Buy Vringo To Get Something For Nothing?

| About: FORM Holdings (FH)

Vringo (VRNG) is a small company betting on a patent lawsuit against AOL (AOL), Google (GOOG), IAC (IACI), Gannett (GCI), and Target (TGT). If Vringo's intellectual property claims are real, Vringo's market value will rise from tens of millions to hundreds of millions of dollars. Along these lines, entrepreneur and trader James Altucher wrote a stunning argument for Vringo, essentially claiming title to the invention of Google Search.

Since this argument was made this past weekend, shares have nearly doubled, not because of anything in particular that Altucher said (he didn't say anything new), but because Altucher spoke so forcefully. And despite the runup, if Altucher is not grossly wrong about patent litigation, VRNG shares remain grossly undervalued.

Some things to keep in mind are:

  1. Altucher is long VRNG
  2. The lawsuit was filed in September 2011 so it's already priced in to shares, and
  3. How confident should one be in Altucher's opinion?

"Time itself started with the Big Bang." Altucher makes this claim on his blog. Perhaps after reading some Hawking Altucher fancies himself smarter than those who disagree. Altucher's claim is controversial because for time to have not existed at some point would mean that existence itself began spontaneously. Think about that for a second. How does existence begin spontaneously?

Altucher's conception of time and space represents the idea that something can come from nothing. This is quite ambitious fare for a few lines on a blog. Apparently Altucher (like me) is the type of guy who likes to make grand, oversimplified statements in areas of others' expertise. And tellingly, "something for nothing" is Altucher's vision for suing Google. But Altucher only presents one side of the story, as today's rally showed only one side of the possibilities for VRNG.

Our fragmented patent system sometimes gets things right and sometimes doesn't. And even when it gets things right, seldom will it achieve perfection. Law is more about reconciling competing interests than it is about dictating truth. But there is a vague consensus about what behavior should be encouraged in intellectual property.

"Laws of nature" cannot be patented, because this would create a monopoly and thereby discourage innovation. For example, if Altucher invents a way to go back in time and fund Applied Semantics in 2001, he will not be permitted to patent time travel itself, only the novel implementation in his machine.

This raises the question: is filtering in search a novel invention? Or is it an obvious application of a law in nature? This is a non-obvious answer that specialists will help decide in an ongoing debate. Like a stock exchange, which bids prices, search engines facilitate the exchange of information via the "bids" of end user behavior. Search engines rely on information primarily from a "market dynamic" within the marketplace of ideas, and as such this dynamic is essentially a law of nature.

Google has made sweeping improvements in applying the basics of this law. So to compare a crude patent that described an algorithmic goal, with Google's ongoing achievement of said goal is akin to comparing nothing with something.

The basic claim made in the lawsuit is that these two patents are valid. The patents broadly describe a filtering mechanism for generating search results and advertisements based on the relevancy of information as demonstrated by the behavior of users. If a user clicks on or refers to a given website, this is factored into the ranking of search results.

Clearly Google does this. So with a valid patent, Google does tens of billions of dollars of infringing business, has been infringing via PageRank for 14 years, has been doing so "willfully" since settling with Overture/Yahoo (YHOO) in 2004, and will need to pay a healthy sum to Vringo in order to avoid "going to zero".

Scott Rubin summarizes the Yahoo "precedent":

If Google was infringing on the patents that were owned by YHOO and had been granted to Overture, then the thinking is that they are infringing on the search monetization patents which were not granted to Overture because they had already been patented by Lycos. To make a long story short, these patents are now owned by a company called Vringo, and they are suing Google for a ton of money. Altucher seems to think that they have a case and that Google will settle.

The problem with the Yahoo comparison is Google settled with Yahoo prior to IPO. Google was in an early growth period. A more mature Google isn't necessarily going to hand over half a billion dollars. And, crucially, the fact that Google settled with Overture/Yahoo doesn't necessarily mean Google was ever really infringing.

The Vringo patents are a very selective way to draw an interval in history. Decades prior to the patents, there was a sociology of citation that existed in academic journals. This is the dynamic cited by Google when it was created at Stanford the same year Vringo's scavenged patents were filed. And of course after the patents, companies well beyond Google have implemented their own versions of end user filtering.

This lawsuit isn't just against Google. It's literally against anyone who embeds Google to monetize his or her website. It's theoretically also against anyone resembling search who filters advertisements and results. So this is an intellectual property assault on Pandora (P), Facebook (FB) and Amazon (AMZN). In other words, James Altucher is saying you should buy Vringo to shake down the Internet. But we have a patent system that reserves laws of nature, so this claim should be found overly broad.

Like search results, stock market prices represent a filtering engine for ranking information. So if you're thinking to buy VRNG's lawsuit, consider that it was known long before today's runup. The only news is that vultures like Yahoo are litigating a little more loudly these days. But that doesn't mean Google has to settle.

Look at the litigation so far with Apple (AAPL) -- Google and others are winning a lot of these claims. So I don't see how recent developments translate in the grammar of the market to "Google going to zero". And news of the lawsuit (before Altucher's recent publicity) has done nothing to send VRNG to infinity:
Click to enlarge

(chart from Google, click to enlarge)

There are smart people who know about intellectual property and the Internet, yet disagree with Altucher; otherwise the price of VRNG would not have stayed below $12 million for so long. Now it's up to $19MM on the PageRank rumor. If the rumor is true, the stock should go to hundreds of millions.

So, the market is taking a decidedly pessimistic view on this rumor, implying perhaps a 5% chance of legitimacy. While normally I would consider this pessimism a buyable discount, I think there are serious reasons to question Altucher's claim. We know there is no shortage of lawyers in finance. We know there is no shortage of Internet insiders with money to invest. One would think they would have understood this opportunity by now if such an opportunity really existed.

So if you think the chances of a $350 million settlement are really 10%, then this stock is severely under-priced. Ditto if you think 1/3 chance of a $700 million settlement. But to buy this rumor, make sure you know more than most people betting against you. And remember that James Altucher has a habit of making grand proclamations about getting something for nothing. I rate Vringo "hold" at these levels.

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

Additional disclosure: I am long Pandora, whose filtering system Vringo may or may not claim intellectual property rights to.