Network-1 Technologies (NTIP) is one of the smallest corporations listed on the New York Stock Exchange. At a market-cap of $69 million, it is not going to be the next trillion-dollar company, but it can be an excellent investment opportunity for those who do a little research.
For some background, Network-1 Technologies is a holding company of tech-focused patents. The corporation purchases patents ranging from telecom to data networking and licenses them to other corporations. Due to companies refusing to pay for usage, Network-1 has many patent infringement cases going at any given time. Despite this being a nightmare for most, it is a way of survival for Network-1 which would be worthless without its patents. Or would it?
According to the most recent 10-Q, dated June 30, 2018, the company had $32,959,000 in cash. That’s over half of the assets and nearly half of the market cap. In addition to the large cash holdings, an additional $27 million is held between CDs, short-term bond funds, and corporate bonds. In other words, there are $60 million in assets which contribute nothing to the revenue stream. The total assets of the company lie at $62.7 million with only $2.4 million in liabilities (predominately income taxes payable). If you’re looking for downside protection, here it is.
The good news does not stop there. The board recently initiated a dividend which pays $0.05 per share semiannually effectively yielding 3.45%. This dividend is due to be paid through March 2020 when the Remote Power Patent expires. This patent has been the majority source of revenue for the company recently and thus its expiration could bring an end to the dividend if another substantial source of revenue has not been identified. That being said, the large cash holdings would provide an adequate base to pay dividends, since only a percentage of total cash is required for operations. Preserving the cash for further buybacks could be the plan however.
The ongoing repurchase program was authorized for $17 million and currently has $1.6 million remaining (10-Q Note J). So far, most of the shares purchased have been cancelled, but a significant number have been implemented into the stock-based compensation program which has led the executives and directors to hold 31.5% of the shares as of March 15, 2018. Management's ownership of the company has been between 30% and 33% since 2011, though the buybacks have made this number fluctuate. Since 2011, the share repurchasing program has purchased 7.6 million shares, though fully diluted shares over this period only decreased by 4.5 million due to the stock based compensation program. Over the years, the compensation program has offset a sizable portion of the purchased shares, but we should expect buybacks to continue to outpace dilution from compensation. Over the past 7 years, buybacks have averaged $1.94 million per year, with dilution from compensation at $1.6 million per year. The net effect of which are buybacks of roughly $0.34 million per year. With compensation and buybacks both heavily determined by licensing revenues, the two will move in step, with buybacks outpacing dilution.
Before I go into the valuation, a summary of recent litigation needs to be done to preface some of the income I will be referring to in my estimates. The Remote Power Patent, a majority source of revenue for Network-1, is a patent regarding the transmission of power over ethernet ports to power network devices. In November of 2017, a jury in Texas found that claims of the Remote Power Patent held by Network-1 were invalid and not infringed by Hewlett-Packard. As a result of this verdict, many of the company’s top licensees including Cisco, Dell, and Netgear ceased to pay royalties. The company disagreed with this judgment and a judge agreed to reverse the ruling on August 30, 2018. Now that the patent has been ruled as valid, many of the licensees who ceased payment are now obligated to pay missed royalties along with royalties until the patent expires in 2020. This was a monumental decision for Network-1, which saw 100% of its revenues in 2017 come from the licensees of this patent (10-K Page 17). For the purpose of my valuation I will only estimate the revenues as coming from the Remote Power Patent as no other patents are currently providing a materially significant source of revenue for the company.
As for a valuation, the normal metrics do Network-1 Technologies no justice. I would go as far as to say that P/E ratio is meaningless in this case due to the way the business operates. A better valuation method is a residual income model, because a residual income model represents most effectively how “the patent monetization cycle is long, costly and unpredictable" (Page 22).
To kick off the residual income model, we will start with the total stockholders’ equity as shown on the last 10-Q as $60,334,000. From here, the net income will be estimated for the next few years and from net income the equity charge (cost of equity per year) will be subtracted. The net income sans equity charge represents residual income and will be discounted for the future and then added to stockholders’ equity to arrive at final valuation.
Starting to estimate the revenues for the future, I decided to stop at the year ending 2020 to represent the expiration of the Remote Power Patent. While another portfolio of patents could very well be monetized by this time, it is safer to be conservative in valuing earnings. For the remainder of the life of the Remote Power Patent, I have projected the licensing revenues from Polycom, Cisco, Dell, Netgear, and the other smaller licensees as follows:
|Cisco||*Deferred to 2020||*Deferred to 2020||$15,900,000|
Polycom was required to pay three payments of $1,000,000 each in October of 2017, 2018, and 2019 for licensing the Remote Power Patent. The HP Jury-Verdict meant Polycom was no longer obligated to pay, but the recent validation of the patent means Polycom will be obligated to pay the final two payments in 2018 and 2019. (Note I)
Constituting 43% of revenues in 2017, licensing revenues from Cisco amounted to $7,073,930. If sales for devices covered under this patent remain constant, this 2017 level of licensing revenue from Cisco can be projected for 2018, 2019, and the first quarter of 2020. Despite the recent ruling validating the Remote Power Patent, the overturning of the HP Jury-Verdict does not necessarily obligate Cisco to pay. The terms of the Cisco licensing contract stated Cisco was not obligated to pay in the event of an "adverse ruling" (Page 24), which the HP Jury-Verdict was. Though the verdict was overturned, the court also denied Network-1's motion for a new trial on infringement, which would be needed to enforce payment from Cisco. Network-1 believes an arbitration ruling (Page 29) may be needed to force payment, which is why I have deferred licensing revenue from Cisco to 2020. By then I expect Network-1 to have successfully defended its patent, especially after the recent litigation validating it.
*Note: Cisco contributed to 43% of all licensing revenues in 2017 (Page 18), and 100% of all revenues came from licensing the Remote Power Patent (Page 17), so 43% of all revenues came from Cisco's licensing of the Remote Power Patent.
Dell & Netgear
Dell, Netgear, and Cisco together accounted for 69% of all revenue in 2017 (Page 16). Since Cisco was 43%, Dell and Netgear together made up 26% of the Network-1's revenue in 2017. No further breakdown is supplied, so splitting the ratio down the middle at 13% each will suffice. $2.14 million in licensing revenue came from Dell and Netgear each in 2017, so this will be my annual revenue estimate into through Q1 2020. These payments will be due in 2018, 2019, and 25% of a payment due in 2020 representing the expiration of the Remote Power Patent in the first quarter of the year.
My original projection was having a conservative 30% by revenue, or about half, of the licensees besides Cisco paying royalty payments after the validation of the Remote Power Patent. This resulted in an annual revenue from Remote Power Patent licensees of $4.9 million. Because the Dell and Netgear combined are $4.28 million, I comfortably project $620,000 from the remaining licensees on an annual basis through the first quarter of 2020.
Since we have available the first two quarters of 2018 documented already in 10-Q's, the remaining projections I have made for the year can be added to the revenue of $19.9 million for the first half of the year. This results in a total projected revenue for 2018 of $25.8 million. Revenue projected for 2019 and 2020 can be projected using the table provided above. Adding the values for each year results in estimates of $5.9 million in 2019 and $17.1 million in 2020.
To estimate net income per year, I have come up with an average profit margin of 34.43% based on total net income divided by total revenues for the period 2010-2017. Due to the variability in earnings from licensing deals, I decided it was best to base profit margin off of the totals over time versus the average of every year. Using this profit margin, the estimated net income for the years 2018, 2019, and 2020 are $8.9 million, $2 million, and $5.9 million respectively. After the equity charge of $3 million per year is subtracted and these residual incomes are discounted, the resulting value of Network-1 stands at $67,760,202. Per share this becomes $2.87.
NTIP shares have recently traded close to this number, so why would anyone buy shares? A few reasons. One reason is the calculations I made are extremely conservative. Another is that I have only included revenues from the Remote Power Patent, and only gone to 2020. Effectively what I have done is value the company assuming no revenues are brought in past 2020. The difficulty in an accurate estimate of revenues beyond the 2020 is that none of the other 60 patents currently held by Network-1 are generating meaningful income. As stated in the most recent 10-K, “There is generally a significant lag time between acquiring a patent portfolio and recognizing revenue from those patent assets” (Page 22). The closest thing to an estimate as to when the remaining patents will bring in revenue is a wild guess. That is why I did not feel comfortable including any revenues being realized after 2020. So, while the $2.87 seems low when shares have been trading within ~5% recently, one must remember that this figure represents exhausting the last bit of revenue from a single patent with no further revenues from the other 60 patents.
One could reasonably expect Network-1 to be able to monetize a significant portion of these remaining patents, so there is some upside potential. Though information is limited, the most promising patents appear to be in the M2M/IoT patent portfolio acquired in December 2017 (Page 4). Originally a portfolio of only 12 patents, the Machine-to-Machine/Internet of Things portfolio has grown to 18 over the course of 2018. These 18 patents relate to the authentication and the usage of embedded SIM cards in different mobile, machine to machine, and IoT applications. With IoT and mobile markets growing at exceptional rates, the acquisition of these patents appears to have been an intelligent investment. Security and identification of IoT devices has been a hot topic recently with many IoT devices lacking the same privacy features of more complex mobile devices. For a succinct article on the subject, I recommend this one from Cisco.
IoT devices lack the same sorts of security features that cell phones have, allowing hackers easy access to these devices. Perhaps one of the most unnerving instances of such was the lax security in Fiat-Chrysler's Uconnect infotainment system, where individuals were able to remotely control a Jeep on the highway. The growth of internet connected devices has outpaced the security for them, increasing the demand for the security measures contained in these patents. From the limited information in the Network-1 press releases, some of these patents include features such as 2-factor authentication as well as methods of communication between drones, automobiles, and other connected machines. As the market for connected devices continues to grow, eventual revenues from the M2M/IoT patent portfolio should be expected. For this reason, I see a lot of potential in Network-1.
Consideration of Risks
As much as it appears that Network-1 will continue to be able to grow, there are noteworthy risks. Litigation risk must be the greatest. With nearly all of Network-1’s revenues deriving from litigation, failure to protect and assert their patent assets would be disastrous. This includes failing to obtain a new trial on infringement against Cisco. In the event that Cisco is not required to pay for infringing the Remote Power Patent, the valuation would drastically change. For one, losing Cisco would most likely mean a discontinuation of the dividend (Page 18). Cisco also makes up 33% of projected earnings through 2020, so according my residual income model, the projected share price would drop from $2.87 to $2.66, a loss of about 7.3%. Investors should expect the share price to drop greater than 7.3% if this were the case, as the market sentiment regarding Network-1's ability to further protect its patent assets would be diminished. Other unfavorable rulings in ongoing litigation could mean lost revenues and would materially affect Network-1’s ability to continue paying dividends, monetize its remaining patents, and acquire new assets. By the end of 2023, the only remaining patents will be within the M2M/IoT portfolio if no acquisitions are made. An inability to monetize these patents in a timely manner could mean posting future losses, but this is 5 years in the future.
Another risk are the fixed operating costs, which are going to act as a drag on the business especially with much lower revenues. The largest fixed operating cost, general and administrative, has been roughly constant at $2.5 million annually the past 4 years, and so has professional fees and related costs (the cost of proceedings with the Patent and Trademark Office) at $2 million annually. Total, these fixed costs will be $4.5 million annually. With the reduction in revenues do to the HP Jury-Verdict, expect these fixed operating expenses to cause an even greater drag on the fair value of the shares. The remaining operating costs are all heavily dependent on licensing revenues. "Stock-based compensation" is dependent on income and share prices, while "costs of revenue" includes a royalty type compensation program for executives based on licensing deals (Note H, 10-K). Ultimately, it will be the fixed costs that pose a risk, as there could potentially be far less income to cover them in the future with the expiration of the Remote World Patent.
While I would like to see about half of the remaining cash, $15 million or so, spent on acquiring more patents, management is being cautious for the expiration of the Remote Power Patent. At the very least, shifting a significant portion not required for operations into higher yielding securities would stave off inflation. The past 4 years, Network-1 averaged $14.8 million in cash operating costs, far less than the $33 million cash position. While this number does not include buybacks or dividends, which should average a combined $4.5 million annually, it shows that $33 million in cash is not necessary for operations, and a larger proportion could be shifted to higher yielding securities. Hoarding so much cash is unproductive and will not aid Network-1 in realizing new revenues. Because of this, I would consider the current cash position detrimental to the timely realization of new revenue streams, though the current, high levels of cash do make individual shares of NTIP far less risky than patents which may not become monetized and expire worthless.
Overall, Network-1 Technologies represents an interesting investment opportunity. For one, there is significant downside protection with the combination of cash and short-term securities holdings. Management also has accumulated 31.5% of the shares, and the stock yields 3.45%. With the largest revenue stream due to expire in 2020, other patents are going to have to be monetized for Network-1 to survive. This can be an unpredictable and lengthy process, which is why investors need to be wary. Future earnings estimates are quite difficult for the company, but with the significant downside protection offered by the assets, as well as the patents which have not yet provided significant revenue, Network-1 shares provide a secure investment for those adhering to a buy and hold strategy.
Disclosure: I am/we are 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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