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RPX Corporation (NASDAQ:RPXC)

Q3 2012 Earnings Conference Call

October 30, 2012, 17:00 p.m. ET

Executives

Cynthia Hiponia - IR

John Amster - CEO

Adam Spiegel - CFO

Analysts

Tim Quillin - Stephens, Inc.

Daniel Leben - Robert W. Baird

Brian Karimzad - Goldman Sachs

Daniel Amir - Lazard Capital Markets

Operator

Good day ladies and gentlemen and thank you for standing by. Welcome to the RPX Corporation Third Quarter 2012 Financial Earnings Conference Call. During today’s presentation all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions) Today’s conference is being recorded today Tuesday October 30, 2012.

And I’d now like to turn the conference over to Cynthia Hiponia, Investor Relations, RPX. Please go ahead.

Cynthia Hiponia

Thank you, Britney. Good afternoon and welcome to RPX Corporation’s third quarter 2012 fiscal results conference call. Joining the call today are John Amster, CEO; and Adam Spiegel, CFO.

The agenda for today’s call includes commentary from John followed by a discussion of the financial results from Adam.

This afternoon RPX issued a press release announcing its third quarter financial results, which is available on the company’s website at rpxcorp.com. This call is being broadcast live over the Internet and the audio of this call will be available on the Investor Relations page of the company’s website.

I’d like to remind everyone that this conference call will contain forward-looking statements that are not historical facts, but rather are based on the company’s current expectations and beliefs. RPX’s actual results may differ materially from these forward-looking statements. Please refer to the company’s SEC filings for detailed information.

In addition, non-GAAP financial measures may be discussed during this call. Reconciliations to the most directly comparable GAAP financial measures are included in the table attached to the earnings release on the website.

One final note, we may have a disruption from the building Intercom system, if this happens we will hit mute and continue the call momentarily. And now I’d like to introduce John Amster.

John Amster

Thank you for joining us on our call today. We especially appreciated given what’s going on in the East Coast and we hope everyone is okay in that regard. I’m going to start by running through some quick highlights for the quarter and then Adam will discuss our financial results in more detail.

We were pleased with our performance in Q3, revenues were up 23% from year ago to $47 million and non-GAAP net income grew $9.4 million or $0.18 per pro forma diluted share. Our net acquisition spend in the quarter was $26.4 million covering eight transactions. We also expanded our client network and continue to see a very positive renewal momentum which I will discuss in more detail in a moment.

I want to start by updating you on the key external driver of our market MPE litigation. We were operating in a multi-billion dollar market that has a large and growing patent solutions we provide. More and more companies are experiencing MPE litigation and its associated costs and risks. In Q3 for example more than 680 suits were filed against more than 770 independence. More than 80 of these companies were sued twice or more in the quarter and more than 50 of these companies are not yet our best clients. In more than 375 companies experienced MPE assertion for the first time in the third quarter.

As we said in the past these companies are not yet near-term prospects for our core service, but this naturally does provide a good sense or how the addressable market for our insurance operating and longer term market for our core service our development. The costs of dealing with this growing threat are large. Two academics who wrote the first in-depth analysis of the MPE cost study that we conducted had a total cost of MPE assertion at $29 billion last year. At RPX we look at direct cost only and we still conserve it we estimate the annual cost of MPE litigation are nearing $10 billion whichever approach you take to quantify the impact, the most significant fact to bear in mind is that the vast majority of MPE cases more than half the cost for operating companies are legal expenses. In other words this is in market with transaction cost of around 50%. It's incredibly wasteful and an ecosystem with billions of dollars being spent, it amounts to a massive tax on operating companies.

Before we begin operating our defensive patent acquisition services, there were few if any adaptive ways for companies to lower this tax. There was a clear market need and we believe the growth of our network to more than 120 companies is proved that our solution meets that need.

By aggregating capital from a large group of participants we have been able to become a large scale buyer in the market acquiring patents before they become a costly problem for our clients. We also use this aggregating capital to acquire licensing ways to patents already in litigation, thus securing dismissals for our clients and in the process saving and legal and potential settlement costs.

From inception through the end of Q3, RPX has deployed more than $0.5 billion including client contributions to purchase patent assets. For our clients that is translated into very tangible risk production. More than 270 dismissals from litigation and hundreds of other litigations that we believe were prevented from ever occurring.

By our calculations RPX buying has reduced the collected MPE impact on our clients by more than 40%. Just through litigation dismissals alone we have reduced our clients (inaudible) on average by 14%. Probably the best proof of our positive impact for clients is our renewal activity which continues strongly throughout the quarter and left us again above our targeted 90% renewal rate at quarter end. This positive measurable impact in return on membership fees has also driven continued growth in our client base and we ended the quarter with 128 member companies up 8 from the end of Q2.

We are pleased with the steady growth of the network and we remain confident that we will continue to expand overtime. Those we have often said and we have seen this year, client acquisition in our business will not be a steady ramp. There are many factors that enter into a company’s decision about joining RPX and quarter-to-quarter pace of the networks growth can be irregular.

Those deciding factors of course become more subtle when (inaudible) companies that has four or five MPE litigations then we (inaudible) company that is dealing with dozens of assertions every year. For some companies including many of the early members of our network we did not have to do a great deal to explain the value and ROI of the (inaudible) solution. We by no mean saying that there are not a meaningful number of companies where the ROI cancels out.

Today the companies in our near-term pipeline had on average 4.4 litigation since the beginning of 2011. Over 130 companies have been sued five or more times during that period, so there is still a very healthy number of prospects where we believe our services get to a meaningful ROI. But we also know that we need to be more quantitative in how we explain the problem and the value of what we provide. For some of these companies our vision of more rationale market with less MPE impact is still (inaudible) enough to join RPX. For others we need to demonstrate quantifiable return on their membership dollars. The key to doing this to illustrating clearly just how frequently they are going to be a litigation and just how much those law suits are going to cost is there.

The more we know about the actual cost of different litigations, the actual behavior of different MPEs, the actual value of different patents to different plaintiffs in short, the more we know about what an MPE litigation will actually cost to particular company the more clearly we can make the business case for joining RPX. As it happens the essential role that RPX was established in the market has given us access to a tremendous amount of extremely valuable data. I think most of you are aware that RPX is administrating the MPE cost that was sponsored by the coalition for patent fairness to help the U.S. congress better understand the impact that MPEs are having on operating companies.

In this role we have compiled (inaudible) and analyzed the data from more than 90 companies and build a truly unique database of market and litigation information. It's the first of its kind in our industry and it's allowing us to present client prospects with increasingly clear data driven picture of their future risk both in terms of how many MPE litigation they are likely to face, how much those litigations will cost and how much they can reduce their MPE related cost by joining RPX.

We made good progress integrating this data and analysis into our sales process. We are pleased with the positive impact of these process and sales collateral changes have made. And we expect to continue refining these materials and processes going forward.

At the same time that we have strengthened the quantitative foundation of our selling efforts. We also been improving the qualitative aspects as well. We have begun the process of transitioning to a more traditionally organized enterprise sales function and it begun managing our pipeline towards specific internal goals metrics.

As with the process changes, we are pleased with the early impact of the organizational changes but we expect this process will continue to evolve overtime. We also been highly strategic in acquisition in both our sales and renewal efforts. The Altitude was a good example of this. As we mentioned in the past we created an immediate and quantifiable benefit for many existing clients that has help support our renewal efforts throughout the year. The transaction has also helped bring in one new client to-date and we are optimistic that it will continue to support our client growth. We are also pleased with the transaction we recently completed with Acacia in which we acquired rights to four separate litigated portfolio in a single transaction.

In the process we put together a cost effective package that will produce dismissals to more than 10 clients. Certain of the portfolio also represented significant address for prospective clients several of which have already signed with us with totally others to follow.

In addition to the sales and acquisition process we continue to improve the value of our data market intelligent services. In the last couple of weeks we rolled out several major enhancements to our client portal. If you haven’t seen the portal you really should and we would be happy to arrange a walk through. Spending even a few minutes in the portal will give you a good idea of just how deep the available information is. We believe we offered the most complete integration of data available anywhere today related to patents and patent submits patents available for sale, historical and credit patent litigation and MPEs. The portal enables our clients to seamlessly obtain the key information in need to assess most of the patent risk they base today.

When an operating company receives a letter asserting a patent, they want to get a complete picture of the situations possible. They typically ask what can I learn about who is asserting the patent, what is the patent and where did they come from, has it been litigated and if so by whom and so on.

Companies have traditionally paid outside tens of thousands of dollars to do this kind of research for each assertion they receive. We make it available to our clients as part of our service. As we continue to invest in our data infrastructure we will further differentiate our client service offering with high value proprietary content that cannot be obtained from any other source regardless of the cost.

Before I hand it over to Adam, I want to give you a quick update on insurance service from an operational perspective. We made solid progress during the quarter in terms of pipeline management; we have tightened the arbitration underwriting processes and enhanced other important processes as we head into 2013. The updated portal will also be highly leveraged by the insurance business.

On the business side of insurance we signed our first two policyholder in Q3 as a reminder our targeted market for the insurance operating here in the early stages is small to medium sized businesses that are just starting to feel the pinch from MPE assertion. Response from our initial company calls continues to be very positive and our exclusive distributor relationship with AM one of the leaders in business insurance will also help us build traction and momentum. We believe we can double or triple our insurance client roster by the end of this year.

Now the annual revenue from this early insurance clients is small typically on the order on 100,000 to $200,000. So, the insurance business won’t have the material impact on our revenues, even so we are very excited about insurance and what it has to RPX’s overall value proposition and our long-term vision for the company. That vision is to rationalize the patent market and help all operating companies significantly reduce the billions of dollars that they are currently spending on unnecessary litigation and legal.

By extending our risk mitigation and cost reduction services to a broader audience of companies facing MPE assertions. The RPX insurance offering helps us achieve that vision. And our success doing so of course will greatly expand our addressable market to include the thousands of companies dealing with MPE litigation in any form not just the hundreds that are currently being hammered by multiple litigations every year.

With that I will turn it over to Adam to walk through the numbers before we take your questions. Adam.

Adam Spiegel

Thanks John. I’m going to focus our financial discussion today on your non-GAAP metrics, which excludes stock-based compensation and amortization of intangibles. These items are reflected net of the respective tax effects. A complete reconciliation from our non-GAAP metrics the associated GAAP metrics can be found in our press release on our website.

Starting with the P&L. Revenue for the third quarter increased 23% to $47 million compared with $38.4 million in the third quarter of 2011. We ended the quarter with 128 clients up from 120 at the end of last quarter. We had no material or other revenue in the quarter.

Non-GAAP cost of revenue which is primarily the amortization expense from our patent assets with $21.9 million for the third quarter compared to $16.4 million in the third quarter of 2011. Expected a percentage of total revenue, non-GAAP cost of revenue was 47% for the quarter compared with 37% for Q2 and 43% in Q3 of last year. As a reminder last quarter our non-GAAP cost of revenue as a percentage of total revenue was impacted by the recognition of $9.4 million of other revenue related to structured transactions.

Non-GAAP SG&A expenses which excludes stock-based compensation and the amortization of acquired intangibles were $10.3 million in Q3 compared to $10.7 million last quarter and $7.1 million in the year-ago period. A quick reminder here that the year ago period has a benefit of $2.1 million recovery of expenses that have been incurred in prior periods.

Our headcount as at the end of the quarter was 126 which compares to 99 a year ago. Non-GAAP net income in Q3 was $9.4 million compared to $9 million in a year ago period. Non-GAAP net income per pro forma diluted share was $0.18 for the quarter as compared with $0.17 in year ago quarter. For the three months ended September 30, 2012 our GAAP and non-GAAP effective tax rates were both 37%.

Turning to the balance sheet, we finished the quarter with approximately $209 million in cash, cash equivalents and short-term investments. Our cash, cash equivalents and short-term investments exclude a $10 million deposit related to a potential patent acquisition. We expect this deposit to return in the near future.

Our deferred revenue balance at quarter end was $98.7 million compared to $97.5 million a year ago. Looking at patent investment activity. We completed 8 patent portfolio acquisitions during the quarter and our gross and net acquisition spend on patent assets was $26.4 million. Gross acquisition spend on patent assets for the trailing four quarters ending September 30 was $176.2 million as compared with $96.8 million in a year ago period.

Net acquisition spend on patent assets again for the trailing four quarter ending September 30, was $121.9 million compared to $80.8 million in a year ago period. As we discussed previously these spend metrics will bounce around based on the size of our acquisitions.

Turning to the outlook for the fourth quarter. Our current expectations are as follows. We expect revenue to be in the range of $48.7 million to $49.2 million and non-GAAP net income in the range of 9.8 to $10.4 million. We forecasting approximately 53 million diluted shares outstanding on a pro forma weighted average basis and our non-GAAP tax rate is forecasted at 36%. When we add this guidance to the results of the first three quarters of the year reported already, we get the following full year expectations.

Revenue in the range of 194.8 to $195.3 million. Non-GAAP cost of revenue as a percentage of total revenue we are expecting to fall within the 42 to 43% range. Non-GAAP SG&A we are expecting to fall within a range of $42.2 million to $43.1 million. And non-GAAP net income in the range of $44.6 million to $45.2 million. For the year we are forecasting approximately $52.7 million diluted shares outstanding on a pro forma weighted average basis. And our non-GAAP tax rate is forecasted to be 36%. We are still estimating that our next spend on patent assets for the full year will likely fall within the range of 110 to $120 million.

And now we are ready to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Tim Quillin with Stephens, Inc. Please go ahead.

Tim Quillin - Stephens, Inc.

In terms of fourth quarter additions what kind of visibility do you have, I know it's lumpy but do you have any visibility right now on how we should think about additions in the fourth quarter. And how are you doing in kind of moving conversations up to the C level especially for some of the larger holdouts that would benefit from your service?

John Amster

We think that the longer transition we are doing a lot of education and collective marketing on that topic but nothing any meaningful change in our interaction with our pipeline today. But it's a great question that’s something that we are very ideally overtime we really do continue to shift that the nature of the discourse more from a business decision from where it is today which is really more of a legal decision. In terms of visibility we generally don't talk about visibility in terms of the pipeline. All we really can say is that we have been making progress throughout the year in building the pipeline and we feel good about our client end at this quarter and we feel like we are continuing to be on that path of progress.

Tim Quillin - Stephens, Inc.

Can you just help us understand how are you thinking about 2013 in terms of SG&A expenditures and patents spending?

John Amster

We really can’t, I don't think. At very high level things are not changing, there aren’t dramatic changes going on. We still are looking at the same thing that we are really focused on operationally. We continue to build out the data that’s an important thing for us we are making focusing on building out insurance, but all these things there is nothing really meaningful or different that’s changing in our business today as we sit here and look at it.

Operator

Our next question comes from the line of Dan Leben with Robert W. Baird. Please go ahead.

Daniel Leben - Robert W. Baird

First, just on the 8 client bookings, can you give us some color around given kind of magnitude of the size of those clients that would be appreciated.

John Amster

So, about half of the clients that were signed were kind of 200,000 bucket with annual revenue. And the other half of those that were signed were roughly consistent with kind of our overall average client size which is similar on the order of $1.5 million.

Daniel Leben - Robert W. Baird

And just for clarification, the two insurance clients are also included clients for the subscription business right?

John Amster

And just as reminder we are only selling policies which practically means that if you our interest in buying a policy we are going to sell you membership at the same time.

Daniel Leben - Robert W. Baird

And then to follow-up on the question, thinking about ‘13 and beyond just help us understand the process as you are thinking about the growth in med acquisition spend relative to booking. How much does that plan change or not change based on booking when we get to the end of the year and see what the final number looks like.

John Amster

We are still thinking along the lines of what we have been articulating for quite a while now which is that we will as we think forward that our acquisition spend will likely increase. But it will likely increase at a lower rate than the rate of growth of our top line. So, that really well we are not giving any kind of specific guidance around anything going forward, fundamentally that’s still the way we think about the business.

Daniel Leben - Robert W. Baird

And then could you just give an update on [August dilution]?

John Amster

There is not really any update (inaudible). But no activity to report there.

Operator

Our next question comes from the line of Brian Karimzad with Goldman Sachs. Please go ahead.

Brian Karimzad - Goldman Sachs

On the Acacia transaction you mentioned dismissals for 10 existing clients out of it, but that else be viable in some prospective. Can you give us maybe a sense of the scale of prospective who are near-term prospects that would be involved in the litigations.

John Amster

And just to be clear it was actually 10 clients, so it wasn’t necessarily 10 clients at that very moment. Some of the prospect of some clients are going to be dismissed from the litigation. There is we have a fair number of options how likely that list is unclear, we are going to continue to plateau it. One of things that we look at this, (inaudible). Part of what we are doing is building out the inventory and that’s not the reason why (inaudible) that transaction. In terms of precise numbers in near-term visibility I really can’t speak much more on that.

Brian Karimzad - Goldman Sachs

On the insurance model, any sense on how the margin profile that’s going to shake up?

John Amster

Nothing that we have discussed publicly and we are going to continue to defer on that until later point. It's not material enough at this point and but it's definitely something we will be talking about next year.

Operator

Our next question comes from the line of Daniel Amir with Lazard Capital Markets. Please go ahead.

Daniel Amir - Lazard Capital Markets

So with regards to your new clients or the 8 clients that you signed up, can you give a little more visibility on kind of what type of verticals these clients might have been and how does that match in terms of kind of your long-term strategy in which verticals you plan to target into next year as potential area where you can expand to new clients?

John Amster

So, the clients are in our normal what I’d call our existing vertical markets, e-commerce software, consumer electronics is really our core base. We didn’t expand (inaudible) to be expanding new verticals last quarter. The answer is not really. And again that’s okay, we got plenty of addressable market left in the core verticals where we got really good penetration and that’s a good thing for us to be able to d. and I think part of what you see is the fact that we were able to get bunch of existing clients out which is important for supporting (inaudible) but also bringing new clients at the same time. And I think the results of Q3 were pretty less that make in our model.

Daniel Amir - Lazard Capital Markets

And then in terms of kind of the new vertical, I mean which verticals would you be targeting next year, you think it's (inaudible) are going to come from the current verticals?

John Amster

I mean we are always targeting new verticals, we mentioned in the past, we talked about the [news services], we talked about auto, we do consider the MSOs, the cable industry a bit of the key there is developing the relationships and as they get more and more unfortunately experienced with MPE problem, they will become more and more (inaudible) and we just need to develop relationships so that one there is a moment to bring them in, we are able to need a solution for them on a certain problem, or we just get into the point where they realize that the magnitude their problem requires our solution. So, we will continue on those and we will continue to longer receive any verticals emerging as MPE start to tide in different areas.

Daniel Amir - Lazard Capital Markets

One other follow-up in terms of you’re a client’s find out that’s more than previous quarters. I mean is it due to the type of transaction you did with Acacia, that led to these new clients or is there actually or improvement I guess in your sales efforts have led to a much higher new client base here?

John Amster

It's just a very normal example of the variability in our business model and this last quarter we did have in advanced in more clients and other there might not be that bad. And so really it's just an illustration of normal variability in our business model. I do think we started seeing some effects of some of the changes we made on the sales process while again on the margins and really that’s a long-term cost as that we just need to keep focusing on and I think if you look at last three quarters and that’s just the normal variability in our (inaudible).

Operator

Our next question is a follow-up question from the line of Tim Quillin with Stephens, Inc. Please go ahead.

Tim Quillin - Stephens, Inc.

My first question is do you feel like at this point you have gotten back some bank for your buck on the Altitude transaction for full return or is it jury still out?

John Amster

I guess the jury is still out but we would expect at this stage jury still be out. We definitely though that was going to take more time to harness if you will and I think our progress in harvesting it is really solid and so I think we are kind of where we thought we will be on that.

Tim Quillin - Stephens, Inc.

And that you will be able to convert one potential client into a client, how many would you expect to convert eventually?

John Amster

We never give any precise number on how many we would expect to convert but there is a bunch, but the one client conversion isn’t while the one client conversion is reporting, from our perspective the impact of that transaction have on renewals was really, really important. And so we got a lot of that get out of the transaction just based on renewals, the client ads are going to be upside that we look forward but again we are kind of where we thought we would be.

Tim Quillin - Stephens, Inc.

John in the descript you talked about 130 I think it was non-clients that has been sued five or more times over the past couple of years or so. In the past you talked about 275 non-clients that have been sued two or more times over the trailing two year's or 18 month or whatever it was. I’m just wondering what is proven to be kind of the sweet spot or the over under in number of patent assertions that kind of greases the wheel for adding new clients or driving renewals?

John Amster

It's not that we are, what we are talking enterprise sales focus that detect the thing that we want to be tracking those metrics a lot more carefully and trying to analyze different pieces and quantify pieces of the sales project. So, it really is a good question. Generally speaking we are targeting companies that sued more often enough. And likely they are to be able to cancel out the ROI for our service. And we definitely look at a company (inaudible) 2011 likely has a pretty significant MPE expense and they are likely positives. And it's very likely as well that it's there in the right verticals we can cancel out in our life, but we don't have real precession on an exact number but it is something that we certainly focus.

Tim Quillin - Stephens, Inc.

I was wondering if you have goals in terms of insurance clients that they expect to bring on in 2013 or so.

John Amster

It is exclusive. (Inaudible) press release for those of you who haven’t seen it, I believe this is probably on our website. We are not locking to something that doesn’t work. But the goal there is that they are once the best is not the best distribution channels for related insurance. They have been on the cutting edge of trying to do things with respect to patent.

Tim Quillin - Stephens, Inc.

And did you say that 2 of the 8 client additions in the quarter were the insurance clients is that right?

John Amster

Correct.

Tim Quillin - Stephens, Inc.

And so we should think about I guess think about maybe mentally adding client additions that on a lower rate as we build the model, but I guess you wouldn’t even say that don't get out of yourself on 2013 revenue contribution there?

John Amster

Yes, that’s exactly what we will say.

Tim Quillin - Stephens, Inc.

So, on SG&A you actually scaled back SG&A here at the end of the year relative to what you have told us a few months ago. Is a goal of free cash flow positive something that would drive your SG&A thinking in 2013?

John Amster

We are really is just not talking about 2013 at all here, the question about scaling back our G&A we have done a couple of things throughout the year, our hiring has been a little behind where we had planned. There is a component of our collective compensation that is base on our performance against our plan and frankly we are not performing as we hoped. And so some of the difference in overall G&A is a reflection of competition. So that’s a function of hiring and then frankly there is enough uncertainty in areas of our business that kind of make it difficult to move budget precisely and when you add all that up as we get closer to the end of the year. We start taking some of those uncertainties away.

Operator

Thank you, at this time I’d like to turn the call back.

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