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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