Network-1 Solidifies Patent Validity; Launches Audit Against Cisco

Summary

• Recent key decision by Patent Office on a Network-1 patent helps to solidify a major revenue stream.
• Company quietly launched an audit on Cisco's royalty payments. Based on preliminary audit findings, Network-1 "believe[s] there will be additional royalties due".
• Audit could positively impact revenue projections by of several million over the patent's life.
• There is a total lack of coverage and analysis of these developments in the investment world.

Often overlooked Network-1 Technologies (NYSE:NTIP) owns an important and very valuable piece of intellectual property. Patent number 6,218,930, referred to as the Remote Power Patent, describes a method of sending a low level current to a connected device to determine whether that device is ready to receive power. This technology is critical for modern networks to ensure devices efficiently receive the correct amount of power, without risk of damaging devices. The Remote Power Patent was explicitly mentioned by the standardization taskforce while they were crafting the 802.3af Power of Ethernet (PoE) technical standards back in 2001. The 802.3af standard was eventually adopted in 2003 and is now ubiquitously entrenched in modern data networking equipment.

Network-1 believes that all 802.3af compliant products utilize the technology claimed by this patent. In fact, in July 2010, Cisco Systems (CSCO) settled litigation and took a license for the Remote Power Patent covering all 802.3af compliant products sold by the company. Cisco agreed to pay Network-1 up to a total amount of $112 million, under certain conditions. $32 million was paid upfront in 2010. In addition, Cisco is required to fork out future royalty payments up to $8 million a year through 2015 and up to $9 million thereafter until the end of the life of the patent in 2020.

Network-1 has now negotiated a total of 16 license agreements with respect to the Remote Power Patent, including Extreme Networks, Netgear, Motorola Solutions, and several other data networking equipment manufactures. Twelve of these are currently producing ongoing royalties. In September 2011 the company filed a second round of patent infringement suits against 16 companies.

This second round of litigation was stayed, or put on hold, pending an Inter Partes Review or "IPR" of the Remote Power Patent with the United States Patent and Trademark Office (USPTO). The IPR request was filed by Dell, Avaya, HP (HPQ), and Sony (SNE). IPRs are designed allow a party to prove that patent claims are invalid in light of prior art, as to make such patent claims unenforceable. Clearly these major companies are threatened by the patent. But two weeks ago, in a big blow to them, the USPTO Administrative Patent Judges handed down a final decision that stated the parties "…have not shown by a preponderance of the evidence that claims…of the '930 patent are unpatentable". Thus, IPR proceeding was closed and the patent stands valid.

Why is the IPR development important?

The USPTO action is important because it strengthens the enforceability of the patent and puts Network-1 in a better negotiation and litigation position. Critically, Cisco and other existing licensees' continued royalty payments are contingent on the Remote Power Patent's validity. The closing of these IPRs greatly reduces the risk of the claims being cancelled; thus, the continued stream of millions in ongoing royalty payments from these entities suddenly has become more certain going forward.

How much are these future revenues worth?

Valuing intellectual property is very difficult. Fortunately, the Remote Power Patent also has a lot of history and data in which to ground this analysis. Ongoing royalties from the Remote Power Patent were approximately $16 million over the past two years. These revenues have historically proven steady, about $8 million a year. In addition, we can safely assume these royalties will continue as the IP covers basic, fundamental IEEE technology that equipment companies must adhere to so their devices are compatible. In fact, according to the Cisco license agreement, Cisco will pay royalties on all products that comply with "…any future standard that requires detection…in a manner substantially similar to that required by the PoE IEEE Standard 802.3 af-2003 and 802.3 at-2009."

Just to verify the conclusion that this "detection" element will indeed be included in future industry standards, I reached out to a very key member of the 802.3 task force, who is currently working on new and revised standards for PoE products. Here is what he had to say:

"One of the basic tenants of IEEE standards is for things to interoperate. Damaging things is viewed as bad (rightly so) and not what you would expect when something 'interoperates'. To prevent damage, the Task Force that worked on the original PoE standard, 802.3af, invented the concept of detection. This is the 'low level current' to which you refer…There has [sic] been no proposals to change detection and in fact one of our objectives is for new PSEs and PDs be backwards compatible with legacy PSEs and PDs, where appropriate. This means that we CAN'T change detection. Beyond that, it would be foolish to fix what isn't broke." [Emphasis is original]

This chairperson, at the forefront of the standard setting process, clearly believes this technology will continue to be vital in future networking devices, as there have been "no proposals" to alter this detection aspect. And as he explained, in many ways it "can't" be changed. Further, Cisco is heavily involved in crafting this standard; the fact that they acknowledge the Network-1 owns a piece of this technology speaks volumes.

These facts provide the case for a dependable stream of future ongoing royalty revenues from already-signed licenses. So, assuming sales are flat from these existing clients through the life of the patent, this would equate to roughly $56 million more in total windfalls. This is conservative because revenue is actually growing. In fact, last quarter, licensee running royalty revenue from the Remote Power Patent was the largest in company history. Furthermore, this projection does not account any growth of new licensees or upfront payments, which could be substantial. Cisco, for one paid $32 million upfront. But this base estimate only considers existing licensee's ongoing royalties.

Risks to the assumption of continued payments include: a successful challenge to the patent's validity, a move away from 802.3af standard technology, or a loss of market share by licensees to non-licensed competitors. However, in light of recent USPTO events and the opinion from an industry insider, these risks should be relatively minimal.

Why PoE portfolio revenues could actually grow.

First, there are at least 11 infringers that have yet to pay for use of the technology, including several large users of the Remote Power technology who owe both backed damages and royalty payments on future sales. With the validity being upheld, Hewlett Packard and others have fewer defense options. A simple Google search will show you HP, in addition to other major hardware manufacturers, is making a plethora of 802.3af compliant products. An example here states that these "...are IEEE 802.3af- and IEEE 802.3at-compliant switches". Cisco is explicitly paying royalties to Network-1 for use of this same exact technology.

Network-1 may also reap significant additional payments from a major existing licensee. In December 2013, management very quietly launched an audit on the royalties paid by Cisco. There was no PR released by the company. In fact, nobody seems to have taken notice of this potentially key development. But buried in the recent 10-Q by Network-1: "In late December 2013 we exercised our right to audit the royalties paid to us by Cisco… "as a result of the work of our auditors to date we believe it is likely that Cisco has not included all licensed products in their quarterly royalty reports to us as required by the license agreement. Accordingly, we believe there will be additional royalties due us for 2012 and 2013 as well as the three months ended March 31, 2014,.." Although the company "cannot be certain of this because the audit is not complete", adding this language to an otherwise skeleton 10-K means the company has good reason to believe beyond a mere hunch that they will "likely" be receiving additional backed royalty payments from their largest. Although we do not know the results of the audit or the size of the missed royalty payments, the analysis below suggests there could be a significant amount of additional money left to be received, perhaps several million, before Cisco would hit their yearly royalty caps.

This chart breaks down total revenues and estimated revenues attributable to Cisco for the past two years, as well as the 3 months ended 2014. Total revenue number were taken from the 10-K. I have parsed out Cisco's contribution based on statements in the same filing.

Statements of Income and Comprehensive Income	12 Months Ended		3 Months Ended
	Dec. 31, 2013	Dec. 31, 2012	Mar. 31, 2013
Royalty Revenue	$8,017,000	$8,698,000	$4,491,000
Estimated attributable to Cisco (77%, 77%, 91%)	~$6,173,090	~$6,697,460	~$4,086,810
Potential add'l payments to highest royalty cap (max potential recoverable from audit)	~$1,826,910	~$1,302,540	??

Click to enlarge

Note: Dovel & Luner LLP gets a 24% cut of Cisco payments

Remember, the audit will increase the product base for its largest licensee for past use and going forward. This could significantly increase the revenue projections for Network-1 possibly by millions total over the next several years, depending on the results of the audit. Thus far, I do not believe the investment community has taken fair notice of the preliminary audit findings. The final results could present an upcoming catalyst for the stock.

Of course, there are risks involved. These include the normal pitfalls of the very tough business of intellectual property enforcement and licensing. For example, an unknown third party filed an ex parte reexamination of the Remote Power Patent in 2013. It could eventually have an adverse effect on the patent's validity and thus on these continued royalty payments. Further, currently litigants could drag the company through courts for several more years.

However, there is a lot to like about Network-1. First and foremost, it is a firmly profitable company and it is trading at a fair price. Network-1 is a $40 million dollar company with $19 million sitting in cash. Network-1 is also diversifying and growing by partnering with additional patent portfolio owners beyond the Remote Power Patent. In the past year, the company acquired 2 more portfolios at attractive prices. The added value from these may begin to become clearer throughout 2014.

Oddly enough, Network-1 is almost completely ignored by the investment community; no analysts, no message board or social media engagement. But the company possesses a proven piece of very valuable, proven intellectual property and still has room to grow royalties. And now, Network-1 is in a position to sit and collect on a suddenly-more-reliable flow of ongoing royalty payments that will, according to preliminary audit findings, "likely" increase over the course of 2014 and beyond.

Disclosure: I am long NTIP. 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.

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