Crossroads Systems CRDS
July 17, 2006 - 6:22pm EST by
matt657
2006 2007
Price: 1.35 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 37 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Crossroads Systems, Inc. (OTCBB: CRDS) is a patent litigation play. It has a base case value of $1.20 and multibagger optionality. Based on recent and historical precedent, CRDS could have claims to 1%-2.5% of a $4bln annual revenue stream. Astute value investor Lloyd Miller III is the largest shareholder (13.7%) and has an observation seat on the Board. The company also has $80mln+ in Federal NOLs.

 

On June 28, 2006, CRDS announced that it had settled its patent infringement litigation vs. Dot Hill Systems (NASDAQ: HILL) for $10.5mln (representing past sales) plus a 2.5% go-forward royalty. We estimate applicable sales of approximately $100mln based on conversations with management. CRDS settled similar litigation in June 2001 with Pathlight Technology (since acquired by Advanced Digital Information Corp.) for $15mln. Besides HILL, the company has existing related licenses with HP, Hitachi, Pathlight Technology, Nexan, FalconStor and several other unnamed (confidential) companies. On July 5, 2006, in a conference call regarding its IP, CRDS disclosed another new agreement which has netted an additional $2.5mln - no other terms were disclosed.

 

Most of the action in what the company calls its “intellectual property campaign” is centered on their patent # 5,941,972 (‘972).

           

The ‘972 patent is the initial patent in the family describing “access controls.” CRDS asserts that its access control patents apply to any company manufacturing any Redundant Array of Independent Disks (RAID) with access controls or any Storage Area Network (SAN) devices that provide selective access among hosts in Fiber Channel and/or Small Computer System Interface (SCSI) SANs.

 

If for example, a SAN system can automatically restrict access to specific servers or switches, the supplier can expect a call from CRDS lawyers. Besides, CRDS has received multiple continuations of the ‘972 patent within the U.S. These continuations allow the company to broaden the ‘972 patent in terms of what the technology covers. In the lawsuit with HILL, the ‘972 and ‘035 continuation were the primary patents upheld.

 

Patent Strength:

 

CRDS has now had five precedent-setting events that have served to strengthen their patent portfolio.

 

(1) In September 2001, a jury found that the ‘972 patent was valid and that Chaparral had infringed. The found all of Chaparral’s RAID and router products infringed all claims of CRDS ‘972 patent. CRDS was awarded a 5% royalty on Chaparral’s router product line and 3% on its RAID product line.


(2) Chaparral subsequently appealed the decision and contended that the ‘972 patent is invalid and they did not infringe. In February 2003, the Federal Circuit of Appeals affirmed the lower court ruling that the patent was valid and willfully infringed by Chaparral. This was significant in that a higher court found their patents valid and reinforced the lower courts decision.

 

(3) Building upon this success, CRDS filed suit against Pathlight on April 14, 2000.  Pathlight settled the suit in June 2001 prior to a jury verdict for a $15mln lump sum cash payment. On an anecdotal level, Pathlight’s press release on the settlement admitted to both the validity of the CRDS patent and their infringement - this disclosure is very strange even for the guiltiest of infringers.

 

(4) On November 4, 2003 CRDS filed suit against Dot HILL. In 2004, a third party requested that CRDS ‘972 patent be re-examined by the U.S. Patent Office (USPTO). A re-examination essentially seeks to prove that the USPTO made a mistake in granting such a patent or that their current patent claims are not valid. The USPTO responded and confirmed CRDS ‘972 in full with no amendments to its patent claims. This is significant because the defendant would have to overcome the presumption that its patent is valid. With a clean re-exam, the hurdle is even bigger for any future defendants to overcome.

 

(5) The most recent validation came from their settlement with HILL on June 28, 2006.

 

Now, CRDS has multiple forms of leverage to use in seeking future licensing deals from obvious infringers such as IBM, LSI Logic (Engenio), Adaptec, and Xyratex amongst others. Not only can they point to material settlements, they had two different courts find their patents as valid and enforceable, as well as a successful re-examination that found their patent claims as indestructible.

 

Key Take-Aways from Discussions with Management:

           

We told management that we see applicable HILL revenue of $87-120mln; management said to shoot towards the lower end of the range - so we assume $100mln.

 

Management acknowledged that the applicable market size is $13bln, but due to existing relationships and licenses CRDS will only be pursuing about 1/3 of it focusing on the small and mid-size companies - so we assume $4bln.

 

Amicable licensing arrangements if compared to the HILL settlement (revenue size) would look like $4-5mln in back licensing one-time payments and 1% royalty rate on future sales. Future litigation settlements should look similar to HILL (2.5%).

 

So, back licensing seems to cover about 5 years assuming:

 

(1)     $100mln in applicable HILL revenue: $100mln x 2.5% x 5 = $12.50mln

(2)     $100mln x 1% x 5 years = $5mln

 

So on $4bln in revenue per year: 

Patent Market Size

$4,000,000,000

 

 

 

Back Licensing (yrs)

5

 

 

 

Forward Multiple (yrs)

5

 

 

 

 

 

 

 

 

Royalty Rate

Back Licensing Value

Forward Annual Royalty

 Forward Value (5yrs)

Total Potential Value

1%

$200,000,000

$40,000,000

$200,000,000

$400,000,000

2.5%

$500,000,000

$100,000,000

$500,000,000

$1,000,000,000

 

 

 

 

 

 
We don’t hope to convince you that CRDS is worth $1bln+ (but just for fun…. $1bln / 27.8mln shares = $36/share), but rather we want to attempt to add context to the optionality. We believe that the market is not properly pricing Crossroads’ patent enforcement potentials or NOLs. Using our base case valuation this optionality is currently being priced by the market at approximately $4mln.

 

Base Case Valuation:

 

At a stock price of $1.35, CRDS has a $37.6mln market cap on a fully diluted basis. Here’s is a breakdown of what you get for $37.6mln:
 
CRDS (Share Price)

$1.35

Shares Out (Fully Diluted)

27,859

Market Capitalization ($000s)

$37,610

Valuation Ex. Patent Portfolio

Low

Base

High

Net Cash

$19,064

$19,064

$19,064

Historical Business (1)

$6,946

$6,946

$13,876

TapeLabs (2)

$5,900

$5,900

$5,900

NexQL (3)

$0

$1,750

$3,500

NOLs (4)

$0

$0

$0

BIA

$0

$0

$0

Total Valuation ex. Patents

$31,910

$33,660

$42,340

Per Share Value

$1.15

$1.21

$1.52

 

 

 

 

Mkt Implied Patent Value

$5,700

$3,950

($4,730)

Per Share Value

$.20

$.14

($.17)

 

This shows that for about $4mln you are able to buy the Company’s significant patent portfolio that has achieved over $30mln in settlement/license revenues to date! Don’t forget, this valuation has ascribed no value to Dot Hill’s annual royalty revenue that is estimated at $2mln per year + all other potential licenses and royalty revenue as illustrated above.

 

Notes:

 

(1) CRDS provides customers with data routing products, primarily storage routers for storage area networks. For conservative purposes we value this business at a .4x multiple on $17.4mln in LTM sales. The storage device comp group trades at an average of over 1x on a price-to-sales basis and the lowest of all comps trades at .4x sales. Additionally, a recent M&A transaction involving Adaptec in the storage networking industry was completed at .42x sales (but based on conversations with industry analysts this is closer to .8x run rate sales). Although CRDS business is declining gradually, it’s operating at a profit and has developed significant relationships with industry heavyweights such as EMC, HP, Sun Microsystems & Quantum Corp. Historically, CRDS has traded at an average of 1.5x sales but due to the declining aspect of this business an upside case can be made at .8x run rate sales - which values the business at $14mln.

 

(2) CRDS acquired TapeLabs for approximately $5.9mln in April 2006. This price was 1x TapeLabs 2005 Sales of $5.9mln and 5x their 2005 net income of $1.2mln. With the TapeLabs acquisition, CRDS obtained a nice customer base to sell into, an experienced sales force, a virtual tape system that they would have had to develop internally and positive cash flow.

 

(3) CRDS owns 46% of NexQL, a private company, thru a $3.5mln investment. NexQL provides data management solutions that address the needs of real-time, complex, high volume analytical processing. Their technology massively accelerates real-time query runs of massive databases. NexQL is working on a U.S. government contract and is currently part of a government funded program to demo their products. Due to its historical operating losses I have give a 50% haircut to their total investment. This base case value is based in part by their potential for a significant government contract, four patents and significant development partnerships with Oracle, Boeing and Northrop Grumman amongst others.

 

(4) As of 10/31/04 CRDS had $82mln in NOLs. That number has since grown to the upper $80mln’s. We have ascribed no value to this but in the event of any significant income generating events such as additional settlements, licenses or successful business initiatives this would be “monetized” and worth up to $1.00/shr.

 

Business Information Assurance (BIA) – Storage and Security Converge:

 

CRDS is at the forefront of an emerging practice that seeks to formalize information/data security with a focus on maintaining proper access controls and delivery methods of such data. This practice has evolved with multiple data security mechanisms in conjunction with businesses increased attentiveness of such information’s value. A CRDS press release explains the grave need of BIA, “External hackers and authorized insiders pose a significant threat for corporations and government agencies that are under increasing regulatory requirements to safeguard sensitive client information. With high profile security breaches regularly making news, protecting critical database information is more challenging than ever.”  Since February 2005, the Privacy Rights Clearinghouse (a non-profit consumer information and advocacy group) reported that 52mln Americans have had their personal information jeopardized by information breaches. Such instances have not gone unnoticed by the industry. Three significant M&A transactions including EMC & RSA Security, Symantec & Veritas and Network Appliance & Decru all validate the needs to converge storage and security.

 

So the question is - how does CRDS fit into this emerging BIA world? Currently, business organizations across the globe are relying on embedded enterprise-wide security products. In most cases, these security products lack critical functionality and disrupt the network in terms of application and database performance. CRDS has developed a comprehensive independent solution that addresses the data security needs of governments and corporations alike. Their stand-alone database product is poised to serve a niche that has not been exploited yet by providing continuous database security without hampering the network functionality. Additionally, they have three software products that are set to be released this year that are all related to BIA. These products provide extensive security functions and related reports as well as advanced features to enhance the performance and management of data and its movement throughout an organization.

 

CRDS is very well known by its target market even with its mini-market cap. Their reputation alone can get them in the door and their balance sheet will provide comfort to any companies that seriously consider implementing their solutions. Thru their acquisition of TapeLabs they received an experienced sales force and are now expanding that for their new product releases. Per conversations with management, they should know if this venture is going to be a success by the end of the third quarter of their 2007 fiscal year. In the meantime, burn is estimated to be $1.5mln/qtr. Current management projections for revenue and cash flow in this segment for FY 2007 are $5 to $7mln and $-1mln to $1mln respectively.

 

Please note this is a Form 15 company. You can find their quarterly results on their website www.crossroads.com

Catalyst

1) Further License Agreements 2) Further Lawsuits 3) License Income 4) BIA Sales Announcements
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