by: Microcap Speculator

The Microcap Speculator submits: The IP licensing business is a couch potato's dream: buy or develop a bit of intellectual property, negotiate a few licenses, sue those who refuse to pony up, and watch the royalty checks come in.

Of course, its not nearly that easy. IP litigation is extremely expensive. The initial trials generally cost seven figures and are usually appealed. And its not just the legal fees. Each lawsuit runs the risk that the underlying patent could be invalidated.

Like it or not, IP licensing businesses are sprouting up everywhere. They seem to fall into two broad categories: evolutionary and blocking. The difference between the two categories is approach.

Evolutionary IP licensing companies approach existing manufacturers with concepts for improving their products by using the subject IP. Britain's ARM Holdings (ticker: ARMHY), which generates hundreds of millions of dollars annually licensing its RISC processor designs and digital libraries, is a good example of an evolutionary IP company.

Blocking companies, on the other hand, assert that their IP library blocks or covers existing products and try to get royalties from the product manufacturers. Rambus (ticker: RMBS) is probably the best example of this group.

Several months ago I began to research public IP licensing companies from an investment perspective, focusing on smallcap and microcap blocking-type companies. The best of these companies will have at least one broad patent that is likely infringed by major products of large companies (it makes no sense to spend a million dollars to bring a patent suit against a small company that will go belly up if forced to pay royalties). More importantly, they will have demonstrated a proven ability to generate license fees by both carrot (negotiation) and stick (lawsuits).

Here are the smallcap and microcap IP licensing companies currently on my radar. If I am missing any, please let me know.

Acacia Technology (ticker: ACTG): Acacia is best known as the owner/licensor of the "V chip" technology used in television parental control systems. Acacia owns over 140 patents grouped into 38 patent libraries covering areas including audio/video enhancement & synchronization, broadcast data retrieval, computer memory cache coherency, credit card fraud protection, database management, data encryption & product activation, digital media transmission, digital video production, etc. Acacia is in the process of spinning off its biotech subsidiary, Combimatrix, which will leave it as a pure IP licensing company. The IP licensing division generated roughly $5 million in revenues last quarter but was not profitable. However, with over $40M in cash on the balance sheet, Acacia is not struggling. Acacia has expanded its roster of licensees over the past year. Acacia has also been fairly successful enforcing its patents via litigation, although it stumbled a bit in December when a court ruling put its digital transmission patents in doubt. The chart is a bit extended here but I like Acacia. (ticker: BRST.PK):'s patents cover buffering techniques used in video and audio streaming. Following a nasty lawsuit, licensed these patents to Microsoft (ticker: MSFT) in March 2005 for $60M. The company then distributed the payout to shareholders via a special dividend (explaining the spike and drop on the left side of the chart). Recently, Burst's attempts to negotiate a patent with Apple fell apart, resulting in litigation. PBS columnist Robert X. Cringely notes:

"The reason Apple changed its MacWorld announcements at the last minute was because the company sued little a few days before, trying to invalidate the Burst patents. But since Apple sued Burst, Burst shares have gone UP by 30 percent. The market is rarely wrong. Suing Burst was an enormous mistake for Apple, casting a pall on their video strategy and potentially costing the company strategic alliances with networks and movie studios. Apple realizes this now and is struggling internally to find a way to change course and put a positive spin on the course correction. Apple will lose and Burst will win, and Apple won't be able to afford to wait for the courts to decide anything, since time is critical in staking out Internet video turf. I predict that Apple will eventually take a license from Burst, that is UNLESS SOME OTHER COMPANY (Google? Real? Yahoo?) doesn't snatch up Burst first."

The lawsuit against Apple will not be as easy as the Microsoft suit, but I think has a decent chance of prevailing.

Forgent Networks (ticker: FORG): Forgent owns the infamous Patent No. 4,698,672 covering JPEG compression. Over the years, Forgent has generated over $105 million licensing this patent. Forgent still has infringement litigation pending against 40 companies in the United States District Court for the Northern District of California related to the '672 patent. My guess is that Forgent will be able to get another $40-$50M out of the patent, but I don't like it as an investment. Forgent remains unprofitable, due largely to huge legal bills, and its main patent expires in October 2006. Forgent does have one other patent, but I don't think it is a blockbuster and doubt that it will support Forgent's current $76M market cap. Note: a paid analyst covers this stock and has reached a different conclusion.

Neomagic Corp. (ticker: NMGC): NeoMagic, which owns a broad suite of mobile TV technologies, has been on a tear lately. The company is a hybrid of the "blocking" and the evolutionary" models. It offers a complete mobile TV platform called NiMagic 6+. So far, NeoMagic has won one major license from Sony (ticker: SNE) worth $5.6M and a host of smaller licenses. As a result of the Sony license, NeoMagic was profitable last quarter. However, I think it is unlikely that NeoMagic will book a blockbuster license every quarter. Part of the problem is that NeoMagic does not carry a big stick. In its long history it has only brought one suit to enforce its patents, against Trident Microsystems (ticker: TRID), and it lost both at trial and on appeal. The bigger problem is NeoMagic's cost structure. Even though it outsources the licensing efforts to a third party (which takes a cut of the license fees), NeoMagic spent over $4M last quarter on SG & A and R & D. While I like NeoMagic's patents, I just don't see them yielding consistent profits.

Patriot Scientific (ticker: PTSC.OB): Together with a private company called TPL Group, Patriot Scientific jointly owns a patent portfolio relating to the design of advanced microprocessors, digital signal processors, embedded processors and system-on-chip devices. Intel (ticker: INTC) and AMD (ticker: AMD) licensed the portfolio last quarter, and the joint venture is now litigating infringement claims against Fuji (ticker: FUJIY), Toshiba, NEC (ticker: NIPNY) and Matsushita (ticker: MTU) in two lawsuits pending in the United States District Courts for the Northern District of California and the Eastern District of Texas. As a result of the Intel and AMD licenses, Patriot had record revenues (>$10M) and profits ($4M) last quarter. Patriot now sports a market cap just north of $30M but has almost $9M in cash and equivalents on the balance sheet. I like Patriot's chances in the pending litigation and think its patent portfolio could yield many more licensing opportunities.

Star Scientific (ticker: STSI):
Star Scientific is a one trick pony, but it could be a pretty big trick. Star owns a patent on a carcinogen-reducing method of curing tobacco. While it does produce some cigarettes and smokeless tobacco on its own, the future of this company is tied up in a large stakes patent infringement suit against RJR. Almost a year ago, the judge in that case oversaw a preliminary trial on RJR's defense of inequitable conduct. The litigation is now at a standstill while the parties await the court's ruling on the inequitable conduct trial and two RJR motions for summary judgment which are also pending. I am a bit surprised that the rulings have taken so long, but I don't think that indicates that the judge is leaning one way or the other. Here are my concerns: (1) even if Star Scientific prevails in the lawsuit, RJR will almost certainly appeal, so Star likely will not see a payout for years; (2) Star has funded itself with a series of dilutive financings which I expect will continue; (3) Star has bestowed some very generous contracts on its executives even though the performance in its operating business has not been impressive; and (4) Star is already fairly richly valued, with a market cap of $251M.

DISCLOSURE: I am long PTSC.OB. I have no position in any of the other companies mentioned above. Not a recommendation to buy or sell any security. For informational and educational purposes only.