Internet Patents Corporation (NASDAQ: PTNT) is a microcap shell company with assets consisting of over $29.5 million in cash and short-term investments, as well as a series of seven patents and two patent applications relating to a variety of technologies in e-commerce, graphical user interface (GUI) development, and automated underwriting and generation of insurance rate quotations.

Background and balance sheet

Founded in 1995 and formerly operating as Insweb (an online insurance marketplace and portal), the company invested heavily in development of its ecommerce platform, and in the process filed patents on several interface and web technologies which it retains to this day.

At the peak of the internet bubble the company once traded for over $200 per split-adjusted share. Following continued losses after the bubble’s collapse, the company sold its online business to Bankrate Inc (NYSE:RATE) at the end of 2011, and has subsequently focused on conserving cash while attempting to monetize the value of its intellectual property and NOL tax assets through targeted litigation against allegedly infringing companies.

As a result of past losses and R&D expenditures, PTNT has federal and state net operating loss tax carryforwards of approximately $142.9 million and $64.4 million respectively. The recent carrying value of deferred tax assets is approximately $49.5 million (before considering an additional $10.2 million in carryforwards relating to past stock option expense), which has been entirely excluded from the balance sheet under a valuation reserve. Although the value of these NOLs would appear unlikely to be realized given the company’s lack of operating profits, they could provide a very sizable tax shelter in the event of a favorable outcome of the patent litigation currently in progress results in a cash settlement and potential licensing revenue from other related firms.

With almost $30 million in cash and equivalents and $854k in total liabilities, PTNT’s current market cap of $23 million near $3.05 per share represents a 25% discount to its net cash alone, while attributing zero value to its NOL tax assets and to any future potential licensing income or patent infringement damages resulting from its intellectual property portfolio.

Intellectual property monetization

The firm’s patents begin to expire in 2019 through 2025, and cover a variety of ecommerce, insurance, and interface display technologies and methods fully described in the recent 10-K: http://www.sec.gov/Archives/edgar/data/1077370/000143774914002782/ptnt20131231_10k.htm

The company’s patents appear to be broadly defined; and many were developed and filed relatively early in the commercialization of the Internet, adding to chances that at least some will be upheld as novel and non-obvious at the time of their filing. Although the likely monetizable value of these patents is difficult to determine, a single settlement could potentially provide a very material cash inflow relative to the current market cap (and current negative enterprise value).

During 2012, IPC filed patent infringement lawsuits against six companies alleged to infringe its patents relating to event logging and the use of dynamic tabs in a graphical user interface (GUI). The U.S. Patent and Trademark Office granted the defendants’ petition for re-examination of the Event Log patent, and the relevant lawsuits are currently stayed pending this procedure. After a lower court ruled PTNT’s Dynamic Tabs patent was invalid in September 2013, the company initiated an appeal in January of this year.

The outcome of each of these cases appear highly uncertain, but could create an extreme degree of positive upside optionality if any of the firm’s broadly-defined patents on ecommerce, interface, and insurance company are successfully upheld and prosecuted. Success in a single such lawsuit could potentially generate an ongoing stream of licensing revenue from multiple internet and software companies wanting to avoid the potentially much greater expense of an infringement action. Importantly, any such revenue would come at very low cost to the company and would be sheltered by its sizable NOLs.

Management, cash burn and incentives

PTNT’s CEO owns a total of 1.9 million shares or 25% of the common stock, which theoretically should align management with shareholder interests, particularly given the potential for very high returns if the company is able to realize additional value from its substantial tax assets. PTNT has only 3 employees and very limited operations, but management compensation totals $300k for the CEO, $220k for the General Counsel, and $128k for the CFO. Cash burn has averaged approximately $0.5 million per quarter, principally consisting of legal expenses from ongoing patent litigation and enforcement lawsuits. PTNT did pay a special cash dividend of $5 per share in 2012, indicating a real willingness to return cash to shareholders that hopefully may soon be rekindled by the activist efforts further detailed below.

Potential activism

Affiliates of activist hedge fund firm Osmium Capital own 1.1 million shares or 14.4%, although their recently filed Form 13-G indicates no immediate plans for activism. Interestingly, the controversial billionaire Dr. Phillip Frost owns 500,000 PTNT shares or 6.45% of the company: http://www.sec.gov/Archives/edgar/data/1077370/000114420414032795/v379407_sc13g.htm , and Barry Honig owns 688,000 shares or 8.9%. Honig recently penned a lengthy open letter to PTNT CEO Hussein Enan making the case for a return of capital to shareholders, as included in a recent 13-D filing: http://www.sec.gov/Archives/edgar/data/1077370/000141588914001435/ex99-1.htm

As Honig’s 13-D points out, PTNT is the only patent licensing firm trading at a discount to EV; returning $24 million to shareholders would result in an immediate cash distribution of $3.09 per PTNT share, while keeping over $4 million cash in the corporate treasury which should be more than sufficient to ride out current legal appeals and patent examinations. If such a return of capital takes place, investors could effectively receive tax-free return-of-capital cash distributions in excess of the current market price, while retaining a free call option on the outcome of ongoing litigation, with the potential value of a successful outcome greatly magnified by the extremely large deferred tax assets at PTNT.

Although the case for a return of capital is certainly straightforward, the simultaneous involvement of Frost and Honig adds an additional layer of complexity. While having had undeniable success as Chairman of Teva Pharmaceuticals (NYSE:TEVA) and in past transactions selling Key Pharmaceuticals and Ivax Corporation for remarkable gains, Frost has also been involved in a series of more promotional deals facilitated by his control of Ladenburg Thalmann (NYSE:LTS), often acting together with Barry Honig, whose involvement here is unlikely to be coincidental.

Whatever his motivations, Dr. Frost is certainly not unsophisticated or naive. Considering the blocks controlled by Frost and Honig in addition to Osmium Capital, a potential activist effort would have a strong chance of succeeding, particularly as the high net cash value of the CEO’s shares relative to his current salary make a return of capital favorable for management as well as outside shareholders.

Frost-controlled entities such as recurrent VIC bugbear Opko Health (NYSE:OPK) have frustrated short-sellers by taking advantage of sustained rich valuations through secondary offerings and acquisitions. While any direct takeover of PTNT could cause NOLs to expire, a differently structured transaction such as a direct purchase of intellectual property assets by a separate entity could be another potential route toward enabling some of PTNT’s substantial NOLs to be realized.

Conclusion

In comparison to BKF Capital (BKFG), PTNT is considerably less straightforward as a value investment in a discounted cash shell, due to its ongoing cash burn for legal expenses and the fact that PTNT’s ability to successfully monetize its patent portfolio has yet to be demonstrated. However, the magnitude of its NOL tax assets could potentially create extreme upside optionality for shareholders in the event of positive legal rulings or licensing agreements involving any of its intellectual property assets. With PTNT’s net cash alone creating a decent margin of safety, the recent 13-D filing by an activist shareholder could create a potential catalyst for a significant return of capital in the intermediate term, while leaving shareholders with substantial upside in the event of a successful legal outcome. In the current market environment where deep value stocks remain few and far between, I have been accumulating PTNT shares below net cash value as an attractive addition to a diversified value portfolio.

Continued pressure by activist shareholder forces tender offer or special dividend

Asymmetric upside potential from IP monetization sheltered by substantial NOL tax assets