Internet Patents Corporation (PTNT) recently announced it initiated 3 lawsuits against the following companies for patent infringement: eBags, TellApart, General Automobile Insurance Services, and Active Network (NYSE:ACTV). IPC is trading well below net cash, and presents one of the best asymmetrical trades I've seen in a long time: good upside potential, limited downside.
If IPC prevails, investors could realize a 2X to 10X return. If IPC were to lose all these lawsuits, investors who got in at the recent $3.50 level would probably come close to breaking even. After an in-depth analysis of IPC and its patent portfolio, I have quadrupled my original position.
In 1996, when the Internet was in its infancy, IPC, then known as InsWeb, was developing cutting-edge e-commerce solutions. Back then, if you wanted to get anything done on the Internet, you often had to invent it yourself. IPC took the bull by the horns and invested over $100 million developing and patenting processes that made e-commerce efficient and user-friendly. IPC alleges that the defendants are using its proprietary technology, and is now seeking to be compensated.
IPC's strong cash position
In October 2011, InsWeb sold its insurance company lead generation business to Bankrate (NYSE:RATE) for $65 million. The company then paid a $5 per share special dividend in March and converted itself into a patent licensing company, changing its name to Internet Patents Corporation. That left the company with about $31.4 million in cash, or $4.07 per share. IPC has no debt.
IPC's patent portfolio
IPC holds 6 patents, 2 of which focus on e-commerce transactions. Patent 6,898,597 covers Event Logs, while patent 7,707,505 refers to Dynamic Tabs for a Graphical User Interface. IPC's four other patents focus on online insurance activities. The current lawsuits focus on e-commerce transactions, and at this point, I don't know the royalty potential for the online insurance patents.
The first case is against eBags and TellApart and focuses on the Event Logs patent. The second and third cases are against General Automobile Insurance Services and Active Network and involve the Dynamic Tabs for a Graphical User Interface patent.
Here's my understanding of one way in which the Event Logs patent applies to e-commerce companies:
When you go on an e-commerce site and look at a particular item, your browsing history is logged and that information is used to present relevant ads to you in the future. In other words, let's say you go to a website because you are looking for a briefcase. You find one you like and spend a minute or two reading about it, but you don't make a purchase. That information is captured, and at a future time while you are browsing on another website, an ad pops up and displays more briefcases and related products based on your prior browsing history. This type of targeting benefits both the consumer and the retailer because consumers get to see things they are actually interested in, and retailers get to present their pitch to consumers who have a reasonable probability of becoming purchasing customers.
This process, called retargeting, is something that most Internet users are familiar with and a technique that most e-commerce companies are using. I believe that the Event Logs patent has much broader applications, and retargeting is only one area of potential infringement. I have no idea how many companies could be using IPC's technology, but I wouldn't be surprised if more defendants were named in the future.
IPC initially targeting smaller companies
Management is taking a very prudent and cost-effective approach by initially targeting smaller companies. This strategy not only gives IPC a greater chance of success (smaller companies are often more likely to settle before trial), but also keeps the costs minimal. If IPC can win any of these smaller cases, it will be in a stronger bargaining position when approaching larger companies.
$31.4 million in cash limits downside risk
IPC has not offered any guidance regarding the potential dollar value of the settlements, but in my opinion, the company would not be pursuing these lawsuits unless the potential was large. IPC currently has about $31.4 million in cash, 64% of which is owned by insiders.
If the probable outcome for these cases was not substantial, it would be easier for the company to just sell the company as a shell, and distribute all the cash, mostly to themselves.
IPC's strong cash position provides a good safety net for investors because if all these lawsuits were to fail and the cash was distributed, those who invested at today's share price would probably come close to breaking even.
Number 1: IPC spends about $7.5 million in outside legal fees, loses all 3 cases, closes the business, sells the company as a shell for $3 million, and distributes remaining cash. Shareholders receive about $3.50 per share, ($23.9 million in cash, plus $3 million from the sale of the shell).
Number 2: IPC continues discovery, burns about $2 million, and then decides the cases are not worth pursuing. The business is closed, the company is sold as a shell, and the company distributes approximately $32.4 million in cash, or $4.20 per share ($29.4 million in cash plus $3 million from the sale of the shell).
Number 3: IPC receives $30 million in settlements, or $4 a share. This moderate success opens the door for the prosecution of dozens of other cases which has a positive effect on share price. Shares trade above $12, based on the $8 per share in cash, plus the perceived value of future lawsuits.
Number 4: IPC receives $100 million in settlements, for a total of $17 per share in cash, plus a $10-$20 per share premium based on the perceived value of future lawsuits. Shares trade between $27 and $37.
Number 5: IPC hits a home run and receives $200 million in settlements for a total of $30 a share in cash, plus a $20-$30 per share premium based on the perceived value of future lawsuits. Shares trade between $50 and $60.
Worst-case scenario not bad for shareholders
I don't think IPC will need to spend $7.5 million prosecuting these cases. The company has proven its ability to keep the burn rate in the $1.6 million per year range, and all the cases should be resolved within about 18 months or less. Although the industry average for prosecuting cases of this size is approximately $2.5 million per case, I believe IPC will be able to keep costs below that figure for the following reasons:
Number 1: It appears to me that IPC is handling much of the litigation in-house and will only contract out the heavy lifting to an outside law firm when necessary. Much of the litigation process is simply administrative, and can be easily handled by IPC's in-house attorney, Eric Loewe.
Number 2: Since most of IPC's $31.4 million is owned by insiders, I believe management will keep costs as low as possible. After all, it's mostly their money.
But let's say I am wrong, and IPC does end up spending $7.5 million. That would leave the company with $23.9 million in cash, plus $3 million from the sale of the shell, or $3.50 per share.
Is IPC a better trade than VirnetX or Vringo?
I've done well with VirnetX (NYSEMKT:VHC). I started following the company when it was trading at $2, bought shares at $5, and with its incredible volatility, the stock and options have provided ideal trading vehicles. I believe we could see similar gains with IPC, and at this point, I believe IPC has more upside potential than VirnetX.
I began following Vringo (VRNG) when it was trading at $1.25 and enjoyed many profitable trades, including a recent 300% options gain. However, I was expecting much greater share price appreciation and right now I believe IPC has more upside potential than Vringo.
If IPC is able to achieve success with its patents, the share price should at least double. With a large settlement, we could easily see a 10X return, or a $270 million market cap. If the patents prove to be enforceable and hundreds of other e-commerce businesses are liable, we could see even larger returns.
IPC makes an ideal takeover candidate
High-quality IP portfolios are valuable right now, and once Wall Street becomes aware of IPC, we could see a takeover bid. A bid could come from an institutional investor, another IP firm, or a big tech company. IPC appears to be considerably undervalued and any reasonable bid would be a positive catalyst for the share price.
IPC is sitting on a gold mine: $31.4 million in cash and patents that could be worth hundreds of millions of dollars. All this for a company that is currently valued at $27 million. This mispricing will not last.
For complete disclosure and disclaimer information, click here.
Disclosure: I am long PTNT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.