Internet Patents' Special Dividend Should Unlock Value

| About: Prism Technologies (PRZM)

Last month I noted that Internet Patents (PTNT) was trading for less than its cash balance, and argued that the company's plan to return much of its cash to shareholders made it an interesting potential buy. The company (formerly known as InsWeb, traded under stock symbol INSW had sold essentially its entire operating business to Bankrate (NYSE:RATE) for $65 million in October, and in December, announced plans for a special distribution in the first quarter of 2012.

On Wednesday, the company announced the details of that distribution: a $5/share special dividend, paid on March 9th to shareholders of record as of February 10th. The stock jumped nearly 8% on the news, and closed Thursday at $8.60.

There are still questions surrounding the company's exact financial condition. For one, there are 1.4 million "outstanding and exercisible" stock options, a sizable number considering the 6.6 million in outstanding shares. Some of the options are owned by CEO Hussein Enan, who also owns 24% of the outstanding shares. In the company's most recent 10-Q, it noted one of the conditions of the Bankrate deal (emphasis mine):

Mr. Enan, who holds approximately 24% of our outstanding shares on the date hereof, has agreed that he will not, among other things, sell, transfer, assign, tender in any tender or exchange offer, or otherwise dispose of any of his shares or, with limited exceptions, exercise any stock options for our shares.

Does this agreement still hold, now that the acquisition has closed? What are the exceptions? And how many options will be exercised? Based on current shares outstanding, the dividend would total some $33 million; the additional shares created by option exercise could add another $7 million to the total distribution.

Based on current share count, the company has a market capitalization of $56.8 million at Thursday's close of $8.60. Internet Patents should have at least $71 million in cash, given the $65 million payment from Bankrate and the $6 million in cash on the books before the acquisition. There are also potential payments to the company for "working capital adjustments" and potential bonuses to executives, according to the release announcing the sale. The company has also likely burned a small amount of cash in the most recent quarter, as it expected to have no revenue for the quarter.

As such, share count is of particular interest here. At 6.6 million shares, the stock would offer $5.75/share in cash for a net cost of $3.60 (subtracting the $5 dividend). Fully diluted, the cash balance would drop to $31 million, giving $3.88/share in cash at the same net cost. However, the stock options were issued in April 2008, when the company filed an S-8 registering 1.5 million new shares for its stock option plan. The stock closed that day at $11.19, well above its current price, which likely explains why less than 100,000 options have been exercised since then. Thus, it would appear that many of the options have strike prices still above the current $8.60 level, and will thus not inflate the share count.

As far as taxes go, the company had $187 million in net operating loss carryforwards (NOLs) at the federal level, and $76 million at the state level as of December 31, 2010 (per the most recent 10-K). It would appear the gain on the sale will be tax-free for the company. For investors, Internet Patents said the following regarding the special dividend:

The distributions made in the 2012 fiscal year will be treated as dividends to the extent of the Company's current earnings and profits for the 2012 fiscal year for U.S. federal income tax purposes. To the extent the distributions made in the 2012 fiscal year exceed the Company's current earnings and profits, the distributions will constitute a return of capital to the extent of the shareholder's tax basis and then will be treated as gain from the sale of the common stock.

Seeing as how the company may have no revenue for 2012, it seems earnings will likewise be non-existent, and the distribution will lower investors' cost basis in the stock, rather than create a taxable dividend.

As such, for an effective cost of $3.60/share, PTNT should offer over $5/share in cash. Going forward, the company has said to plans to continue as an operating concern, striking licensing deals for its five internet patents (a non-exclusive license was granted to Bankrate as part of that agreement). It did mention the possibility of a sale of the patents in the most recent 10-Q, a move that would likely lead to outright liquidation; but, in announcing the special dividend, CEO Enan noted that Internet Patents had "begun the operation of our new intellectual property-focused company." The licensing business will not create earnings in the near-term -- or ever, possibly -- but neither should it burn shareholder cash at a particularly high rate. Even in our most pessimistic scenario regarding share count, the company will have a cash balance above its market capitalization after the special dividend is paid. As such, the protection of that asset seems important.

There is one more tantalizing possibility for the stock in the future. From Wednesday's release:

In addition, the Board plans to evaluate the potential to make another special cash distribution to its stockholders pending the determination of several items related to the Bankrate transaction including a working capital adjustment and transaction-related expenses, as well as the outcome of the Company's efforts to further optimize its ongoing expense structure.

In other words, once the dust has settled, the final numbers in, and the cash balance sufficient, another special dividend may be on the way. Might PTNT stock literally pay for itself? There are some details to be figured out, but it appears it might still be possible.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I may initiate a position in PTNT at any time over the next few weeks.