Stocks I’m looking at: RPX Corp
I came across this idea from the Joel Greenblatt’s Magic Formula investing website. The website is a take off of the book he wrote, “The Little Book that beats the Market”. The website basically allows you to sign up for free and access a stock screen of the top 50 stocks based on the formula described in the book.
I’ve had some luck finding stocks from this screen in the past. Argan Inc (AGX) and Furiex Pharmaceuticals (FURX) are two stocks that I have done well on. The screen tends to dig up companies in obscure businesses that I would otherwise ignore. RPX Corp is no different.
RPX is in a business that I didn’t even know existed. In fact, I’m not even sure it did exist before RPX.
RPX buys patents. Then it sells memberships to companies that allow them to use the patents that RPX has in their portfolio.
Investing in patent rights in and by itself is not a new thing. But typically its been done by companies interested in making money off of litigation associated with enforcing their patent rights. This Forbes article, put out at the time of the RPX IPO, covered the topic of “patent trolls” as they are known, with some detail.
The business model that that RPX employs is a little different. They guarantee that they will not litigate using any of their patents. The business model is strictly one of selling subscriptions to companies to use the patents that they control. From the Q3 10-Q:
The Company’s clients pay an annual subscription fee and in return, receive a license from the Company to substantially all of its patent assets and access to its proprietary patent market intelligence and data.
I’ll get back to the business in a second but first let’s look at the numbers.
RPX Corp came up on the list because it meets the two criteria of the magic formula. It is trading at a low price to EBIT (its cheap) and it has high returns on capital (which usually suggests its in a good business with barriers to entry).
I took a look at the “cheapness” and in my opinion, while the company is not expensive, I think it’s a stretch to call it cheap. On a GAAP basis RPX Corp earned 15 cents per share in the 3rd quarter and 60 cents per share for the first 3 quarters. Within that 60 cent number are some one time earnings that probably should be ignored. Doing so would put recurring earnings at about 60 cents per share for the year.
I am surprised that these numbers would land RPX Corp at the top of the magic formula list. Its worth noting that earnings look a lot better if you go with the company’s non-GAAP methodology, of which the primary difference is to remove stock options. Doing so leads to earnings of $0.19 for the quarter and $0.69 over the 9 months. This puts the price to earnings closer to 10x. But I was no aware that the magic formula ignored stock options.
Where RPX Corp moves up the charts with the Magic Formula criteria is with return on capital. Below is the quarterly return on capital (less net cash on the balance sheet) at RPX since the IPO.
While the raw numbers at RPX show some promise, I am still trying to get comfortable with the RPX Corp business model.
When you listen to RPX management give a presentation, you will hear them talk about how their business opportunity lies in the transaction costs associated with patent litigation. There are two costs associated with a patent litigation; there is the cost associated with the patent user paying the patent holder for use of the patent, and there is the legal cost associated with getting the fee paid, either through negotiations or a trial. It is by minimizing the legal, or transaction costs, that RPX can add value.
RPX acts as a middle man between the patent user and the original holder of the patent. And while they may be able to negotiate a better deal for patent users if they are representing a number of them and create some value that way, the majority of the value they create, and the essence of their profitability, is the ability to facilitate the transaction between the holder and user of the patent for a cost that is substantially less than the legal costs that would be incurred otherwise.
The business model that RPX has used to realize this value since the IPO is, in my opinion, flawed. The company charges clients for membership that allows them to use the patents RPX Corp holds. But at the same time RPX states that they will not use those patents to initiate their own litigation.
This creates a problem with free-loading. If a client has no fear of litigation, why purchase a membership? To some extent this gets mitigated as RPX purchases patents based on its existing client needs. But its still a limiting factor as it provides no incentive for a new client to sign up if the patent they are concerned with is already held by RPX.
What the company needs is a sustainable business model as a benign middle man without eliminating the threat of litigation that justifies their existence in the first place.
RPX Corp seems to be aware of this. They have begun to lease patents, rather than buying them outright. There are two positive outcomes of leasing as opposed to buying. First, the company that owns the patent can litigate against non-member companies, which provides incentive for non-members to become members. Second, members have to renew their membership to remain protected under the RPX umbrella.
The second obstacle that the company faces is that they have to prove to prospective clients that the value they are adding (in reduced legal fees) are greater than the cost of membership. I could see this being difficult, but the best evidence that the company has been successful is that they are growing their client base with consistency.
The company is also expanding their business into insurance against patent litigation. While they didn’t provide a lot of details on this but they said they had signed up a few companies in the 3rd quarter and expected more to sign up in the fourth quarter. They also explained that the insurance business was an additional product available to members, and not a standalone product open to anyone.
Again from the 10-Q:
During the three months ended September 30, 2012, we also began underwriting patent infringement liability insurance policies. For the three and nine months ended September 30, 2012, the effect of the insurance policies that have been issued have not been material to our results of operations or financial condition.
So there appears to be promise on the growth front, at least on paper. But what I struggle with is knowing how much more opportunity there is to grow out there, as well as how good are the company’s patent assets. The basic problem is that I do not have the expertise to understand the RPX patent portfolio or the specifics of the patent industry, and unlike a lot of industries where there is data readily available to figure it out, with the patent business it seems pretty opaque; even details on the RPX patent portfolio are few.
I did buy a small position in the stock last week. Because I like the potential I see, but just can’t quantify the chance that the potential plays out, I plan to keep it that way for now.
Thank you for the analysis. I did the exact same thing a couple months ago: I found RPXC using the Magic Formula Screen, did some reading, and initiated a small position. I sold shortly after their Q3 earnings call.
In addition to the issues you mentioned, I am concerned that there is no meaningful catalyst in sight. Unless either (a) there is a major spike in subscribers, or (b) the insurance business takes off, I’m not sure what would cause the market to begin appreciating RPXC more. RPXC already counts as subscribers many of the biggest targets for NPEs, and they provided limited guidance into expected new subscriptions. So I don’t think (a) works. Regarding (b), I think (agree?) that it’s hard to establish whether RPXC will be able to make the product appear compelling to smaller companies. NPE litigation has obviously grown quickly, but I don’t know how smaller companies typically calculate the risk of being targeted (nor what portion of that risk would be mitigated via subscription).
I always find your analysis extremely thorough and insightful, so I look forward to any further RPXC posts (or other posts, for that matter).
agreed. Seems like a shot in the dark to me. They could come out with a great quarter next quarter and show strong subscriber growth but it seems like I am just guessing whether that will happen or not. Maybe if I was a patent lawyer I could get more insight but I’m not. So I sold for now.
Ditto, that I stumbled across this in the same way, albeit a year later as it is still on the MF screen as of Dec 2013. I was actually attracted to it, and I quite liked your analysis that it’s not particularly cheap. From what I understand, the MF screen is relative ….that is stocks may not be absolutely cheap but are cheap relative to others.