With so much fear surrounding the PIPCO sector, now is the time to be greedy, says leading IP investor
Mark Argento is a founding partner of boutique investment bank Lake Street Capital Markets and one of the leading analysts of public IP companies (PIPCOs). The businesses he covers include Acacia Research, TiVo, Unwired Planet and Vringo. He recently spoke at our NPE2015 event and we decided to catch-up with Mark for a more in-depth interview on his views of the IP sector.
How did you come to cover the IP market?
I came to the IP industry focusing on the research side through my years as a sell-side analyst. I focused on digital media and other licensing-centric type businesses and companies like TiVo and Immersion, and others that ended up as very IP-rich organisations. I got more familiar with the idea of IP as an asset and started looking for companies that had business models that were focused on trying to monetise either their own internally developed or externally developed assets. I saw this nascent market start to develop in the late 2000s and kind of our first foray into the research space was with Acacia Research back in 2009 when it was still a $3 to $5 stock.
And now you still cover Acacia and TiVo and a few others?
Exactly – so we’ve expanded our coverage over the years. We’ve also had some of the smaller IP names under coverage but we’ve kind of backed away from that a little bit because there hasn’t been as much to do recently. We’ve realised that the key to success is to have a) a balance sheet and b) a diverse and high quality IP portfolio. We think ultimately, when the political and macro environment stabilises for IP and licensing companies, that the guys with the better IP and better balance sheets are the ones that are going to do well.
You mentioned the benefits that a company like Acacia gets from being the size it is – at what sort of size does it become interesting in terms of balance sheet or market cap?
Institutional investors can’t make an investment of more than 5% or 10% of a company because most, for charter or portfolio management reasons, don’t want to own a disproportionate amount of a company. So, by default, the real institutional money is going to be focused on some of the larger names.
The other thing I think is important when it comes to IP companies and licensing companies, is that because the revenues and the profitability are so lumpy you can easily get chewed up by carrying expenses that are too high. What we’ve really come to appreciate and believe is that the model that ultimately endures is a smaller core team, keeping operating expenses as variable and as low as possible. Ultimately when the profits and the payday come, you can share that with the team and the IP owners, but you have to create as much variability in that as possible.
There have been some guys who have tailored their newer business models – Marathon Patent Group would be a good example although that’s a company we don’t write on actively – and done a nice job in bringing in assets but also remaining fairly lean and mean. That’s key. We want to make sure that there is a return on invested capital in these businesses and that the return to shareholders doesn’t get chewed up by having higher fixed costs through the non-productive periods.
How have you seen investors’ views of this market change?
They’ve gotten incrementally smarter. Five years ago there weren’t the tools there are today to be able to look into a litigation environment or be able to look into IP; there wasn’t even Google patents. A lot of the stuff we use now didn’t exist. With tools, with more information and more being written on the space and more public companies out there making public disclosures, institutional investors have gotten a lot smarter.
Unfortunately what has happened in that period of time is the political and regulatory environment has become a lot choppier and created uncertainty; and uncertainty is not something that institutional investors appreciate and gravitate towards. So while the institutional investors have gotten smarter, a decent amount of them have pulled off to the side to wait for a little bit of resolution in the regulatory environment, including the America Invents Act, and also because of some of the recent Supreme Court rulings.
Do you have any sense how long that might last? The AIA obviously took many years to pass and now we have another piece of legislation emerging and that might take many years to pass, so does that mean investors stay away until that’s resolved?
No. It will take a while to truly appreciate how any legislation that is implemented impacts the industry, but I think investors have come to believe that focusing on the higher quality assets is going to be key. The focus of the legislation for the most part is on what I call the ambulance chaser, nuisance lawsuit IP guys which most investors have completely discounted. So I think that when anything is signed and it is not damaging that could be a kind of a catalytic event for the sector. Assuming that it’s fairly watered down and fairly standard, I think actually signing a Goodlatte Bill or something like that could be an incremental positive for the sector.
There are quite a few different models in the space – you have Acacia which licenses but doesn’t own much IP, Marathon which has a buy-and-build strategy and someone like Finjan which has developed its technology in-house – do you see one model as particularly well suited to the public markets?
Ultimately the things that public investors appreciate and gravitate towards are predictability and profitability, so investors will tend to favour companies that have more predictable licensing revenues – the InterDigitals of this world –and not those with more episodic revenue. With a model like Acacia’s, while you may not be booking running revenue licence deals, the portfolios monetise over time which, while not completely predictable, gives you more than your traditional one and done, lottery ticket type mentality.
The reality, though, has been that with some of the new legislation and some of the new rules, you get things knocked out, you have to re-file them and things get pushed out. Acacia’s Adaptix portfolio would be a perfect example - that’s been in the monetisation queue for three years and they ended up having to re-file on a few claims because they got knocked out. Things like that create the unpredictable nature of this business and leave it un-investable for a decent number of institutional investors.
What proportion of investors are the lottery ticket players who are looking for stocks that have a big case against an Apple or a Google or a Microsoft and are looking for the big damages awards and then profit on the upside?
I’d say a lot of people have learned their lessons. The big one for many years was obviously Virnetx. They never really grew their IP portfolio and had some success with the assets they have and then most of it was tossed. There’s always going to be the speculator, but institutional capital for the most part has realised that playing the lottery ticket is a little bit of a suckers’ game. While you’ll always get some guys who try to speculate and maybe use options and try to hedge out, for the most part true institutional investors are probably going to take positions in more diverse portfolios. I think after Vringo’s issues and, like I mentioned, Virnetx’s issues and even Pendrell, which had a pretty big case go against it, investors are leery that even if you do get a win that it could be easily overturned by the courts.
There has been some talk about consolidation in the market – we’ve seen one offer by Marathon for Spherix – do you expect to see consolidation among public IP companies and if so what might drive it?
I’d like to see consolidation of some of these assets. It’s really interesting when you talk to CEOs and operators of these companies; some want to see consolidation, but a lot of the guys who are the consolidators – the ones with the balance sheets or the capital – have their hands full with working and monetising their own portfolios. A lot of the other assets that are available through consolidation are more brain damaged than it’s worth and so, for the most part, nobody has been quick on the trigger. We’ve seen a little bit of low-ball trolling out there - Marathon threw in a less than aggressive bid – but it seems that the industry is a little bit paralysed right now and no one is in the mood to pay up for anything at this point.
Do you see that paralysis shifting in the next year?
That will be a function of the stock performance and hopefully getting a couple of real licensing deals to the tape. It’s the old Warren Buffet maxim – be fearful when others are greedy, be greedy when others are fearful – right now it could behoove some of these guys to be a little greedy when people are fearful. When does that switch? It could be six to 12 months depending, to a degree, on the legal calendar, but it’s going to be mostly driven by the equity values and the liquidity in the space.
What advice would you give to a PIPCO CEO?
I would say figure out how to substantially grow your asset base while at the same time mitigating your expenses. Put a syndicate together of best-in-class service providers – contingent attorneys, engineers, diligence teams – but keep your core costs as low as possible. Really focus on trying to drive a true return on invested capital. There are obviously smart guys in this space, but I don’t think many have thought about the true ROI that they’re getting or that they need to achieve for public shareholders. And then embrace technology and figure out other ways to monetise your IP above and beyond the high-friction, costly way that the industry is using today.
Where do you see the sector in five years?
I think a lot of the smaller guys will have gone away or some consolidation will have occurred. You’ll have a few best-in-class operators that are good capital allocators and have credibility to get licence deals done. The market will still be fairly opaque - I don’t think we’ll have these transparent, openly public markets that many have thought we’d have in this space. I still think it will be very much negotiated type licence deals. I do think you’ll see insurance and risk mitigation products start to proliferate – that could be a bigger market than the traditional licensing monetisation market that we see today.