Saturday, July 26, 2014

Acacia Research ( Nasdaq - ACTG ) -- For Whom the Bell Trolls

Acacia Research (ACTG $15.00) is a leading provider of patent enforcement services.  In its early years the company partnered with small patent owners to force infringing parties -- often large corporations -- to license their technologies.  Those gigantic companies often wore down the little guys with endless legal maneuvers and other tricks.  Acacia leveled the playing field with deep pockets of its own and the expertise to negotiate realistic transactions.  Acacia typically split any proceeds 50-50 with the patent owners.  Over the past three years Acacia has focused more on "marquee" technologies that offer the potential for substantially larger returns.  The company's strong suit still remains the cell phone and consumer electronics area.  But it also has moved into medical devices, automobiles, and energy technology.  Financial results experienced a decline during the transition process.  New portfolios ordinarily take a couple of years to prepare.  Those game plans now are moving into the execution phase.  Trial dates are approaching.  Negotiations are intensifying.  Secondary targets are being added to the list.  And the business climate is improving now that patent reform legislation has reached its conclusion in Washington.  The pace of settlements could accelerate over the next year and remain vibrant after that.  The size of those settlements probably will much larger than what Acacia was accustomed to in the past.  And new patent portfolios could be added on favorable terms as the legal climate normalizes and Acacia asserts a leadership role in the industry.

The company faced heavy political headwinds over the last few years.  The Obama Administration pursued several initiatives designed to eliminate the impact of so-called "patent trolls."  Congress passed a law of its own.  The intention was to prevent shakedown operators from extorting settlements.  Acacia's portfolios generally were and are of higher quality and actually deserved compensation.  But the environment encouraged most infringers to delay making deals in hopes the law would move in their favor.  Revenue declined as a result, exerting pressure on earnings.  Acacia had and still has ample financial resources to stay in the game and wait for the legal questions to be resolved.  A few months ago Congress essentially dropped the matter when the latest "patent reform" law was tabled without a vote.  Many of the largest technology companies in America put pressure on Congress because the proposed law would have made it difficult for them to protect their own intellectual property.  Since then the pace of negotiations has picked up.  The companies Acacia is pursuing have begun to realize the price will only go up if they fail to settle.  Congress isn't going to bail them out.  Acacia also is forcing the issue by driving those companies to court.  The company has nearly two dozen court dates scheduled by the end of 2015.  Those showdowns often lead to settlements.  And settlements usually set the stage for deals with other companies that are infringing the technology.

A cascade of large revenue deals could develop.  Several companies are charged with infringing multiple patents that Acacia controls, moreover.  Acacia has bundled patents in the past into so-called "structured transactions."  That approach might resurface, creating unusually large payouts.  Some of the amounts could be so large that Acacia might start putting infringers on the installment plan.  The company already has started testing out unit based royalty deals.  Up until now almost all the company's transactions have involved some form of a perpetual license and a one-off payment.  Cellular telephone deals in particular are possible candidates.  Neither side wants to pay too much or receive too little.  So payments might be structured to reflect the actual number of units sold.

More patent portfolios are being pursued.  Now that the political uncertainty has faded more companies are expressing interest in monetizing their intellectual property rights.  Acacia is well positioned to take on that business.  During the slowdown the company often had to make up-front cash payments to secure even 50-50 rights to top notch portfolios.  When money was collected Acacia would recoup that first, and then split any winnings.  Some outlays may still be required to secure especially attractive rights.  But the deal flow could move faster and be consummated on better terms.

Earnings remain impossible to predict.  But as Acacia's more recently acquired portfolios start to contribute the law of averages could make the forecasting process more realistic.  The addition of more patents could reinforce that trend.  Margins have become more challenging to estimate, as well, due to the upfront patent acquisition investments Acacia has and continues to make.  The company amortizes those outlays over an average period of five years, rather than tie the expense to money collected.  So the accounting expense is constant even though the corresponding revenue may bounce around.  Right now Acacia is amortizing several portfolios that aren't generating income.  That will change, hopefully.  But for now reported earnings are on the low side.

Most operating costs are fixed.  Contingent legal fees are variable.  The lawyers don't get paid unless they win.  Payments to the original patent owners are variable, too.  But administrative expense is fixed.  That item actually was reduced 15% last January.  So any material increase in revenue should drive pretax margins to superior levels.

We estimate revenue will improve to $300 million in 2015 to provide earnings of $1.15 a share.  In 2-3 years income could reach $1.75 a share on revenues of $400 million.  Acacia's existing patent inventory appears capable of supporting an even stronger showing.  New patent intake could lay the foundation for sustained above average growth well into the decade.


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Sunday, July 20, 2014

Health Insurance Innovations ( Nasdaq - HIIQ ) -- Expands its Platform

Health Insurance Innovations (HIIQ $12.75) is a leading provider of short term medical plans.  It provides ancillary products, as well, including hospital indemnity, pharmacy, vision, and dental insurance.  A growing percentage of customers bundle more than one plan.  The company works with several major carriers like ING, Cigna, Nationwide, and U.S. Fire.  Those companies provide the actual underwriting.  Health Insurance Innovation works with them to design the products.  Primarily, though, it acquires the customers through its own agents and an external network of more than 100 call centers.  A variety of marketing techniques drive business to those sites.  The short term policies offered by the company are significantly less expensive than comparable Obamacare plans (excluding subsidies).  They normally extend for 6-11 months, making them exempt from the new law's stipulations regarding pre-existing conditions and guaranteed issue.  For healthy individuals, they provide attractive coverage because the same services are provided and the price is much lower, often as much as 40%-50%.  In the past a lot of prospective customers were reluctant to buy short term medical plans because they couldn't be renewed automatically.  That's still the case.  But under the new law if a chronic disease is acquired an individual can switch to an Obamacare policy, ensuring treatment.  Most of Health Insurance Innovation's customers are young and healthy.  Fewer than 5% are prevented from renewing due to health factors.  Those people now can buy a guaranteed issue plan on an exchange, eliminating that small risk.  Business has accelerated during the first half of 2014 as a result.

A recent acquisition will broaden Health Insurance Innovations' potential market.  The company has been working with Health Pocket, the new unit, for the past six months.  Much of the acceleration in growth the company has enjoyed is due to that relationship.  Health Pocket offers a database for consumers that contains virtually every health insurance policy for sale in the United States.  An easy to use interface enables potential buyers to search by key variables including price, deductibles, doctors, disease coverage, and geography.  Once a prospect narrows down his choices a toll free number appears, directing him to an agent who can explain the details and determine the right deal.  A click to chat option is available, as well.  The percentage of callers who purchase is much greater compared to callers responding to banner ads and other general promotions.  Growth in new business has topped 100% at Health Insurance Innovations over the past two quarters, driven in part by Health Pocket's high quality sales leads.  That trend in the short term medical segment appears likely to continue.

The Health Pocket deal will open up the Medicare Advantage and Small Group segments, as well.  Health Pocket currently is diverting those leads to other companies, earning a small commission.  Health Insurance Innovations plans to steer them to its own agents and affiliated call centers, sharply raising revenue per policy.  Customers who are best served by Obamacare plans, due either to the likelihood of subsidies or other factors, will be directed to the appropriate exchange.  Those deals will generate a modest commission.  The Medicare Advantage and Small Group markets each are at least 500% larger than the short term medical segment.  Revenue could exceed the short term business in 2-3 years, perhaps sooner.  Margins promise to be similar.

Profitability is likely to widen as volume expands.  In-house agents and external call centers earn commissions on the business they close.  Those expenses are variable.  But Health Insurance Innovation's technology platform is highly scalable.  Those costs are likely to increase far less rapidly than sales.

Our 2014 estimates assume that consolidation expenses will temporarily impact profits.  Some non-recurring costs are inevitable as the two companies officially join forces.  Health Insurance Innovations already is spending heavily on sales and marketing.  Those efforts might be reorganized to put some weight behind the Medicare Advantage and Small Group initiatives.  But the total amount spent may not expand too much.  If they do, earnings may finish below our forecast of $.40 a share.  (Prior to the merger we had estimated income of $.55 a share on $80 million in sales.)

Next year sales could advance 67% to $150 million to provide income of $.95 a share.  New business may climb at an even faster pace.  Revenue is recognized on a month to month basis, though, so even if a mountain of policies is written the recognition of that business will be spread out.  Medicare Advantage and Small Group plans ordinarily renew at a higher rate than short term policies, creating the potential for additional leverage down the road.  In 2-3 years revenues could attain $250-$300 million to yield income of $2.05-$2.65 a share.  Applying a P/E multiple of 20x to the midpoint of that range suggests a target price of $47.00 a share, potential appreciation of 265% from the current quote.


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Wednesday, July 2, 2014

Northern Technologies International - Rust Never Sleeps

Northern Technologies International (Nasdaq: NTIC $20.45) is a leading provider of anti-corrosion technology and solutions. The company mixes its formula with plastic pellets to create plastic sheets, which can then be formed into bags of various sizes. Parts are placed into the bags to inhibit vapor corrosion. The chemicals inside the bags release gases that will settle on the parts, keeping them protected. Once the bag is opened, the chemicals will evaporate. The company also sells to oil and gas companies, both to preserve flanges on ocean rigs and to safeguard oil storage tanks.

Northern Technology initially sold its products to automobile manufacturers. The company's offering is an alternative to "dipping lines," a method where car parts were coated in grease to protect them from rusting during transit and storage. Dipping tanks take up space and also present fumigation and fire hazards. Also, dipped pieces have to be cleaned off before being put to use.

Corrosion costs companies around the world roughly $300 billion per year. Of that amount, losses in the oil and gas industry total about $126 billion. Northern Technologies currently generates 9-10% of its revenue in the oil and gas sector. The company expects this business to grow faster than its core business, based on increasing demand and not much in the way of direct competition.

Nothern Technologies has two primary opportunities when it comes to the oil and gas industry. The first is protecting flanges on off-shore oil rigs. These rigs have miles of pipes that are connected by these flanges. Left unprotected, flanges generally need to be replaced in a matter of months. Rust and corrosion can  prevent the flanges from opening or closing, and a malfunctioning flange can lead to disaster in the event of an emergency. Revenue from an oil rig depends on the size of the rig and the number of flanges that can be treated. Some flanges operate at a high temperature that would compromise the corrosion inhibitor. Northern Technologies  generates about $50 in revenue for each flange it treats. Larger oil rigs can have around 8,000 flanges.

The company also treats oil storage tanks. The crude oil that's stored in these tanks usually isn't in there alone -- significant amounts of sulfur, water, and other contaminants like to crash the party. The sulfur and water can combine into hydro-sulfuric acid, that is very damaging to the tanks. It can cost a company millions of dollars per day to take a tank out of commission for repair or replacement. The company charges $25,000 on average for a tank job, but it ranges from $10,000-$100,000 depending on the size of the container.

Nothern Technologies operates with a number of joint ventures. The business model is derived from the Coca-Cola system, so the company ships the "secret ingredient" -- in this case, the chemical additive -- to its partners, and lets them deploy it in projects worldwide. There is a basic understanding that Northern Technologies will provide ongoing technical support to its joint ventures, including R&D. The joint ventures are responsible for sales and marketing in their respective territories. Northern Technologies pays taxes in the countries its joint ventures operate in, and receives foreign tax credits in the US. It is responsible for any difference between the foreign rate and the US rate.

Price negotiation can be impacted by the customer's circumstances.
In 2004, one U.S. automaker learned the value of Nothern Technologies the hard way. The automaker decided to shift to a Chinese part supplier to cut costs. The problem was that this new supplier had very little experience in shipping these parts overseas and didn't take proper precautions. The parts passed through essentially every type of climate imaginable on the route from Northern China to Detroit. The parts were useless upon arrival, and the carmaker had to have new parts delivered via air freight to prevent production lines from shutting down. The automaker wound up losing billions of dollars that year. The company then hired Northern Technologies to work with the manufacturers in China and ensure the parts could be safely shipped by sea. In this case, Northern Technologies was able to negotiate a very favorable deal, because the automaker didn't have much of a choice.

Earnings per share have increased 58.8% since 2010, from $0.51 to $0.81 in 2013. We project earnings will finish 2014 at $1.05, and we have set a 2-3 target of $2.20-$2.80 per share. Applying a P/E ratio of 20 to the midpoint of that range suggests a target price of $50 per share, an appreciation of 145% over the current price. Revenues figure to be in the neighborhood of $28 million for 2014, per the company's guidance, a 24.4% increase over $22.5 million in 2013.

Eric Ramsley

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