RPX Corporation (NASDAQ:RPXC)
Q2 2016 Earnings Conference Call
August 2, 2016 17:00 ET
JoAnn Horne - Head, IR
John Amster - CEO & Co-founder
Bob Heath - CFO
Trevor Campion - CEO, Inventus Solutions, Inc.
Jeff Meuler - Baird
James Berkley - Barclays
Matthew Galinko - Sidoti
Good day and welcome to the RPX Q2 2016 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to JoAnn Horne, Head of Investor Relations for RPX. Please go ahead, ma'am.
Thank you, Felicia, and welcome to RPX Corporation's second quarter 2016 earnings conference call. With us today to discuss the results are John Amster, Chief Executive Officer of RPX and Bob Heath, Chief Financial Officer. The agenda for today's call includes commentary from John followed by a detailed review of the second quarter financial results and updating of 2016 guidance by Bob. And then we'll open the call up for Q&A. Also joining the call for questions will be Trevor Campion, CEO of Inventus.
This afternoon RPX issued a press release announcing its second quarter 2016 financial results which is available on the company's Web site at www.rpxcorp.com. This call is being broadcast over the Internet and the audio of the call will be available on the Investor Relations page of the company's Web site.
Also please note that there are slides corresponding to the information discussed today available on the IR site.
I'd like to remind everyone that today's discussion will include forward-looking statements that are not historical facts but based on the company's current expectations and beliefs. These forward-looking statements include but are not limited to expectations regarding the growth of the company's business and the business outlook for the year. The company'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 will be discussed during the call. Reconciliations are included in the table attached to the earnings release and on the Web site. And with that, I'll turn the call over to John Amster
The second quarter RPX underscored the growing diversity of our revenue stream. Total revenue grew 23% year-to-year reflecting the addition of Inventus to our operations at the start of this year. In the patent business, we ended Q2 with 317 total clients, a net addition of 31. Our renewal rate in the quarter was just under 90%. We ended the quarter with more than 150 insurance clients. As our results indicate, we're holding our own in a tough environment and having some encouraging successes in the discovery services business notably in our European operations. U.S. sales have been solid as well and we anticipate meaningful contributions from domestic operations in coming quarters.
Overall, Inventus is successfully converting its pipeline while expanding in new geographies and verticals. This solid performance reflects our original strategy for the Inventus acquisition as our growth in the patent market flattened, diversifying our revenue stream into related areas of legal spend was a logical step. The goal was expanding the top line to complement our patent business and generate cash. Inventus did that for us in Q2.
We think Inventus' performance is being driven largely by the competitive advantages of our new spotlight business analytic tool which helps General Counsels better manage their costs. We recently began integrating patent data into this spotlight platform, which will further differentiate our offering.
As we discussed in the past, the use of data and analytics is a strategic emphasis for us and helps us leverage the combined operations of our discovery services and patent business. It's early days yet but we think this approach will be useful for clients and that the value proposition will be compelling. We've already seen some modest sales synergies and we think we can tap into a broader opportunity with many of our patent clients and prospects whose budgets for discovery-related services are significantly larger than for patent clearance.
Nonetheless, the current operating environment for patents remains challenging. We do have a very resilient operating model that we can manage through attention to operating expenses and our patent spend to deliver solid and consistent cash flow. But our core subscription patent business is still susceptible to the impact of M&A or sector weakness and we continue to see that impact in Q2. In the past, we've managed through M&A attrition by growing the client base and that's been more challenging in the current market environment. So we're revising revenue guidance down a bit for this year. Bob will have the details.
After operating in this market for nearly a decade, we know that NPE activity ebbs and flows. At the moments it ebbing a bit and as a result some of our clients and prospects may feel that their risk from NPE assertion and litigation is lower than in the past. In some respects this makes sense. The Alice decision in the growing use of IPRs have given NPEs reason to rethink some campaigns and the patents they might have otherwise asserted, so that has reduced the amount of plaintiff activity. At the same time, there's a perception among some companies that IPRs and the more aggressive attitude by the courts have fundamentally reduced risks for patent defendants.
Our position is that perception and reality are slightly out of sync. There definitely is less current risk in the patent space from patents that are susceptible to challenges, but patent risk is not going away. Even as we are seeing less nuisance litigation we are still seeing serious and costly NPEs suits move forward. This year alone there have been several high profile 8-figure settlements. This is still a multi billion dollar annual problem.
Alice and IPRs are helpful but really only at the low end of the problem. And even with ebb in the current pace of litigation, the engine of the NPE problem is still running. The United States Patent and Trademark Office issues approximately 300,000 new utility patents each year, hundreds of millions of dollars are still being invested in the patent licensing model and dozens of operating companies are still monetizing their patents.
In many cases, that is putting strong portfolios in NPE hands. The patent litigation pipeline is still flowing. In the meantime, we're focused on efficiency and have made and will continue to make operational changes in order to ensure solid cash generation. And I would also stress that we have steadily introduced additional ways to deliver quantifiable value to clients including our market intelligence, our IPR filings and our expanding drove of prior art.
We've published more than 200 prior art reports to-date and we know that the art we identified has been cited in more than 80 validity challenges by our clients. We're also finding new ways to allocate patent spends to deliver value. Later this evening, the Kudelski Group will be issuing a press release announcing a syndicated licensing transaction with RPX. Kudelski is a digital media security provider headquartered in Switzerland. They were an operating a company, not a NPE. But operating companies often hold portfolios that represent significant patent risk and it can make compelling financial logic for RPX and its members to clear patents held by operating companies. This transaction demonstrates how the clearing house we have built can work very effectively with operating companies.
So while NPEs are the primary focus of our solutions, our ultimate goal is to make any exchange of patent value rational and efficient. Participants can be NPEs, universities, individuals or operating companies. We're more or less agnostic about that. We just believe that patent owners and users can determine value through a market mechanism and without litigation. That's always been our vision of a future industry-wide clearing house. The Kudelski transaction is the most recent example of how we're putting that vision into practice.
Overall then, we're weathering this cycle in the market as best we can. And even though we understand the drivers are very real and are modifying guidance accordingly, we remain optimistic. RPX is still delivering significant value to its clients and the engine of demand is still there.
In the second quarter, for example, in just those sectors where RPX is currently active, more than 475 unique companies were named in NPE suits and more than 400 of these are not yet in the RPX network. More than 70 companies were sued more than once by NPEs during the quarter, of these nearly half are not yet RPX members. More than 180 non-client companies were sued by NPEs for the first time. Clearly, there still is and there will continue to be a need for effective solutions to the problem of patent risk. That will do it for me.
Here's Bob with the details.
As JoAnn noted, please refer to slide deck on our Investor Relations site, which corresponds to today's second quarter 2016 financial discussions. I encourage you to review this deck and today's press release for the full details of our financial results. As usual, our discussion will focus on non-GAAP metrics which include stock-based compensation, amortization of acquired intangibles other than patents, certain non-cash items that are delineated in the press release and the tax effects of each adjustment. Complete reconciliations from our non-GAAP metrics to the associated GAAP metrics can be found in our press release and Investor presentation.
As John mentioned second quarter total revenue was $83.1 million, an increase of 23% from Q2 2015. Subscription revenue for the quarter was $63.2 million, a decrease of $4.3 million from the prior year period and down $3.9 million sequentially. This decline reflects the impact from the same factors we identified earlier in the year, namely where no uncertainty arising from merger activity from the sectors we serve; budget pressure in certain technology sectors and factors related specifically to the U.S. patent system.
Discovery services revenue was $19.3 million, representing a 46% increase from revenue of $13.2 million in the second quarter of 2015. The increase resulted primarily from growth at Inventus' European operations. Sequentially, discovery services revenue was up from $10.6 million in Q1 2016, but please remember that in Q1, Inventus' results were included for only 69 days in the quarter.
Inventus' pro forma revenue for calendar Q1 was $13.5 million. It's important to note that discovery services revenue can fluctuate significantly from quarter-to-quarter as large projects ramp up and down as evidenced by our Q2 results. Likewise margins in the discovery services segment can shift based on the mix of activities in the quarter. And finally, fee related revenue for the quarter was $0.6 million.
Within the patent risk management business we finished the quarter with 317 clients and net additions for the quarter of 31 primarily new insurance policyholders. The renewal rate was just under 90%. As we've explained in the past, every year we usually have one or two larger clients that will be challenging to renew at all or at least renew at their previous rate. This year, mostly due to merger activity we actually had four or five clients that were tough renewals and the situation did not all play out as we have predicted or are still playing out over the course of this year. This is reflected in our drop below 90% in the Q2 renewal rate.
Importantly we have modified our assessment of upcoming renewals to reflect the current market situation and we expect the renewal rate to stay around 90% in Q3 and Q4.
Non-GAAP cost of revenue increased by 31% to $48.5 million from $36.9 million in Q2 2015 and patent amortization were $37.7 million in the Q2 results. Non-GAAP SG&A was $18.9 million. As discussed on our last call, we took steps in Q2 to reduce SG&A to take advantage of synergies and align our cost structure with our reviewed revenue outlook in the patent business. These included a head count reduction to 15 to 20 employees across the company. The $18.9 million of SG&A expense in Q2 does not reflect these cost reductions as one-time severance costs in the quarter slightly exceeded the savings. But our revised guidance for the full year reflects roughly half of the $5 million in annualized cost savings resulting from this initiative.
Non-GAAP net income for the second quarter was $9.1 million or $0.18 per diluted shared. This compares to $11.2 million for $0.20 per diluted share in the second quarter of 2015. For the quarter, EBITDA in the patent and discovery services segments was $48.5 million and $57.5 million respectively.
And consolidated non-GAAP EBITDA was $54.1 million and non-GAAP EBITDA minus net patent spend was $33.3 million in the quarter.
Our net patent spend was $20.9 million this quarter and $37.1 million year-to-date. As we discussed last quarter, we are seeing lower pricing on certain patents especially in the pre-litigation market, which allows us to do more for our clients with pure dollars. We actually had one of our more active quarters in terms of deal activity and in fact, total deal volume for the first half of 2016 was at the high end of historical levels.
Average amortization on patents acquired in Q2 was approximately 25 months and as we think about future amortization periods, we suggest to use approximately 30 months for amortization.
Turning to the balance sheet, we needed Q2 with $199.1 million in cash equivalents and short-term investments. And our deferred revenue balance was $123.1 million down from $140 million in Q1 reflecting the seasonality of client renewals.
During Q2, we repurchased 1.6 million shares of RPX stock for $15.2 million at an average price of $9.42 per share. Since the Board authorized our share repurchase program in Q2 of last year through the end of Q2 2016, we have repurchased a cumulative 5.9 million shares of our stock for $65.2 million at an average price of $11.12 per share.
Now to guidance. For fiscal year 2016, we are updating the following outlook on revenue. Subscription revenue of $255 million to $260 million down $10 million from prior guidance reflecting stabilization of our run rate for the remainder of the year.
Discovery services revenue increases to $67 million to $69 million from last quarter's guidance of $61.64 million again reflecting a Q2 run rate during the second half of the year and the general variability, I discussed earlier. And fee related revenue of $8 million to $15 million based on the first half results and fee revenue of $5.5 million we expect to recognize in Q3, yielding total revenue of $330 million to $344 million for the full year.
And turning to non-GAAP cost of revenue of $198 million to $200 million, an increase at the low end of the range. Our revised cost of revenue guidance for the year includes patent amortization in the range of $156 million to $162 million, which reflects a reduction in patent spend mostly offset by shorter than expected amortization and higher levels of activity in our discovery services business.
As for quarterly guidance, for Q3, we expect combined subscription in discovery services revenue of $81 million to $83 million. Fee related revenue guidance for the third quarter is $5.5 million and hence total revenue guidance in the range of $87 million to $89 million. Third quarter non-GAAP net income is expected to be $10 million and $11 million with 50 million diluted shares outstanding on a weighted basis. And for Q3, we expect EBITDA of approximately $58 million to $59 million.
And JoAnn is letting me know, I may have misread a number for the Inventus EBITDA. It was $5.7 million for the quarter.
And finally, subsequent to the release of earnings today, we execute an agreement that will add $2 million to fee related guidance on top of the guidance I just discussed and which is in today's press release. And the impact of this agreement will be to add $2 million of fee related revenue and approximately $1.3 million to our net income for each of Q3 and full year 2016 as compared to the issued guidance.
And with that we would like to open it up for your questions.
Operator, we'll take questions now please.
Certainly. [Operator Instructions] We'll go ahead and take our first question from Jeff Meuler with Baird. Please go ahead. Your line is open
Yes. Good afternoon, everyone. I think discovery revenue guidance has increased, but discovery full year EBITDA guidance is unchanged, another comment about margins in that business can vary quarter-to-quarter, period-to-period but anything else you say in terms of the one part of the guidance moving, the other not?
This is Trevor Campion. Thanks for the question. I think that you're looking at it correctly. There's some variability in the margin mix. Couple that with the one-time extraordinary costs we've incurred as we've expanded into a new mainland European country, I think we're being a little bit consecutive in how we look at that. I think it's fair to think about all things being status quo all are moving to the higher end of the range but hedging ourselves a little bit, it's still a little bit of uncertainty as to what services our clients will demand.
Okay. And then, when I see the comment in the press release about taking appropriate operational steps to ensure you hit the cash generation goals, I guess how much of that is SG&A-type expense actions versus are you specifically bringing down the cash patent spend at all to hit a full year cash generation goal, or is that reduction more just a result of the efficiency that you're getting in the prelitigation spend and the general I guess market softness?
Jeff, its Bob speaking. It's really all of the above. With regard to the savings I alluded to, the $5 million on an annualized basis, that's predominantly going through the SG&A line. On the patent spend, we are taking the spend down because of the observations I made about pricing as well as adjusting for the new revenue outlook.
And then on the tough renewals, anything you can say about the conversation or what's been generally surprising in those four or five situations to the extent to which you've had those conversations. To you are they not believing they are getting the same value from the solution that you're believing they're getting? Or is there something company specific or merger activity specific that maybe driving the more challenging renewal discussion?
I think the mix of answers. It's company specific. And I think the mix has been typical to what we have seen over time, Jeff. In some cases I would say they are -- there is a connect in most cases that's not the case. It's more just things specifically going on within a company that make it difficult renewal environment M&A being the most obvious example. And there is also in some incidences it really was very predictable for us and had more to do with the market environment and particular companies sector. And so, yes, I mean it's all of the above nothing in particular -- the general kind of a conversations with our clients is that they really do see the value in what you are doing. And usually there is not -- usually the disconnect is not the answer.
Okay. And then just finally, is there some sort of catalyst type event that we investors can be looking forward to get out of the broader -- near-term market lull in terms of NPE market activity?
I'm not sure if there's any single catalyst. I think -- the generally the way this is going is that pendulum swings and it doesn't go from one side to the other. It moves gradually. And in particular in the patent space, I think that's true because you're talking about things that happen in legislation and then seeing that legislation play out in the courts and then courts doing their own thing and then seeing that play out further in the courts. And I think we're seeing all of that happening right now. So we're seeing things like IPRs and Alice play out in the market, and we are seeing signs of gradually things moving back towards the center. And so I think that's the key thing is just seeing more and more of those signs of people paying real dollars to either purchase patents, settle patent litigations or courts coming out with what I would say are more middle of the road, not every decision that you read about being a pro defendant decision.
And I think over time as our clients see more and more of that, they will and prospects, they will realize that this is not a problem that's going away, and I think that's the perception and headwind that we're battling is the problem is going away. It's not according to the statistics that we look at. It's very much at a level of activity that should get this company back to growth on the patent business. So I don't think you can look for a single catalyst, just more and more small catalysts of companies paying real dollars, people buying patents that are really the evidence that we're putting in front of our clients every day that this problem will persist.
Correct. Thank you.
Thank you. [Operator Instructions] Our next question comes from Darrin Peller with Barclays. Please go ahead. Your line is open.
Hi, guys. This is James Berkley for Darren. Just real quick, just one more question, some of the guidance changes, noticed subscription revenue dropped off a little bit for year end guide versus first quarter's guide for the full year and discovery was revised up. I think I understand what's going on the subscription side, but if you just talk about a little bit what's driving discovery to be a little bit better than you had previously anticipated. I would appreciate it. Thanks.
Hello, James. A couple of factors. First of all, our pipeline really has never been stronger and our conversion rates have effectively competing, I think at a higher level than we have in the past against the rest of the sector. In particular, we have added some very high-profile and important net new clients that have a strong demand for our services today. And in conjunction with some of that whole connectivity, we have opened new geographies in Mainland Europe that we have not had a substantial presence even prior. So I think a combination of all those factors is what's moving us north.
Okay. Thanks. And just switching gears real quick. If you could talk a bit about your efforts to bring certain clients and just something you talked about several quarters ago, but just an update on your efforts bring certain clients to the subscription fee above their old cap in the rate card and how that's playing out. Have you had any success there or what kind of feedback have you gotten?
There's nothing really new to report on that front. Obviously, we are always looking to try to get our clients to acknowledge the value we deliver by increasing their subscription revenue, but I think John gave you a good sense of the atmospheric factors that make that a little more challenging in this environment.
Fair enough. Thanks, guys. I'll turn it over.
Thank you. And we'll go ahead and take our next question from Matthew Galinko with Sidoti. Please go ahead. Your line is open.
Hey, good afternoon, guys. Question about if you could just, so I acknowledge the environment's not as great in the NPE side, but in terms of the pipeline for clearing how tight deals that don't really touch on NPE, is there any change in that environment in terms of how many you're seeing that are potentially accessible to you versus how many of those transactions are actually happening in the marketplace?
The pipeline of those transactions is as robust as it has ever been. There's -- I think we said this in the past. We're always working on a lot of things and staying in front of our clients about a lot of opportunities in the market that you don't read about. There's also some things that you read about and I think it's a reasonable assumption that we're working on everything in the patent market that you might have read about and the cadence of those deals actually happening has been pretty consistent. There's usually a deal or two every year.
The Kudelski deal we think is a really interesting one. Not that dissimilar to great companies like Kodak that had really strong patent portfolios and histories of licensing where there comes a time where, a large enough group of the market is looking for that clearing house type of efficiency. And so each time one of these things happen; it reinforces our vision of this happening on any transaction. And, you know, getting to the point where it is a more regular thing that is hard to say. What we can focus on is only just keeping in front of our clients with all of these opportunities and that pipeline is really pretty strong.
Fair enough. And maybe if I could just ask in one different way. If less patents, let's say making it into the hands of NPEs to work on certain campaigns, is it reasonable to say that more should be going through that clearing house-type model that's -- just going between operating companies and not touching NPE hands and so it's a potential for the cadence for that to pick up at all and are you seeing any signs that that could happen?
So, it's a very good question and I think in theory, our view would be -- we would love to clear everything prelitigation and absolutely that's the ultimate vision. Especially in an environment like the one that we're in right now where there's generally a perception that plaintiffs are losing and defendants are winning, that is not -- we are more focused on litigation catalysts than we have been before. And so I think in theory we would love to see more go to prelitigation. In this environment it's actually the other way around whereas as Jeff noted on in his question, one of the first questions, we are able to do a lot of prelitigation clearing at great prices right now, which is delivering good value to our clients, but we still need to do a lot of litigation.
Importantly, though, the original premise of your question that there's less getting in the hands of NPEs, I don't think that's right at all. There are still a healthy number of operating companies that are divesting major portions of portfolios. You can Google patent sales this year and there's been really interesting private equity activity investing in patent portfolios. There's been interesting public sales, tens of millions of dollars of patents have been transacting.
I think one of the things you're seeing, as you're seeing NPEs adapt. You're also saying that NPEs stayed on the sideline a little bit to see how some of these new post grant challenge things would be used in the litigation context. And also just stockpiling patents that are not susceptible to things like CBM challenges or Alice challenges. And so we actually see a very robust pipeline of litigation. That level of activity is not so much the problem. The reason why I said in the prepared remarks it's out of sync is I think the perception is that the problem has ebbed a lot more than it actually has.
And so right now our focus is on making sure we're not missing any catalysts, being really smart and active about getting in front of our clients with as much visibility as we can as to what's happening and just trying to clear as much of this as we can and deliver that value which I think in this environment we've been doing a very good job of.
Great, okay. And just one more. I know you touched on the subscribe adds and being on that basis mostly on the insurance platform. I'm just curious if you can give a bit more color on the insurance platform, how that's coming along, how the distribution network is and see, firemen is having the same impact on your ability to ramp that business.
The short answer is the insurance business is going just fine. We just renewed our -- this is the third year or beginning of the third year that we're able to sell A-rated paper. I know we've been talking about it forever. But, the reality we've been in the market with something that brokers could sell for going on this is the beginning of our third year. We've made the investment a little over a year ago and even starting to educate those brokers.
We needed to make sure that we had the right things to sell before we could do that. So really we've had a full suite of products that brokers could sell for less than a year. And in that, under 12-month time period, we've sold something to a company in every level of the risk spectrum, which is a really encouraging sign for us and for our partners at Lloyd's. And so we just need to keep doing what we're doing which is educating brokers and going out there and trying to sell as many of those things as we can and find catalyst to drive insurance clients in.
On the lower end of the risk spectrum and the earlier stage companies, that program has been successful and we're seeing, good momentum there as well and while the numbers are not a revenue mover for us right now. We think for the future of that business it's really, really important because we are able to get the next generation of companies to not look at the patent problem as a litigation problem, but rather as one that they could outsource to us and especially as we expand our services with things like the Inventus acquisition we're providing discovery services, that early connection with companies we think is going to be something that we can leverage significantly over the years to come.
Got it. Thank you.
Thank you. [Operator Instructions]
Okay, operator, we'll just move to closing remarks.
Thanks, everyone for joining the call and we look forward to talking to you next quarter.
And that goes conclude today's program. We like to thank for your participation. Have a wonderful day. And you may disconnect at any time.
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