Acacia Research ( Nasdaq - ACTG ) -- Risk and Reward Increase

Acacia Research (ACTG $29.00) reported excellent on target Q4 results.  The company completed two large settlements in the period.  A string of smaller deals were signed, as well.  Revenues advanced 219% to $66.3 million.  Earnings topped our estimate, coming in at $.31 a share (fully taxed).  Margins expanded more than anticipated because few royalties were paid to Acacia's partners.  Most patents are jointly owned by the company and the original inventor.  In the past licensing proceeds usually were divided equally, after expenses were deducted.  Over the past year, though, Acacia has begun to frequently pay inventors some upfront cash in exchange for a higher percentage of any future payouts.  No money is paid to the partners until that upfront fee is recovered first.  A number of deals in the quarter reflected that arrangement, creating the appearance of higher margins.  An alternative accounting method would show those payments simply as a return of capital.  Acacia's method is the one used by GAAP accounting rules.

Spending on patent purchases surged in 2012.  Acacia spent $328.3 million to acquire intellectual property rights in 2012, compared to $14.7 million the year before.  Some of those purchases resulted in 100% ownership, eliminating the need to pay future royalties altogether.  The rest were partner deals where the inventor received upfront cash.  Under the old model risk was limited to the cost of prosecuting patent infringers.  The use of upfront payments heightens risk because that cash needs to be recouped before true profits can be realized.  The potential rewards are greater, as well, because once break even is achieved Acacia is in line to earn a higher percentage of the subsequent winnings.

Government regulation has become a factor.  Concern that technology companies have used patents to corner their markets led to the passage of the America Invents Act in 2010.  Compliance with those rules has raised the price of pursuing patent claims.  The U.S. Department of Justice also has begun hearings on the potential for using third party companies, like Acacia, to accomplish the same purpose.  Key patents could be licensed to an intermediary, shielding the original holder from liability while still enabling it to corner its market.  Acacia says the law is helping its business by knocking out less well capitalized competitors.  It also says the Justice Department's investigation probably has merit but doesn't directly affect any of the company's licensing programs.

Revenues and reported earnings are poised to advance sharply in 2013.  Acacia's growing inventory of patents is boosting its average revenue per settlement, particularly in the technology industry.  Margins are improving, too, because it's almost as easy to negotiate a 15 patent deal as it is for a single patent.  Legal expenses are falling, moreover, as more deals are settled instead of going to court.  With multiple patents available to work with, quantity discounts ("structured transactions") become more feasible.

But the court room remains an option.  On April 8, 2013 the company will square off with Apple Computer to enforce its smart phone patent portfolio.  Acacia already has won large settlements from several companies, most recently Nokia.  Based on valuations proposed by Apple itself during its recent court case with Samsung the potential payoff to Acacia and its partners could be several hundred million dollars.  Samsung is a licensee of Acacia's technology.  If Acacia prevails Apple no doubt will challenge the verdict and try to delay payment.

We estimate fully taxed 2013 income will rise 38% to $2.00 a share.  Revenues could advance 34% to $335 million.  Performance could vary considerably from those estimates.  New industries -- medical technology, energy, and automotive -- are being addressed.  Those patent portfolios are being built up currently.  They could yield significant leverage down the road.

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