As reported last week, Vringo (NASDAQ:VRNG) paid $22 million in cash in exchange for a stash of patents from Nokia. (see "Vringo Investors To Fund New Business Model"). Vringo's stated motivations for the purchase are purely driven by monetization potential, with an investor presentation identifying key licensing areas as Communication Management, Data and Signal Transmission, Mobility Management, Radio Resources Management, and Services. However, Nokia successfully negotiated licensing terms to protect its commercial interests at the possible expense of Vringo's monetization potential.
First, Nokia receives a whopping 35% royalty that kicks in too early. Second, Nokia placed significant conditions on Vringo's use of "essential" patents. Third, Nokia's prior licenses may limit the licensing market for the acquired patents.
Nokia Royalty Will Delay Vringo's Profits
According to Vringo's announcement, the "purchase price for the portfolio is $22 million, plus to the extent that the gross revenue (as defined in the Patent Purchase Agreement) generated by such portfolio exceeds $22 million, a royalty of 35% of such excess." Unfortunately, we must speculate about what "gross revenue" means since the purchase agreement itself was not made public. However, assuming "gross revenue" means the revenue generated by licensing the patents without deductions, Vringo left itself with a significant bar to meet just to break even.
As Vringo, Acacia (NASDAQ:ACTG), Rambus (NASDAQ:RMBS), Virnetx (NYSEMKT:VHC), and countless other IP plays have demonstrated, litigation is presently a necessary component of most significant monetization plans, which requires Vringo to hire lawyers. Suppose Vringo hires contingency lawyers at an average rate of 33%. Of the first $22 million in gross revenue generated by Vringo, it will keep only $14.7 million -- and that's before accounting for any internal operating costs. From that point forward, Nokia's 35% royalty kicks in, meaning that Vringo only keeps 32% of gross licensing revenue. Therefore, to generate the additional $7.3 million it needs to break even, Vringo will have to gross an additional $22.8 million. In other words, if it hires lawyers on a one-third contingency, Vringo needs to gross $44.8 million, more than double the purchase price, just to break even.
Nokia Licensing Restrictions Will Frustrate Vringo's Monetization Efforts
Vringo's announcement continues to explain that "if the company ... files an action against a telecom provider to enforce any of the assigned patents ... then the company will be obligated to pay to Nokia a substantial impairment payment." Vringo chose not to disclose the amount of the payment, but that will not matter. Vringo also said that "because all of the foregoing actions are within the company's sole control, it does not expect to be obligated to pay any such impairment payment." In other words, Vringo has no plans to enforce the patents against service providers like AT&T (NYSE:T), Verizon (NYSE:VZ), and Sprint (NYSE:S). The restriction effectively leaves Vringo with two options: handset makers and non-wireless technology.
Nokia's Prior Licensing Affects Vringo's Handset Licensing Options
With Vringo zeroing in on the wireless handset space, a quick check of the handset market is warranted. Recent research suggests the handset market largely consists of Apple and Samsung, with everyone else trailing in their wake. Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF) enjoy a two-party hammerlock on smartphones with 90% of the market, with everyone else splitting the remainder. From a recent New York Times blog:
'90% of the profits in the smartphone space are going to Apple and Samsung, and everyone else from Motorola to Research In Motion to LG to Nokia are picking up the scraps of that 10%,' said Charlie Kindel, a former manager at Microsoft who writes about the mobile industry. 'There's no real sign that's changing anytime soon.'
Importantly, one of those two significant targets may be largely off the table. Nokia revealed in its most recent annual report:
On June 14, 2011, before any of the cases reached final judgment, [Nokia and Apple] reached a settlement of all patent litigation between the companies ... under which they granted a license to each other of their essential patents as well as certain other patents.
Vringo made a big deal about the standards essential patents it acquired, but the prior Nokia disclosure suggests that the possible market available for new licenses is limited, for all practical purposes, to Samsung. What's more, while it may not be possible to determine what "certain other patents" were already licensed by Nokia to Apple, we do know from the same report that "on-going royalties [will] be paid by Apple to Nokia for the term of the agreement." What are the chances Nokia would sell Vringo patents it could use against Apple when Nokia is counting on these future royalty payments? Furthermore, Vringo did not disclose that they would be entitled to a share of Apple's future royalty payments.
Expect Vringo to set its sights squarely on Samsung once the dust clears. Of course, Vringo should not expect Samsung to roll over and cut a $44 million check without a significant fight (witness Samsung's current battle with Apple, for example). Plus, any amount that Samsung might be willing to pay out of court would likely appear extremely unattractive given the large hole Vringo dug to start this venture. Thus, Vringo will almost certainly be banking on a courtroom victory to secure a profit, rather than racing to the security of a settlement.
For example, Vringo's recent settlement with AOL netted only $100,000 in revenue, which falls substantially short of what Vringo would likely have requested from a jury. A prospectus filed on Aug. 9 disclosed the following:
On July 30, 2012, I/P Engine and AOL entered into a partial settlement agreement, which resulted in I/P Engine granting a partial release of AOL as to certain claims raised in the lawsuit in exchange for $100,000.
AOL remains in the lawsuit because of its use of "white labeled" Google ad technology, but the settlement essentially obviates any need for AOL to maintain a separate defense, which likely motivated the payment.
Nevertheless, Vringo accepted a $100,000 payment despite the fact that AOL posted recent quarterly advertising revenues north of $330 million, which demonstrates the massive discount for trial risk that frequently accompanies litigation settlements. With future, aggressive litigation with Samsung almost certainly in its future, and trial outcomes being as uncertain as they are, the only thing to be certain of is that Vringo's purchase will pay off ... for Samsung's hourly fee lawyers.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.