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Summary

  • On an operating basis, CRDS has a minuscule operating loss that is improving, with management guiding to operating break-even or profitability for 2014.
  • Increasing traction in royalty income with growth from $188k a quarter a year ago to $1m plus per quarter today.
  • Potential for additional litigation surrounding CRDS’s ‘972 patent family (ie 40 more letters sent out) - and strong prospects for significant monetization.
  • Non-’972 patent family has real potential and we should learn much more about that within next quarter or so.

Opening:

Crossroads (NASDAQ:CRDS) is a potential powerhouse play that I believe may offer investors multibagger returns in the coming years. Building upon my previous report, the company's most recently reported quarter, and my recent call with company management I am even more optimistic regarding the prospects for this investment.

CRDS's StrongBox product line serves a real need in the marketplace - a low cost device that offers innovative storage management, ease of use and data management. In addition to CRDS's product potential, they are improving their balance sheet.

Crossroads has huge potential in their '972 and non-'972 patent portfolio moving forward. The '972 family has historically generated over $60M in revenues, even without current management's more aggressive stance on IP defense - an approach not taken by the previous CEO. There has been considerable recent traction with IP, with royalty income reaching $1M plus in the most recent quarter, up from $188k in the same quarter a year ago. Moreover, on their recent earnings conference call, management indicated they recently sent over 40 letters to companies they believe are guilty of potential infringement. In addition, cases against Cisco (NASDAQ:CSCO), Dell, NetApp (NASDAQ:NTAP), Oracle (NYSE:ORCL), Huawei and Tandberg are all approaching - in addition to litigation with historic royalty-payer Dot Hill (NASDAQ:HILL).

I recently had the opportunity to speak with the management team of Crossroads to ask strategic questions to build upon my first report. A transcript of the conversation is at the end of this article. I was very impressed with management's vision and outlook.

In relation to peers in the IP industry, CRDS, with a market cap of just ~$35M, has flown way under the radar due to the company's rough past that is now just that, in the past.

Expanded Thesis:

(1) After market hours on March 6, 2014 Crossroads reported earnings better than I had previously expected. CRDS reported revenue of $4.1M and EPS of $(0.28) for Q1 of 2014. Virtually all of the reported loss was due to a $(3.4)M loss attributable to the change in the value of derivative instruments as a result of stock price fluctuations. As explained in my previous report, the ratchet provision that caused the loss expires this month and will no longer affect earnings. Without this ratchet provision, earnings would have been $(0.01) per share, up considerably from $(0.27) in the year ago period. Management made clear that next quarter there will be a reversal of this loss.

An adjusted EPS of $(0.01) beat my estimate of $(0.06) for the quarter and signals a faster improvement in sales of StrongBox and IP licensing. I expect StrongBox to slowly ramp up sales over the next 12 months with a steeper growth curve 12-18 months from now, to what will likely be a few million dollars per quarter (with ~80% gross margins) - and then grow further over time. IP licensing, while not huge, was up substantially y/y and as management states in our interview (below), as we can expect IP licensing to continue to improve. CRDS's IP litigation is also picking up and could add dramatically to earnings.

Even though StrongBox's revenues are minimal today, if there wasn't substantial potential, it would be hard to imagine that Fuji, Hitachi and IBM would spend time training their sales teams and offering it to their customers. An upside shift in the growth curve for StrongBox could take 12 months, but a unique, 80%+ margin storage product, with significant follow-on orders will be highly valued by investors if it shows signs of gaining traction.

(2 / 3 ) CRDS saw a meaningful pickup in IP licensing revenue last quarter as IP licensing and royalty income revenue jumped to $2.895M. Subtracting the cost of IP revenue of $(383)K leaves $2.51M in gross income from IP. CRDS earned $1.5M in income from IP revenue for the entire year of 2013, so clearly they are gaining traction. With net operating loss carryforwards of $116M, CRDS can avoid paying taxes on damages or awards to boost income for shareholders.

When CRDS secured their $10M loan with Fortress last July there were 109 patents or patents pending, now there are 117 patents. The company's '972 patent portfolio has generated over $60M in revenue, although management states in their interview that previous management stayed away from pursuing certain potential infringers. They avoided going after companies they viewed as potential or current business partners.

Management's more aggressive IP defense strategy can be seen in their recent lawsuit against Cisco, NetApp, and Quantum Corp for infringement on the '972 patents. CRDS's past management took a lax approach to IP defense and did not go after the largest potential infringers. Today, CRDS's new management team is going against the larger players who are potentially infringing upon the company's patents. This increases the potential awards from these companies as the size and breadth of these products are much larger.

CRDS's new management team is aggressively asserting its IP rights. They are going after the eight very large companies and recently sent out 40 additional letters to companies for IP infringement. Management has hired experts to review their non-972 portfolio and stated in our interview that they will have a roadmap on its potential in the next 45-90 days. CRDS's relationship with Fortress adds value, but CRDS has the right to repay the loan and obtain full ownership of the non-'972 portfolio if it is worthwhile for them to do so.

On a call with CRDS, management has stated that emphasis today is placed upon the company '972 portfolio, the current lawsuits related to the patent family and its past success. Although the non-'972 patent family deals with the same technology and has 3.5x as many patents as the '972 portfolio.

CRDS stated in our call that they hired a very accomplished firm to analyze the patent family, held in partnership with Fortress. Also that Fortress are IP experts and are the principals behind RPX (NASDAQ:RPXC). Fortress did their own analysis on the patent family before the deal was closed and were confident it was a worthwhile venture.

(4)The number of patents are one area for comparison when doing a quick look at the value of a company's IP holdings. More important than quantity is the quality of those patents. Crossroads has a very successful past in licensing its patents using a fairly lax strategy where the company avoided the potentially largest infringers/royalty payers. That has since transitioned into a more aggressive strategy - driven by a new management team. It only takes one patent, proven valid with a defendant infringing, to win at trial.

Company

Crossroads

VirnetX (NYSEMKT:VHC)

Vringo (NASDAQ:VRNG)

Parkervision (NASDAQ:PRKR)

Market Cap

$33.11M

$768.54M

$308.44M

$499.22M

Number Of Patents

Over 100 patents. (I)

80 U.S. patents, 100 pending applications (I)

Over 500 patents and patent applications. (I)

163 U.S. and 73 foreign patents. (I)

Past Victories / Settlements

$10.5M against Dot Hill and a 2.5% ongoing royalty rate. The company has never lost or seen any portion of a patent invalidated. Over $60 million in royalties to date.

$368M against Apple, 0.98% against all infringing devices totaling over $300M plus per year.

$30.5M past damages, potential for $1.3B from a 6.5% royalty rate.

$172.7M for past

damages, potential for enhanced additional royalties totaling $300M-$400M

Researching the merits of the intellectual property a company holds can prove very worthwhile for a long term investment. VirnetX has been an successful intellectual property over the past decade. This is based in large part on the strength of the company's IP and how management defends these claims against potential infringers. VirnetX is now a much clearer investment now due to settlements, court victories, several patent validations at the court level and additional patents being granted in addition to other items. VirnetX's early days outline the potential that exists within IP investments, a future Crossroads may also achieve. Screen Shot 2014-03-17 at 7.09.56 PM.png

Vringo is another success story that has been a thrill ride for investors. Vringo was awarded a $30.5M settlement against Google (NASDAQ:GOOG) and a 3.5% running royalty rate. Google claimed to have a workaround in place so ongoing infringement was not something to pay a royalty on, although this was found to be just a colorable variation of infringement. On January 22, 2014 after a settlement conference failed between the two parties. Soon after Judge Jackson issued a ruling awarding Vringo a 6.5% royalty rate through 2016.Screen Shot 2014-03-17 at 7.27.18 PM.png

Intellectual property investments generally take time to come into fruition and are best suited for long term investors in companies with solid IP holdings. CRDS has a successful history with over $60M in royalties to date on its '972 patent portfolio, a growing non-'972 patent portfolio and a new management team targeting much larger companies.

Even if new royalties resulted in a few million dollars per quarter, this could equate to $0.40-$0.50 per share annually, just from royalties. Using the full 20M diluted share count expected in the future, that could make CRDS a $8-$10 stock. This is without considering the company's operating business, including StrongBox.

Considerations:

The number of patents a company has does not precisely correlate to a company's prospective success. Each patent must be evaluated on its own merit. However, given the historic strength and validation of the '972 portfolio, it appears that CRDS is being valued (at just ~$35 million) as if the value of upcoming litigation is zero. Given the size of Crossroads litigants - Cisco, Dell, Huawei, NetApp, Oracle, we are talking about lump sum awards or royalties that could easily dwarf CRDS' current market cap. Again, CRDS has never lost at trial, seen its IP overturned, or failed to settle.

It's notable, when looking at Parkervision, VirnetX, and Vringo that they each had market caps in excess of $100 million, based on hopes of successful litigation, prior to their first victories. Crossroads has a modest market cap, with considerable prospects of IP monetization, and has an operating business that could prove significantly profitable over time.

Intellectual property is very complex. Lawsuits can take twists and turns and can be lengthy. Cases can encompass everything from the Federal Court system to the USTPO. Investors should understand all of the risks involved with the IP segment of CRDS.

Conclusion:

CRDS is a two prong investment story - encompassing StrongBox, a unique product that solves a key problem in the storage world, and a strong and growing two-part IP portfolio with a new management team that is aggressively defending it. Management has a plan not only for the future of StrongBox, but for defending and expanding its '972 and non-'972 patent portfolios against larger litigants. Crossroads has flown under the radar due to its rocky past, but its future has the potential to be extremely successful, rewarding shareholders handsomely.

Call With Management - Giving The Story More Perspective:

(All questions below are answered by CRDS's CEO Richard K. Coleman, except for a few at the end answered by CFO Jennifer Crane)

(Tom) Mr. Coleman, Mrs. Crane and Mr. Hood I appreciate you all taking the time to speak with me regarding several strategic questions surrounding Crossroads.

(Richard K. Coleman) Thanks Tom, we appreciate the opportunity to offer more clarity for current and prospective investors in Crossroads.

On the call you mentioned that royalties grew from about $200k in the year ago quarter to about $1.1 million this quarter in large part due to a single customer. You also mentioned that you don't have visibility into the customer. Is $1.1 million or so a reasonable baseline royalty number for modeling purposes?

· We think it's a baseline number. Remember the royalty revenues to Crossroads depend on someone else's sales, but they are not sharing with us their sales plans. There is no reason to believe the payment amount is anything other than a baseline figure. A larger company acquired the company that had the licensing agreement to our technology, and sales have grown. The revenue we recognized was not due to an acceleration of their payments, simply an increase in sales of the licensed products.

It sounds like Sphinx might have growth in the future, where a couple quarters ago it sounded like a declining legacy product - what has changed? Has something in the end-markets made Sphinx more relevant? Have you changed your marketing or sales strategy?

· There have been a few changes. One is that the company's old strategy was to throttle all the way back on other products to emphasize StrongBox. As a result, we deemphasized Sphinx. Our new strategy involves reducing our overall expenses while analyzing all our products, including SPHiNX. Even with reductions in HP OEM SPHiNX revenue, we think SPHiNX will have a good year. We've had lots of customers and partners interested in selling SPHiNX. We've updated webpages, posted use cases and success stories while emphasizing our entire product line. Mainline is a great partner for Crossroads, having the exact type of customers who could purchase SPHiNX. Mainline understands they can offer Strongbox and Sphinx to the same customers.

You haven't been specific with the size or the StrongBox opportunity. Clearly you have some very large partners. When you speak with them, what type of size do they see StrongBox representing 2-3 years from now?

Strongbox is definitely our key opportunity on the product side of our business. It will be a few quarters before our Strategic and OEM partners get their own sales models aligned with our go to market strategy. The slope of the curve will change, but it's too soon to predict when that will happen. LTFS is relatively new, having only been available since 2010. IT buyers have been purchasing disk for a long time to meet every need that they have. With the advent of massive growth in data, there is a new problem: data retention and preservation requirements with limited budget. IT folks have to deal with retention and preservation but don't have the budget to keep up with the massive data growth. We meet the data preservation needs at a lower cost than disk. StrongBox also makes the data easily retrievable by the user. It's a new way to solve a problem, and much more user friendly. Customers want to store everything and have access to everything they store. Public clouds are simply not going to be used by many customers because the files they are storing are simply too large: the ingress and egress costs are prohibitive and it takes too long to send and retrieve files. Why would an IT administrator want to keep data all in a tape library and not over the cloud? Like I said, the file sizes are large and it takes customers a long time to access their data over even the largest internet connections. Also, companies will choose to avoid the public cloud because they don't want the inconvenience and security issues of having their data offsite. As a result, IT administrators are re-architecting their data centers and providing their clients better access through private clouds. They want their data locally available or in a second location they control. Another advantage for administrators using StrongBox is a second copy of a tape can be stored in a secure location off-site, something simple to do using WAN acceleration. We fill a gap and meet specific needs for a $13B industry.

What type of annual revenue from StrongBox would you say is a success in 2 or 3 years? What about a failure? Just trying to get a sense of the magnitude of what you believe the opportunity is.

· We haven't spent a lot of time forecasting revenue out that far. The previous management was too optimistic and we do not want to do that. We've changed our distribution strategy and would rather take a more conservative approach.

How important is the new integration feature you mentioned on the call that you now have in StrongBox?

You're referring to the Avid integration tool. It's very important to the Media and Entertainment industry; but not the only one we are working on. We interface with a lot of companies and technologies, including media and entertainment companies that have played in that space for a long time. This is a critical, large accomplishment.

What are the signposts, I, as an investor, should be looking for; to feel confident that StrongBox is making the progress that you believe it can make?

Sales of new Strongbox units and capacity upgrades. In the last 12 to 18 months, this information was somewhat masked by the custom development and one-time deals with Iron Mountain. That agreement had a lot of revenue but almost no profit.

Another place to look is to our Fuji OEM relationship. They are launching Dternity in the U.S. this quarter. www.dternity.net/ Fuji has the ability from a sales and marketing perspective to drive a lot of revenue to Crossroads.

What is the biggest pushback you get regarding StrongBox? The story you tell regarding StrongBox seems compelling, as does the market opportunity, but revenues are minimal - so what is holding back broader acceptance?

We're early in the game. This is a new solution previously unavailable so buyers are learning they have an alternative to using disk for all of their storage needs. It will take some time for strategic partners to fully understand the value of StrongBox and ramp up their sales. Hitachi understands, but it takes a while to move big companies in the right direction. We're doing some nice deals with Hitachi in Europe because they understand how we drive down the cost of their overall HNAS and HCP products. They understand tiering, and StrongBox plays well in those environments.

We've signed some big name customers but have not announced them all: Mars Rover, Ellen DeGeneres, and government agencies. State and local governments are another good example. There are a lot of them that could be our customers. They don't have large IT budgets and have the same problems that the Ellen show might have. We've also signed 2 PBS stations. We're having success in Europe, but again we don't often name the customers for competitive reasons. The $155k capacity upgrade purchase we announced on the last conference call is an example of an account we don't want to name.

A StrongBox account I can talk about is FotoKem - one of the largest post-production companies in the world. Paul Chapman is a guy with tremendous knowledge and experience - and high expectations - but we have satisfied him. He was in offices in November and addressed all of our employees and explained why he selected StrongBox and Crossroads. He said he likes how StrongBox works and how we helped him with any issues with 24-hour a day support. Our engineering and support team know how to meet the needs of highly sophisticated customers.

What is the timing of the Dot Hill litigation since that one is a little different than the other recent lawsuits?

· I realize it may seem confusing to some investors. We have a licensing agreement with Dot Hill and they're continuing to pay us. The dispute is result of interpretations over some of the terms of the agreement. For administrative and legal reasons, the court has elected to include the Dot Hill lawsuits with the rest of the lawsuits even though there are some significant differences.

You mentioned sending out 40 letters to potential infringers - how long do you wait before you litigate?

· Patents have expiration dates, so we felt we needed to take action and get the ball moving. Lawsuits are a last resort.

Can you give any sense of the opportunity of the non-'972 patents?

· What we can say is we hired a very accomplished firm to do the analysis for us on these patents, held in partnership with Fortress. The IP Finance Group at Fortress is lead by the original guys behind RPX, they know patents and are IP experts. They did their own analysis on non-972 patents before the deal was done, prior to Crossroads borrowing $10 million. They have confidence in the portfolio and we do as well. The process has been underway for 3 months now, and we are close to first readout. After we analyze the results, we'll develop a roadmap of what to do next.

The non-972 patent family was at 109 patents and pending when deal with Fortress was done. Now we're at 117 patents and pending patents. We actively manage the portfolio prosecution and focus on it every day. We made a point on the conference call to pay attention to the size of the portfolio, which is over three times the size of the 972 patent portfolio.

Regarding the 972 portfolio, the company successfully pursued infringement cases against a number of customers, generating over $60m from the 972 patents. We stayed away from some of the largest companies with the hope that they would become partners, but now we are pursuing them also. Simultaneously, we are going after 40 various sized companies that the company did not pursue in the past. All of our patents are in the same business. When we consider how many companies licensed our 972 patents, we have great hope for the non-972 patents also. We are not sure how big the field is, but it certainly has our attention.

Can you describe the relationship/JV with Fortress on the non-'972? If there is actual royalties, how does that get divided?

We are in a partnership with Fortress, with well-defined terms for monetization and how funds are shared between the partners. We have a monetization call option, so for example if we believe there is huge value in the non-972 patents, we have the right to pay off the loans and regain full control of the patents. Fortress is an excellent partner and has added a lot of value to our company.

What is the status of the NASDAQ listing and regaining compliance?

· Nasdaq has not delisted us. We received our original notice in November. We are in close communication with Nasdaq on a regular basis. Removal of the ratchet will pass tomorrow, that will help. In the event we get a delisting notice, we think we'll have a minimum of 45 days to get into compliance while we appeal.

In 1Q your OpEx was $3.9 million - given the guidance of $14-16 million should I model that op-ex declines a bit more in 2Q?

· JC: There were transition expenses in Q1 that go away in Q2. We're looking at other ways to decrease expenses, not headcount, and anticipate OpEx declining a little more throughout the fiscal year.

Were there any 1-time/severance costs in 1Q?

· JC: No, those were in Q4. The cash related to severance was paid in Q1.

How much of the quarterly OpEx is related to litigation expense?

JC: It is in our budget and a minimal expense at this point.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Source: Crossroads Systems: Patience Should Be Rewarded With Solid Returns

Additional disclosure: This article is informational and in my own personal opinion. Always do your own research and contact a financial professional before executing any trades.