In this article, I will be talking about a company called Marathon Patent Group (OTCQB:MARA). This company is essentially a non-practicing entity ("NPE"), or more commonly referred to as a "patent troll." The main reason these companies are called patent trolls is because they do not create or sell products or services, but instead exist to monetize patents through licensing and litigation. Some NPEs obtain patents through their own research and development efforts, while others (such as Marathon) accumulate patents through acquisitions.
A lot of people avoid investing in NPE's, mostly because their business practices seem unethical. In fact, NPEs are universally despised and accused of being responsible for a big spike in patent litigation in recent years. However, according to a recent report that was commissioned as part of a patent reform bill passed in 2011, this is simply not true. According to the report, NPEs account for only 20 percent of patent litigation. The other 80 percent comes from "practicing entities," or real companies such as Apple (AAPL), Google (GOOG), Microsoft (MSFT) and others.
No matter what happens with the new patent reform that's taking place, NPEs are not going anywhere. They have become a major factor in the patent market and an important source of liquidity for patent owners. It is for this reason why I believe that they can be outstanding long-term investments.
A Different Kind of Patent Troll
Marathon's operations can be divided into two complementary business segments. The IP Services Business - provides its clients advice and services that enable them to realize financial and strategic return on their intellectual property rights. And the IP Licensing and Enforcement Business - acquires patent assets, partner with patent holders and monetize patent portfolios through actively managed patent licensing campaigns. As of the June 2013, the IP Licensing and Enforcement Business accounted for 100 percent of the company's revenues.
A common strategy that NPEs employ is to put all of their "eggs in one basket" by acquiring one key patent and aggressively enforcing it against the biggest companies in the industry. This strategy is extremely risky, but the payoff can be huge. The most notable companies who utilize this strategy are VirnetX (VHC) and Vringo (VRNG). Instead of putting all of its hopes on a small number of patents, Marathon's focus is on diversification and risk reduction. The company does this by acquiring multiple patent portfolios of varying sizes and characteristics. Furthermore, many times these patents have a proven history of revenue generation, which further decreases risk and makes its operating results more predictable.
As of this writing, Marathon owned three revenue generating patent portfolios (Sampo, CyberFone and Relay) and one additional portfolio (Bismarck) which is not currently generating revenue. Altogether, the company owned 17 patents in the United States and 38 international patents forming the basis of 34 active lawsuits against more than 50 different defendants. This should provide the company with a diversified revenue stream in the future and allow it to achieve profitability as early as this year.
Partnership with IP Navigation Gives Marathon a Competitive Advantage
In February 2013, Marathon announced a strategic relationship with IP Navigation under which IP Navigation will source selected patent portfolios and execute licensing campaigns on its behalf. IP Navigation, which was founded by Erich Spangenberg, is one of the largest and most well-known NPEs in the world. Since its founding back in 2003, IP Navigation has completed more than 600 licensing transactions and generated more than $620 million in direct licensing revenue and cash settlements for its clients. This partnership gives Marathon a competitive advantage because it gives it opportunities that no other NPE has access to.
It is also interesting to note that the CEOs of these two companies have been doing business together since 2003. Furthermore, Mr. Spangenberg is one of Marathon's largest shareholders, owning close to 9 percent of the shares outstanding. This gives him the incentive to continue putting together lucrative acquisition deals for Marathon. If Marathon does well, the stock price goes up and he makes a profit. Everybody wins!
Highly Experienced CEO with Skin in the Game
Doug Croxall is Marathon's CEO and Chairman of the Board. Prior to joining Marathon, Mr. Croxall was Chairman and CEO of LVL Patent Group, a privately owned patent holding company. LVL, under Mr. Croxall's direction, acquired and enforced two patent portfolios. Prior to LVL, Mr. Croxall was the CEO and Chairman of Firepond for five years, which he acquired back in 2003. While CEO of Firepond, he identified the value of Firepond's patent portfolio and decided to sell the patents into a new private entity for enforcement. The name of this private entity was IP Navigation Group, and the Firepond portfolio (consisting of 14 patents) was one of the first it acquired. These patents would go on to generate approximately $90 million in licensing revenues from 2004 through 2009, helping Mr. Spangenberg grow IP Navigation into the giant it is today. This also explains why the CEOs of these two companies have such a close relationship, and why Mr. Spangenberg is now doing so much to help Marathon.
Not only is Marathon run by a highly experienced CEO, it is also nice to see that the top executives own a large number of shares in the company giving them "skin in the game." As of this writing, Mr. Croxall and John Stetson (the company's CFO) owned 11 percent of the shares outstanding. When including all of the insiders (including Mr. Spangenberg), the ownership is over 22 percent. The only reason insiders would own such a large percentage of the shares is if they were optimistic about the company's future. This also makes the stock a safer investment, in my opinion.
Undervalued Stock with a Catalyst
From my analysis, I have determined that Marathon could be profitable as early as Q3 of this year. I also expect a sequential increase in profitability next quarter. I believe that this will have a favorable impact on the share price because most investors are not expecting it this soon. I will use the CyberFone portfolio to demonstrate why I believe this will happen.
This portfolio was acquired in April of this year for about $3.2 million. In my opinion, this was a great deal for Marathon because this portfolio already had a proven history of revenue generation. For example, over an 18 months period (before it was acquired by Marathon) it generated approximately $15.5 million in gross recoveries from 32 settlements and licensing agreements. This comes out to be $484k per settlement, about 5 settlements per quarter, giving us approximately $2.58 million in revenue per quarter.
Currently 12 named defendants remain in active lawsuits; however, in my estimates I will use 14 defendants, because two settled during the third quarter (not yet recorded as revenue). If we multiply 14 by the average settlement of $484k, we get $6.78 million in potential future settlements. Furthermore, management has mentioned in a recent investor presentation that there are an additional 50 potential targets, so my estimate will almost certainly turn out to be overly conservative.
Not only did Marathon acquire this portfolio for a great price, this portfolio alone has the potential to make the company profitable over the next few quarters. I will base my revenue estimate on CyberFone's historical quarterly revenue generation of $2.58 million. I estimate that the average quarterly "cost of revenue" will be about $290k, excluding "amortization expense" which is included in cost of revenue and accounted for over 60 percent of the cost during Q2. Furthermore, I also estimate that "total operating expenses" will be around $760k per quarter, excluding "non-cash compensation expense" and "non-cash consulting fees" which together were over $820k during Q2. Adding everything together, we get a quarterly cash burn rate of approximately $1.05 million. If we subtract the cash burn rate from the quarterly revenue estimate, we essentially get an EBITDA of $1.53 million.
I believe that Marathon's current valuation does not justify the company's long-term earnings power and growth potential. For example, Marathon's market cap is currently only around $30.83 million. In addition, the company has a clean balance sheet with no debt and $6.39 million in cash, giving it an enterprise value of only $24.44 million. If we divide the EBITDA that will likely be generated from just the CyberFone portfolio by the enterprise value, we get an earnings yield of over 6 percent. Again, this does not take into account the potential earnings from the other portfolios.
In fact, we should not discount Marathon's other portfolios. For example, of the other three portfolios, two of them are already generating revenue this quarter. The Relay portfolio had one settlement in July and the Sampo portfolio had two settlements that same month. The revenue from these settlements will further increase Marathon's profitability during Q3. I also expect Marathon to announce settlements from its other portfolio, which will also add to the company's bottom line.
I have just shown that the CyberFone portfolio alone should push Marathon into profitability. Settlements from the other portfolios are simply "icing on the cake." I believe once Marathon becomes profitable, it will also begin investing in higher risk/higher reward portfolios. However, Marathon's management is smart; they first want to achieve steady profitability before making these highly speculative investments.
I believe that Marathon's shares could more than double once the company announces its first ever quarterly profit. I believe that this transition to profitability will have an even greater impact in this case because Marathon is not very well known yet, so most investors are not expecting it. Another potential catalyst involves a probable NASDAQ uplisting in the near future, which also will have a positive effect on the share price. Overall, I believe that this stock presents the ideal asymmetrical trade; huge upside potential, with limited downside risk.
Risks to Consider
Related to the Business
The patent market is becoming extremely competitive. According to PatentFreedom, there are more than 700 NPEs. Almost all of them have greater human and financial resources than Marathon. Furthermore, Marathon also faces competition for patent assets from operating companies, most of which also have greater resources. Others will certainly also enter the market as the true value of intellectual property is increasingly recognized and validated. In addition, competitors may seek to acquire the same or similar patents and technologies that Marathon is seeking to acquire, making it more difficult for the company to realize the value of its assets. Another potential risk is that as new technological advances occur, some or all of the patent assets Marathon owns may become less valuable or obsolete before the company has had the opportunity to obtain significant value from these assets.
Related to the Common Stock
As of June 2013, the company had 471,154 post-split options and 628,489 post-split warrants. In the future, Marathon will most likely grant additional stock options, warrants and convertible securities. The exercise or conversion of these securities will dilute the percentage ownership of its stockholders. The dilutive effect may also adversely affect Marathon's ability to obtain additional capital. Another risk is that dilution may prevent the uplisting from happening, or at least it will delay it because current exchange rules state that a company must have a share price above $3.00 in order to qualify for listing on the NASDAQ Capital Market. These are just some of the risks that we should consider before investing in this stock.
Summary and Conclusion
Marathon's partnership with IP Navigation makes it different from most NPEs and gives it an enormous competitive advantage. Furthermore, Marathon's CEO is a highly experienced patent expert who has a significant equity stake in the company, giving him the incentive to do whatever it takes to make it succeed. Moreover, the company will most likely become profitable this quarter, which will have a favorable impact on the share price. And finally, once the stock begins trading on a major exchange, the company will get some major analyst coverage which will further push the shares higher. Taking everything into account, I believe this stock has enormous upside potential with little downside risk.