds like what a "scalable architecture for a 3-D virtual world" seems to provide.
What royalty would a damages expert for Worlds suggest to a jury? It seems logical that a royalty might land anywhere from 3-10%, perhaps more due to the commercial success of these particular games and/or any relevant contract for royalties. Our model utilizes 7% which is somewhat paltry in comparison to contractual evidence which we provide later in this article. Using this data point we get $332M in past damages. If Susman Godfrey (Worlds counsel) makes a convincing case for willful infringement, the award may be trebled (which our chart assumes) leaving $997M. We do not currently see how infringement will be separated in this case from willful infringement; therefore we submit that if there is infringement at all, it will be deemed willful.
What about a future royalty? The '690 patent does not expire until August 2020. Using $3b per year in revenues (with a conservative 3% growth rate) for the two games, a 45% apportionment and a 7% royalty we get another $296M on U.S. revenues. Collectively, total damages would be approximately $1.29 billion. Project 35% for Susman Godfrey ($452.5M) and Worlds is left with $840.5M of which another 35% goes to pay taxes, netting them $546M. But wait, Worlds has approximately $41.5M in net operating losses that we project will reach $43M by the end of 2014. Therefore, $797.5M will be taxed. The net-yield with an after tax add back of $43M becomes $561M (this calculation may be performed several ways).
What about other infringers? The MMORPG Market is expected to grow to $17.5 billion in 2015 (source: Superdata Research & Newzoo 2012) from about $13.8 billion in 2013. We expect that Worlds will aggressively pursue license agreements in the event of successful litigation, most likely closely following a successful Markman order.
Should Worlds successfully license to companies producing half of these revenues (beginning in 2014 until the patents expire), they will profit from nearly six years of licenses. Following the same apportionment and royalty formula from the Activision case, this would yield another $126M annually on average. We calculate another $319M to Worlds after legal and taxes, which would add another approximately $4 to Worlds share price at current outstanding share levels.
We suggest this is a calculus that Activision may be focused on if they lose the Markman. They could offer Worlds $250-275M to purchase the patents in suit, (and any other of the continuation patents to the '690), and have a fairly strong likelihood of recouping that money through licenses instead of facing prolonged and potentially costly litigation. For Worlds and its longtime investors it would offer a clean exit at an attractive multiple.
Should Worlds win the Markman and be forced to play this out, we see the potential for a $10 stock based solely on awards in the Activision case. A prevailing Worlds' motion for application of the EMVR would have Katy barring that door - $10.55b x 7%, yielding $738.5M in past damages. Treble that per the willful argument above and we have $2.2b in past damages alone with another $658M in future royalties.
We are not really suggesting this is going to happen; on the contrary we take a fairly conservative line in our calculations. We suggest only that there is a path to such a number. The question for investors is whether a billion dollar award is achievable in this case? It certainly appears so, in no small part because Worlds has prosecuted its patents carefully and has strengthened its hand through what it learned from its previous litigation with NCsoft. Given this, we view Worlds as the preferred high-growth investment in this space and we suggest, at minimum, that investors take a hard look here.
1. The sensitivity analysis at the bottom of our damages chart reflects the percentage likelihood that the litigation does not support our specific case for Worlds. It also reflects our thinking between a 45% apportionment (more likely) and the EMVR (less likely).
2. There is some question, which we continue to explore and debate internally, regarding Activision revenues from Europe and Asia and whether some percentage of those revenues may be subject to a damage award in this case. We believe that Susman Godfrey may be examining this very issue. Given what may not be a insignificant number of overseas players of WOW & COD connecting through U.S. servers, there may be a legal basis to conclude that this infringement occurs in the U.S. and as such would be subject to damages. A quote from the "faq page" of a service called Smoothping, which claims to offer a faster way to play multiplayer online games like World of Warcraft, appears below. The internet is rife with international players discussing connecting through U.S. servers for these games.
"For International players, your best option might be where your traffic first enters the USA. For example, if you are from Australia and play on a WoW Server located in Chicago, you might find you have better in-game latency connecting to a Smoothping Los Angeles server, rather than our Chicago servers. If you are from Brazil and play on a WoW Server located in Chicago, you might find you have better in-game ping when connected to a Smoothping New York server, rather than our Chicago servers."
We include several links to documents, one which is commentary on the royalty arrangement struck between Activision and NetEase (based in China) for rights to host and distribute the World of Warcraft game, the other a contract made public during legal proceedings between the founders of Infinity Ward and Activision. The contract is between Bungie and Activision Publishing (subsidiary controlling Call of Duty). Each provides insights into how Activision values its games. In the Bungie deal (summarized here) we see significant revenue sharing and incentives to create games, which they can only hope will be as popular as World of Warcraft and Call of Duty. In the NetEase deal, it is reported that Activision was granted a 55% royalty, giving us a sense of what licensing the game rights is worth to Activision. We feel certain that Susman Godfrey will use these and other examples like them to draw comparisons between how they are valued and how the architecture central to the operation of these games should be valued.