RPXC: A 6x EV/FCF Monopoly In Secular Growth Area, Now With Adult Supervision

| About: RPX Corporation (RPXC)

Summary

RPXC is a niche monopoly in Defensive Patent aggregation that benefits from first mover/ network effects.

GAAP earnings understate true cash earnings, which should be 50% higher this year than GAAP.

Swimming in cash and now with an activist, buybacks could be hugely accretive at these levels.

Company

Founded in 2008, RPX Corp. (NASDAQ:RPXC) is a niche monopoly in defensive patent aggregation. The brainchild of John Amster, formerly of patent licensing firm Intellectual Ventures, and backed by Kleiner Perkins, the company is a subscription service, where large tech companies (such as AT&T, Google, Microsoft, banks and recently, automotive clients such as Ford) pay a portion of revenue or operating income to RPXC. RPXC, in turn, uses its expertise in the opaque world of patent valuation to pre-emptively buy up patents and/or licenses in the open market that would otherwise be sold to a patent troll, or NPE (non-practicing entity). RPXC also helps settle cases quickly on behalf of their clients when they do get sued by an NPE, thereby minimizing legal and transaction costs. Occasionally RPXC will negotiate a large syndicated transaction for a fee above the normal rate card, as it did last year in brokering the $900 million Rockstar patent acquisition from Nortel on behalf of several of its largest clients (RPXC contributed only $30 million of capital). The company has also launched an insurance product for smaller companies that may not get sued enough to require a subscription, but nonetheless have patent risk. The company has been experimenting with marketing this new type of insurance, and has recently gone to venture capital and private equity firms, insuring entire portfolios of companies. Insurance clients contribute minimal revenues, and RPXC reinsures much of the risk, but part of the objective is to establish relationships with smaller companies that may become big one day.

As of the end of Q1 2016, the company had 120 insurance clients and 166 subscription clients. The company has over a 90% renewal rate on a trailing 3-year basis. The company claims its service has helped clients avoid 4,000 NPE lawsuits, and has helped generate 1,000 dismissals for its members.

RPXC is the first-mover and thus the leader in this space, and benefits from a network effect: As it gains more subscribers, it can buy more patents for its client base, gain more expertise, and become more valuable for other clients. It has no close competitors, and also is a leader in patent litigation data, which is also valuable for its clients.

In Q4 2015 RPXC purchased Inventus Solutions, an E-Discovery firm, for $228 million.

Current Headwinds

Nevertheless, as the company went public in 2011 at 20$/ share, the current share price stands a mere $9.04/share. The company has been profitable, as recently last fall almost 50% of the market cap was in cash with no debt, and the shares were at roughly $13.50/share.

Part of the reason is a slight decrease in the number of patent litigation filed in the past year. In 2015 there were 13,000 NPE campaigns filed, amounting to almost 10 billion in litigation costs and settlements (RPX subscription revenues are roughly $270M). This is still a lot, but it is down from 14,000 suits and $12 billion in costs in 2014. This is partially due to more onerous rules on patent litigation plaintiffs. For instance, there was a case Alice v. CLS Bank International, which helped limit the most frivolous types of patent troll suits. In December 2015, new rules went into effect that forced plaintiffs to submit some evidence of a specific patent that was infringed in order to file a suit. This may seem an obvious requirement, but previously, patent litigation plaintiffs only needed to threaten a company with vague assertions in order to commence a case. This caused many companies to settle rather than lawyer up and participate in a protracted expensive lawsuit. Hence, many frivolous cases were filed in the past, although new rules seem to have put a temporary limit on these egregious cases. RPX estimates that these frivolous cases only amount to roughly 4% of patent cases. Still, the new rules of late 2015 pulled forward many cases as plaintiffs rushed to litigate, which led to decreased activity in Q1.

Still, in Q1, 250 unique companies were sued by NPEs, 210 of these are not yet in the RPX network, 31 companies were sued more than once by NPEs during the quarter, of these nearly half are not yet RPX members, and 120 non-client companies were sued by NPEs for the first time.

The company's core subscription client base also seems to have reached a near-term saturation point, as growth has slowed to roughly zero, as much of the low-hanging fruit has appeared to have been plucked. Moreover, the tech sector has been challenged this year, and RPXC has lost several clients due to financial stress or M&A (when a company gets acquired it ceases to be a client), even as it has gained new ones. For instance, the company recently got its second automotive client, which is a new vertical for them as the auto sector has incorporated more chips and software in car designs. In Q1, despite this challenging environment, RPXC lost 1 net client. Subscription revenue was thus down slightly quarter over quarter from 67.7M to 67.1M, yet increased year-over year (66.2M in Q1 2015).

Inventus Acquisition

In Q4 2015, RPXC was trading at a roughly 16x P/E, but half of its market cap was cash (~360M). So, what did the company do? It bought Inventus Solutions, an e-discovery company, for $228 million dollars. This amounted to over 4x sales (~55M) and 15x EBITDA (~15M in 2015). RPXC did not highlight many synergies, but declared that the company was growing, was an excellent operator, and that there would be opportunities down the road for complementary cross-selling opportunities. Still, as a private company that had been owned by private equity, with no earnings, (likely due to PE leverage), the market sold off RPX for this seemingly expensive acquisition for a company with unknown competitive advantage. Prior to the Inventus acquisition, RPXC was trading in the $13-14 range, and now is in the low 9's. RPXC's market cap has basically been cut by the amount of the acquisition, which means the market thought Inventus was the equivalent of lighting $228 million on fire.

Bullish Thesis

#1: GAAP Financials underestimates current earnings power.

RPX has a curious way in which it calculates its earnings. It largest cost of revenue, or COGS, is actually the depreciation of its patent assets. RPXC has to buy enough patent assets every year to justify its subscription fees, but these assets are amortized over 3-5 years. Therefore, RPXC's COGS is its D&A, but these reflect purchases it made in prior years. Therefore, RPXC's real COGS is really its CAPEX. The benefit of this is that RPX can tailor its patent spend according to its subscription revenue in order to maintain its margin.

Now, last year, the company not only spent $132M on patents, but also paid ~$30M for a syndicated transaction, the Rockstar transaction (its syndicate contributed ~900M!). RPXC was paid a fee to cover the costs, but really didn't earn much margin, and the revenue got recognized in Q4 2014 and Q1 2015. However, that extra spend is still being amortized on the balance sheet, thus elevating the depreciation and lowering this year's net income.

However, in light of industry headwinds, RPXC is forecasting a moderate reduction in patents spend, from last year's 132M and 2014's $137M to a 2016 target of $125-130 million.

Therefore, RPXC forecasts total EBITDA minus patent spend at 91-107 million for 2016, which, after interest and taxes, yields true cash earnings of ~$60 million. (RPXC has traditionally been very accurate in its forward guidance as it has high visibility into its clients and renewals).

However, on a GAAP net income will only be 36-41 million due to the amortization of patents bought in previous years. Therefore, true net income is roughly 50% higher than reported net income!

So, while the company has a forward P/E of roughly 13-14 on a GAAP basis, the true forward PE is 7.5, and an EV/FCF of only 6, or a 16% FCF yield.

While I am normally dubious of a company giving investors alternate numbers to GAAP, in this case, I believe it makes sense. Interestingly, the low GAAP earnings adds the benefit of lower tax expense.

#2 Mangrove Partners Activist Campaign

On March 17th of this year, Mangrove launched a proxy fight and nominated 3 people to RPXC's board, which is a classified board. The company has always had a curious habit of hoarding huge amounts of cash that it was not really spending nor returning to shareholders, so this was a bit overdue. However, the Inventus acquisition seems to have been the final straw that drew in an activist.

While many of Mangrove's criticisms are a bit overdone (they claim RPXC's EV/EBITDA is only 1.5, which as I said before is misleading because D&A is in fact its real COGS), the core of the argument is valid and welcomed.

For instance, last year the company had as much as $360 million of cash, no debt, and a market cap of roughly $750M on average. While the company declared a buyback, its first ever, in Q1, it had only spent $5 million on buybacks through Q3.

Now, prior to the Mangrove letter, RPXC had stepped up buybacks a little, buying back $16 million in Q4 2015 and $24 million in Q1, after the stock had crashed post-Inventus, and recently took on a $100M term loan. Still, this appears a little too late.

Moreover, Mangrove proposed:

- that RPXC quit building out its insurance product, which has increased G&A but has not contributed to revenues. I'm on the fence with this, as this seems like it could be a growth seed, but RPX needs A LOT more clients, as insurance clients contribute minimal revenues.

- rethinking employee compensation, which Mangrove Partners estimates is roughly $400,00/ employee, and to tie compensation to sales targets. I agree with this as insiders and employees own very little stock.

- more shareholder-friendly mechanisms, including de-classifying the board, as well as allowing shareholders to call a special meeting.

- replacing CEO and founder John Amster.

- levering up to 2-2.5x EBITDA and buying back stock (not sure what EBITDA number they are using but the company could certainly take on more debt).

The company may have somewhat begun this path, as RPXC took on a $100 million term loan at libor +2.5% with another $50 revolver that it has not drawn yet. The company now has roughly $200M in cash and thus 100$ in net cash. It seems the company could easily spend $100M on buybacks if it wanted even in a single quarter, which, at these share prices, could retire ~20% of shares outstanding! That would only leave the company in a 0 net debt position! If the company were to use the revolver for another 50 million in buybacks, the company could retire 30% of shares! If the company had the stomach to go into a net debt position, it could even retire more.

It has been frustrating for shareholders, as buybacks would have been very accretive for the better part of two years, but the company has not done so. Perhaps this is due to the company being from Silicon Valley, which is obsessed with growth and revenues over profits. RPXC needs to realize that it is a wonderful, stable, and somewhat boring business, not a high growth tech stock. Mangrove is thus providing a wakeup call. Hopefully, now that RPXC has an activist threat, it will do what now seems obvious and return cash to shareholders via highly accretive buybacks.

#3 Was Inventus that bad?

It is possible, however, that Inventus will turn out to be a success over time. As the core RPXC is stagnating, Inventus is projected to grow 10-15% this year. Moreover, management indicated $5 million in synergies that were discovered, which were not announced at the time of the acquisition. Moreover, while Inventus was originally projected to grow in the high single digits, it looks as if 2016 will exceed that as the company has won a number of large contracts, which includes European expansion. Finally, Inventus has over 1,000 clients, and RPXC has only 286, so there is the possibility that there could in fact be cross-selling opportunities down the road, or other joint collaborations that can help minimize legal costs for their clients.

Valuation

So what is the correct value for RPX? It's pretty simple, really. RPX is a stable, subscription business service, that has apparently matured into little or no growth (except Inventus, which is growing).

Assuming business services generally have as much risk as the overall economy, one can assume an 8% cost of capital (2% risk free rate + 6% ERP). Maybe, since it's a relatively new service one could add a half-point to be conservative, so call it 8.5% WACC.

Using the "true" cash earnings of $60M:

Assuming 0% growth forever, the company should trade at 11.75x ex-cash, so 705M + 100M net cash, which is about $15.58/ share.

Assuming 1% terminal growth, the company should trade at 13.3x ex-cash, which is 800M + 100M net cash, which is 17.40$/share.

Assuming 2% terminal growth, the company would be 15.4x ex-cash which would be $923M + 100M, or $19.75/share.

At the current price of $9/share, RPXC seems wildly undervalued, as the market seems to be pricing in a long-term and sudden decline, or an increased risk of becoming obsolete due to legislation. Either that, or investors are taking GAAP earnings on its face and pricing in a long-term decline to boot.

Still, even when using a $40M after-tax cash flow number, the possible values are skewed to the upside (see chart). A $9 price/share is pricing in some sort of huge risk to a subscription business with 90% retention and a strong net cash position, which I don't think is right.

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Risks

#1: Regulation

In the wake of the 2011 America Invents Act, the 2014 Alice Decision, and the new rules applied to cases in December 2015, it is not surprising that some investors may be wary of RPXC, as it is possible that the U.S. government could legislate away patent trolling.

However, I think that is far from feasible to completely eliminate patent litigation. Patents have been the bedrock of American Innovation since the country's founding, and there are well-heeled interests on both sides of the debate: On one side are companies like Google and Facebook who wish to kill patent trolls altogether, while on the other side are universities, trial lawyers, and pharmaceutical companies who get monetized for their IP. Thus, it would be very difficult to completely eliminate patent litigation.

Even with the new rules and regulations, NPE suits have declined, but only around 4-5%, as the most egregious examples of frivolous lawsuits have been eliminated.

One other thing to consider is that most patents that are litigated are relatively old patents, with 3-5 years left on their life. This is when owners resolve that the best use of the patent is to attempt to monetize via litigation rather than continue to innovate with it.

In the last 10 years, patent issuances in the United States have doubled (see chart) That means that there should be a steady pipeline of patents that should continue to come into the market for years to come. As the world is only becoming more technological, it seems as though RPX's business will remain relevant for many years, even as it is facing near-term mild headwinds due to new rules "pruning" the "dead-weight" of frivolous lawsuits from the impactful suits.

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RPXC is essentially a toll-taking business service for all tech companies in the ecommerce, software, semiconductor, automotive, and hardware sectors. It seems this will be a secular growth area for years to come.

Plus, do you have any faith in the Congress passing substantial legislation? They can't even agree to routine things, like raising the debt ceiling or passing a budget.

Risk #2 Management Obstinacy

There is a chance that Mangrove could abandon its campaign and current management will prevail in its continuing to ignore the interests of shareholders. However, the activist campaign is only 2 months old, so I believe there is a greater chance of it having at least some success - at least in changing some behavior, if nothing else -- rather than failure. Still there is a risk that RPXC management could thwart the activists, and continued to invest shareholder money in ventures that are far less profitable (if at all) than the core subscriptions service.

Conclusion: At 9$/ share, and with a new activist in the stock, I find the reward for RPXC shareholders vastly outweighing any of these risks. My base case is $17.50/ share. Considering the stock traded almost that high as recently as a year ago, this number is not crazy at all, and if the company can reignite growth, may prove conservative.

Disclosure: I am/we are long RPXC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.