We've known and followed some of the goings on at Vringo (VRNG) since late 2009 when we got interested in its video ringtones business as a potential avenue for automatically generated 3D pictures. The idea may have been far out but we liked what it was doing with more dynamic and richer content delivery in the mobile space.
Yesterday the shares jumped 100% on an article posted by the prolific James Altucher on another site. James is a smart, witty and widely followed writer who also happens to be an investor. We're not going to repeat it all here so it's worth going back there and reading the whole thing. Of course his "Google (GOOG) going to zero" linkbait was a cheap stunt.
Judging by the stock action throughout the day it would seem that his analysis is not easily dismissed. It has also stirred up swirls of controversy not just in terms of the company itself but the evils and virtues of click bait, U.S. Patent law, research and writing with "conflicts" of interest.
Rather than get all philosophical on these points let's look at what this is all about from the standpoint of a Vringo investor or potential investor:
On March 12 Vringo agreed to merge with Innovate/Protect (IPC), a company that holds eight long-standing search patents originally granted to Lycos. In exchange Vringo is giving a large portion of the surviving entity to the owners of IPC. As noted in the March 30 10-K filing the owners of IPC will own 67.55% of the new company on a fully diluted basis.
IPC already has been working the legal ropes against some large potential infringers and it's not just Google; AOL (AOL) , IAC/InteractiveCorp (IACI), Gannett (GCI) and Target (TGT) are all named. The core of the patent case is about techniques that improve the relevance of returned search results and related advertisements.
Even though all the recent attention is focused on the potential of the IPC lawsuits the video ringtone and "Facetone" business is an important asset and one that we will come back to in the context of the IPC patents. Revenue is very limited but the availability via carriers and on mobile devices could be important depending on the strategy of the combined company.
As a purely practical matter the patent business has become one that looks more like risk management than real innovation, debate and the rule of law. There are a number of public companies now in this space and they are not all "patent trolls." One of them, RPX Corporaiton $RPXC- $16.47, $807M cap, provides this service to dozens of large companies. Software patents are the most notorious to adjudicate.
If we are playing a risk management game then the conventional wisdom is that your most likely outcome is a settlement that consists of a 1% to 4% royalty. Altucher's article (published on TechCrunch) goes further than it should in terms of talking about "willful" violations and treble damages. Even as a public company, some money in the bank and a very strong case I wouldn't want to draw the attention of the entire Google legal team in a fight to the death.
Turning to the numbers we're going to use a 1% royalty rate because it's low enough to imagine that Google might agree to it versus a lengthy court process. The vast majority of Google's revenue is from this form of advertising and the rest is a rounding error. Google has posted about $150B in revenue so far and is estimated to do $46B this year. It's easy to do the math here - that's a $1.5B settlement for past use and a $460M royalty payment this year. No doubt Google has the best understanding of the real risk in this case and has a strong negotiating team.
If this case were not against Google these numbers would be hard to believe but Google has $37B on the balance sheet and is expected to generate $19B of EBITDA this year and $23B in EBITDA in 2013. So for Google the sums being discussed cause little discomfort. At the same time that means it's going to be hard to scare the company. For example if this went the distance and Vringo won and provided willful infringement with a 4% royalty the figures would be $18B for historical violations and $2B a year in royalty payments. Those numbers are huge but they would not in fact break Google. I wouldn't want to play "chicken" with the company.
At this point it's worth reminding everyone that outcomes in these venues are not the domain of technology or financial analysts. Even lawyers get surprised. Delays are common and as investors flock to VRNG stock expecting quick results might leave just as quickly if results are delayed.
In terms of the stock there are quite a few new shares and outstanding warrants to factor in. Some new preferred has been issued, which is equivalent to about 21M shares of common. Plus about 16M warrants struck at $1.76. There are a few additional shares and warrants (250K and 850K respectively) used to absorb the old warrants of IPC. Earlier the company raised $3.6M through an exercise of outstanding warrants and granted an additional 2.5M in the process.
We're going to use a back-of-the-envelope to estimate share count since it is a moving target. Google lists 10M shares out, S&P Capital IQ lists 14M and our quick math suggests about $57M fully diluted shares for a market cap of $170M at $3/share.
Could there be a Plan B?
What if Google disappeared and the entire lawsuit couldn't proceed? That brings us back to the core business that existed prior to the merger with IPC. It is after all a mobile business with social context. And we know that dynamic rich content and increased relevance are big growth areas. Vringo does have some interesting opportunities to develop its business in and around these markets.
For instance we just wrote something about a private company called Kovio that will bring item level intelligence to all mobile devices with NFC. This is going to open up myriad opportunities and Vringo could use its combination of assets to great effect there. It might not be a patent story per se but the patent portfolio could assist with the adoption of Vringo mobile/social platform products for advertisers.
Investors need to take care on this one. We've noted that the stock action has attracted attention from a variety of sources including some known promoters like Ray Dirks. In the old days we used to refer to these as "cloak and dagger names" because major movements tend to happen in any direction for reasons beyond fundamental analysis.
The fact is we liked the old Vringo business and see serious potential in it. This IP situation has created a whole different facet of the story that is exciting but hard to estimate in terms of magnitude and timing.
Disclosure: I am long VRNG.