Description

Introduction

The team at our family office tries to approach investing with a balanced mindset.  In contrast to larger capital allocators that often get caught in the institutional imperative, we take pride in the flexibility of our thinking and our pursuit to remain creative and open minded in our investment process. 

By striving to see things from varying perspectives, we tend to fish where others might choose not to; this way, our opportunity set is kept fresh and varied. 

Our flexible approach doesn’t mean we don’t rely on a solid foundation of time-tested principles – after all, we consider ourselves value investors, wanting to buy a dollar for fifty cents with a margin of safety embedded in our assumptions about the quality of a business, its valuation and possible risks.  However, we are careful not to confuse discipline with dogma and strongly believe in the evolution of markets and our need to understand what changes and what stays the same. 

By keeping our views of the world dynamic, we feel we can learn, adapt and seek out value in unique places.  For example, our perpetual time frame is a clear advantage and luxury in this market.  We are willing to make investments without catalysts and where the bulk of value comes from the tail end of a stream of cashflows.

In our allocation across asset classes, we spend a significant amount of our time evaluating other money managers that possess the track record and expertise to put our capital to work alongside theirs.

Evaluating other investors isn’t a simple task and, not unlike investing in stocks, it is as much art as it is science.  Our process has helped us appreciate the variety of philosophies, styles and approaches that can ultimately lead to good risk-adjusted-returns.  Whether it is timber, annuities, venture capital or frontier market stocks we tend to look for certain common elements in the teams we entrust our capital with.

The above background is a longwinded introduction to one such asset manager that we like in a very unique asset class that we think has lots of potential.  I present to you Acacia Research Group (ACTG).

Background

Acacia Research Corporation (ACTG) is an industry leader in patent licensing.  In a nutshell, its business model consists of partnering with inventors and patent owners (universities, research labs, corporations, VCs…) to package a portfolio of patents that in turn get licensed to corporate users.  ACTG usually will strike a revenue 50/50 revenue share agreement. 

As of April 2013, ACTG has generated approximately $936 million in licensing revenue.  Through its subsidiaries the company controls over 275 patent portfolios (29% CAGR), covering technologies used across a wide variety of industries (semiconductor, wireless, automotive, medical, energy, and dozens more…).

Acacia has closed 1,200+ licensing agreements covering 154 technologies and been to trial only 4 times in 10 years (something to keep in mind for discussion below).

ACTG’s TTM revenue of $250 MM is still in early stages of revenue potential for existing portfolio base – which represents ~39% CAGR over six year time-frame. In simple terms, the business is driven by portfolio growth, which leads to revenue-producing licensing programs (that hold dozens of patents and agreements), which then turn into licensing revenue.

Intellectual property (IP) is an important asset class worldwide.  It is a central component of innovation, and is at the heart of our knowledge driven economy – which represents a growing piece of the total pie. 

Intellectual Property: center of innovation and value creation in world economy

• A patent is a temporary legal monopoly protected by US constitution and issued by the United States Patent and Trademark Office (USPTO).
• Licensing in US has grown to a $500 billion industry in last 30 years
• Criteria for patent: has to be “useful, novel and non-obvious”
• Controversy: the patent system has been abused by “patent-trolls” who use aggressive tactics to assert frivolous claims (more on this later)

The ability to monetize and market IP, however, has become increasingly difficult for patent holders without a licensing partner.  With a sole focus on this market Acacia has become the dominant player in the partnering / licensing model.

By scaling and expanding licensing programs of existing assets to more licensees, the company continues to generate cash that helps fund its growth in acquiring more partnership programs.

No shortage of controversy; Legal Overview

ACTG isn’t only misunderstood; like a tobacco company, it is essentially universally hated and vilified.  Labeled by many a “patent troll” -- Acacia is ceaselessly attacked by politicians, the media and by corporations who view it as a cancer for innovation.

Here is a good opinion piece that provides some context on the – who is a patent troll? – question:  http://b.globe.com/11BQc0v

Indirectly, Acacia has become a poster child for everything that is wrong with the legal system and – together with other so-called patent-trolls – have come to represent the increasing bureaucracy and legal risks of engaging in entrepreneurship and innovation.

The truth, however, as the op-ed piece suggests is so much more complicated than the political rhetoric would have you believe.  Yes, the legal system is broken and sweeping tort reform is desperately needed.  Yes, some law firms and scam artists abuse the threat of litigation to sue and extort through frivolous claims.  Yes, these people indirectly tax the whole business / entrepreneurship / innovation ecosystem.

When it comes to patent infringement, in many cases firms are unaware they’ve violated someone else’s property rights, and thus are very surprised when a claim is made against them.  In the process, they become a defacto victim themselves - given there was never any intent of wrongdoing.  However, does that mean if someone unknowingly, yet unlawfully, makes use of your property you should just look the other way? 

In our opinion, prior knowledge or not, the point is moot.  The essential most basic component of our capitalistic society, and arguably the most critical aspect of the west’s prosperity, is the ownership of property and the contracts and legal rights attached to it.  A robust legal system to enforce these rights, despite the bureaucracy and unwanted externalities it might create, is absolutely necessary and does more good than harm.

I didn’t go to law school, by no means am I a legal expert, and like most people, I am appalled to read about obscene hourly legal fees / legal costs incurred to enforce some pretty absurd and silly cases.  But having grown up in a country where corruption is rampant and rights of all kind are arbitrarily violated, I have come to appreciate the US justice system and its contribution to the vitality and dynamism of its economy. 

O.K. enough of the rant.  Can the legal system be more efficient?  Yes.  Should the government strive to reform it?  Yes.  Can reform squash the rights of lawful owners to enforce their property right?  Absolutely not.

Should patent trolls worry about the Shield Act, Patent Act and America Invents Act?  Certainly, but if you look at the provisions being proposed closely it is pretty clear that Acacia will be largely unaffected. 

Paul Ryan, the CEO, has actually said that the most recent “executive actions” by Obama are a net positive for Acacia.  The truth is Acacia is tired of having its reputation tarnished and would favor reform that puts a stop to the frivolous lawsuits.

Curbing abusive tactics that target downstream mom-and-pop end users by enforcing overly broad and low-quality patents, that are arguably worthless, has to be stopped.  Shakedowns and extortion through the legal system is too prevalent.  It is worth noting that Acacia views itself to be in the transaction business not the litigation business.  Here is an interesting quote from Ryan:

“The patent market has been extremely inefficient, and over time with any new asset class there will be a variety of business formats that rationalize the process that make the markets more efficient. Historically, the only way you can get paid for a patent, and pretty much 99% the way it is today, is you have to resort to the legal system in order to transact. You'd literally have to sue another company or they generally will not talk to you. And if you talk them inappropriately, they can countersue you. They can file a declaratory judgment against you for just offering a license.  So the structure of the market place really requires a lot of enforcement. Fortunately, we're far enough down the road, we've done so many deals that we have legal arrangements with a lot of leading companies where both sides preserve their legal right and can enter into arms length of discussions without litigation. And we think we'll be moving more and more in that direction, which is great for our shareholders and great for our IP partners because it lessens the friction cost of all the lawyering, improves our margins.”  - Paul Ryan, CEO of Acacia 

This write-up is an extension of a power point presentation I recently worked on for a group of investors.  Please reference it here: https://www.dropbox.com/s/olgdp1z5k6x0jrq/Acacia%20Research%20Presentation.pdf

Investment thesis

The basic premise of the thesis is that ACTG is an attractive play on the growth of IP as an asset class -- by investing in a specialized IP asset management firm with the technical / engineering / legal expertise to essentially buy, sell and make a market in an large and growing, but still pretty inefficient market.

The business model is quite attractive – scalable, capital-light and high-return/margin -- and has a number of similar characteristics to that of a traditional asset manager.  Essentially, growth in AUM – in the form of patent portfolios – is the key leading indicator to future revenue growth and margin expansion as scale is achieved.

Of course, the key driver to driving portfolio growth is human capital.  Acacia employs 55 people in Newport, CA and about 30 of them are IP investment professionals who have the backgrounds, the industry contacts and possess the skills to shop around and underwrite a portfolio of patents in their respective verticals.  These “analysts” (official position titles are usually VP’s of Engineering) provide the basis, fundamentals and thesis of say, a patent portfolio of automotive airbag / sensor technologies or virtualization software used in cloud computing, and then evaluate the potential for enforcement and commercialization with business development, licensing and legal experts at the firm’s headquarters.

In conversations we’ve had with management and a few of their VP’s it’s clear that their due-diligence and decision making process is very much focused on generating attractive risk-adjusted-returns.  They aren’t looking for home runs, instead focused on singles and doubles.  They use words like NPV, IRRs, time and risk-adjusted returns.... Everybody involved is pretty aligned as incentive compensation is linked to incoming deals and performance in addition to the stock-heavy compensation structure.  Upper management also seems to think the stock is a bargain buying up stock in the open market (insiders own ~3%). 

Their track record and approach to underwriting IP investments is quite impressive.  Here is a slide from the presentation that I think is worth highlighting:

• They think like asset managers with an ROI mindset
• Not looking for home-runs; mainly singles and doubles
• Better information, brokers and market makers are emerging creating efficiencies in market. 
• Acacia seeks portfolios that will provide predictable licensing revenues over uncertain litigation – which can be costly, time-consuming and incredibly unpredictable
• Look to deploy capital, ink-deals and approach settlements taking into account timing of monetization / cashflows and magnitude (build DCF’s for portfolios)
• IRR and NPV focused
• Eat risk-adjusted returns

A unique feature of their business model is the variety of ways they can structure a deal with a potential IP partner.  Please check out the PowerPoint for a complete overview.  Here are some points that describe the basic sales-proposition to IP owners:

• ACTG provides a turn-key solution and acts like a proxy for patent authors and large companies to execute licensing agreements through subsidiaries without fear of IP counter-suits
• It enables the monetization of non-core assets while avoiding the marketing / legal complexity of enforcement and marketing
• Comprehensive licensing agreements are becoming increasingly attractive for big firms like Qualcomm or General Electric.  This represents a multibillion-dollar opportunity for Acacia.

By partnering with legal firms on a contingency basis and structuring revenue share agreements with both small and large firms they essentially own free / or very cheap options on portfolios that can generate potentially hundreds of millions of dollars without much up-front investment.  It is worth noting that because of these minority / shared interests ACTG’s balance sheet doesn’t reflect a lot of the IP they own.

More recently, however, as ACTG has gained scale the full outright purchase of entire portfolios has also proven to be a great source of profitable returns.

In addition to approaching valuation by looking at multiples on our expectations for revenues and earnings in the next few years (see presentation); we also can approach it by using a SOTP of sorts, and estimating and the potential revenues for monetized IP, un-monetized IP and new IP. 

Using past performance, monetization time-frames / and trends as a guide we can get a ballpark idea of the revenue potential, GM profits and required opex and capital needed to get them there.  Note: the new IP essentially is a proxy for a terminal value estimate since it is value we believe will be created through future deal-making; however to be conservative we don’t capitalize it indefinitely (offset by discounting it fewer years).  Some difficulty arises in estimating the timing of the CF’s since the business model is clearly lumpy.  Nevertheless we discounted the entire cashflows on a weighted basis to arrive at our PT of $38 for 2013.  This is essentially a DCF looking out 4 years out taken to the present. 

Thesis Overview & Summary

• Contrarian idea with good risk/reward: investment isn’t for everyone…headlines will create volatility. Risk of persecution from government can’t be dismissed
• Capital light; high ROIC business w plenty of runway to reinvest in profitable growth (optionality upside)
• Cheap with very strong growth potential
• Strong balance sheet with >25% of mkt cap in cash
• Operating leverage in an asset class and market that is growing
• No direct competition; structural advantages over fragmented one / two man legal shops
• Eat their own cooking: management wins when shareholders win
• Stock Price: $22.00; Market Cap ~$1100 MM
• $327 MM in cash ($6.67 per share); no debt
• EV of ~$800 MM
• 5.8x on 2013 EBITDA; 4.0x on 2014 EBITDA
• Cash EPS >> GAAP EPS; 2013 cash EPS of $2.25 (excludes amortization & non-cash comp)
• Run-rate is $2.25+ next 3 years and $3.00 to $4.00 in next 5 yrs.
• Strong secular dynamics that benefit IP generators / owners / partnerships.  Acacia offers a go-to-market partnership structure that can help assess value, pursue growth opportunities and monetize assets
• 60% of IP is severely underutilized.  These are perishable assets that need to be farmed out by small companies, individual inventors, universities and research labs
• Opportunity set has extended to large corporations that view Acacia as a resource to execute their licensing IP business. 

Catalyst