Pendrell Corporation (PCO-$2.34)                                                       

Description and Investment Thesis.  Pendrell Corporation (formerly known as ICO Global Communications or ICO) is an undervalued stock with a number of hidden assets, a cheap call option, significant upside potential and an imminent catalyst.   ICO was founded in 1995 with the vision of building a next-generation satellite constellation network, providing voice and data communications services to maritime, aeronautical, terrestrial and government customers. 

While the operating story did not playout according to plan (as discussed below), the company emerged from its unsuccessful venture with three valuable assets:  (1) a $603 million civil verdict against Boeing, which is valued at roughly $774 million (as of 3/31/12); (2) a $3 billion NOL, a reminder of the substantial losses endured through the satellite venture; and (3) $325 million in cash ($238 million after the recent acquisition of ContentGuard), resulting from Dish Network’s acquisition of ICO’s wireless spectrum assets from bankrupt subsidiary DBSD. 

I regard PCO as a compelling investment, with 93% upside to my base case scenario (60% probability) target valuation.  Under the bear case scenario (20% probability), I still estimate 32% upside.  Only under the worst case scenario (to which I ascribe a 20% probability) do I see meaningful downside risk of 26%. 

Base.   $4.52

Bear.   $3.08

Worst. $1.74

Moreover, shareholder interests are highly aligned with management.  A material portion of management incentive compensation is tied to a successful legal outcome by virtue of stock price vesting thresholds that are triggered at $4.50 and $6 per share, respectively.  The company is run by Ben Wolff, long-time deputy of wireless pioneer Craig McCaw.  

While legal outcomes are notoriously difficult to predict, PCO has already won the jury trial against Boeing (in 2008).  We are now approaching the very end of the Appellate Court process, with oral arguments having taken place on January 25th and the three-judge Appellate panel having 90 days from the completion of oral arguments to render a verdict.  Accordingly, the Appellate Court will deliver its verdict no later than April 24, 2012.  We expect this event to be the key catalyst for the stock. 

Boeing Trial Background. ICO began in the early 1990s as a R&D development project, funded by Inmarsat, which was (and still is) the leader in satellite communications to the maritime industry at the time.  In 1995, ICO was formed as a separate company to build and launch a next-generation satellite constellation network, providing voice and data communications services to maritime, aeronautical, terrestrial and government customers. 

In 2005, ICO contracted with Hughes Space & Communications (Hughes) to build 12 satellites and manage the launch of its satellite system.  ICO was to pay $1.47 billion for the satellite construction contract and another $950 million for the launch management services contract.  The satellite launches were contracted by Hughes to an independent company, McDonnell Douglas (MD), which was to launch the satellites using its Delta III rockets.  Hughes purchased 11 Delta III rockets from MD, keeping six for its own inventory and selling five to ICO.  ICO paid Hughes $246.6 million for the rockets and $1.5 billion for the satellite manufacturing contract.

Boeing acquired MD in 1997, renaming the division Boeing Launch Services (BLS.)  The first two Delta III rockets (and their accompany satellites) launched by BLS blew up in 1998 and 1999, respectively.  Hughes sought a refund for itself from BLS and had initially sought the same for ICO.  However, according to ICO's Opening Brief in the Appeals Court trial (March 22, 2010), Hughes' position waivered in  late 1999.  And in January 2000, Boeing acquired Hughes, renaming Hughes as Boeing Satellite Services Inc. (BSSI).  A conspiracy theorist would question the timing of the transaction and suggest that the Hughes acquisition was in part motivated by Boeing's desire to reduce the potential for legal liability and substantial write-offs associated with the repeated failings of the Delta III rockets. 

At this point, ICO was out of pocket more than $1.7 billion and now reliant upon Boeing subsidiary BSSI to negotiate on its behalf with sister Boeing subsidiary BLS for the recovery of its launch deposits.  That deposit capital was desperately needed as ICO was running out of cash and going through bankruptcy at the time. 

After several years of failed negotiations with BSSI, during which ICO was unable to fully recover its launch deposit nor successfully negotiate completion of the little remaining work to be done on its satellites, ICO delivered a Demand for Arbitration to BSSI.  BSSI filed suit against ICO and ICO cross-complained.  Four years of litigation ensued, during which ICO uncovered what it regarded as substantial damaging evidence against BSSI, including internal emails, documents, etc.    

Boeing Trial Award

The jury trial began in June 2008 and lasted for three months.  After five weeks of deliberations, the jury delivered a $741 million verdict in favor of ICO Global Communications against BSSI and its parent Boeing.  The trial court judge modified the award, upholding six of the jury's seven verdicts, resulting in a final judgment in the amount of $603 million.  This verdict represented the largest civil judgment award in California in 2008.  The award grows annually with simple interest at 10% (beginning as of January 2, 2009).   Accordingly, at year-end 2011, the Boeing receivable had reached $784 million and by March 31, 2012 the award should reach $798 million. 

The components of the award are as follows

$370,642,000        Compensatory damages

•         $279,000,000 against BSSI for Breach of the Satellite Contract

•         $91,642,000 jointly against BSSI for Delta III Fraud  and Boeing for Tortious Interference with the Launch Contract                          

$206,600,614        Punitive damages

•         $29,514,372 against BSSI for Delta III Fraud

•         $177,086,242 against Boeing for Tortious Interference  with the Launch Contract                          

$25,984,744          Prejudgment interest

•         $5,579,974 against BSSI for Breach of the Satellite Contract

•         $20,404,770 against Boeing for Tortious Interference with the Launch Contract  (for which BSSI is jointly liable for $9,455,415 for Delta III fraud)

$603,227,358        Total

(Source Pendrell Corporation)

Appellate Court Process and Expected Outcome

The California Court of Appeals (Second Appellate District, Division Eight) received opening briefs from Boeing in December 2009 and a respondent Brief from ICO in March of 2010.  Closing arguments, the final step before the ruling, took place on January 25, 2012.  The three judge panel has up to 90 days to render a verdict in the case, suggesting that there will be a ruling by no later than April 24th, 2012.

While predicting an outcome in a legal case is challenging at best, we take some comfort from the fact that there are several components of the award.  In that regard, we believe it is highly likely that ICO at least recovers the compensatory damages for Breach of the Satellite Contract (valued by the trial court at $279 million.)

• In our bear case scenario, we assume a recovery of the $279 million + simple interest for 3+ years. 

• Our upside scenario simply assumes that the Trial Court's full verdict of $603 million is upheld. 

• In the worst case outcome, we assume the Appellate Court chooses to only award the remaining balance on the satellite launch deposit that is to be repaid, which is estimated at $96 million + interest.

In the event that PCO is successful in the Appellate Court, Boeing could appeal to the California Supreme Court.  However, we believe that it is unlikely that the Court would take on a case where Boeing was found guilty of fraud and that fraud verdict was upheld at the Appellate Court. 

Management Team and Incentive Compensation Structure

ICO is led by Ben Wolff, who most recently served as CEO of Clearwire.  Mr. Wolff served as Board member of PCO for several years and, on December 31, 2009, he became interim CEO and PCO Chairman, replacing Craig McCaw.  He was later named permanent CEO.  We have spoken to Mr. Wolff on several occasions and believe that he is keenly aware of the importance of safeguarding the company's capital, should the company be successful in the Appellate trial.

In July 2011, Mr. Wolff and the company's Chief Strategy Officer resigned from Eagle River to focus on Pendrell full time.  This development was, in part, triggered by a $325 million cash infusion into PCO from DISH's purchase of DBSD (previously controlled by PCO).  Pendrell made three other senior hires in July, including: Chief Scientist, Corporate Counsel and Chief People Officer.  This is indicative of management's plan to grow the business.  The company does not plan to distribute its cash balances.  Instead, it plans to make selective acquisitions that take advantage of the company's substantial tax loss carryforward position.

Mr. Wolff is heavily motivated to increase the per share value of PCO common stock.  Mr. Wolff was previously granted 2 million shares of restricted stock and 2 million options (struck at $1.16.)  The "old" restricted shares vest according to the following framework: (1) 25% vest upon a favorable outcome in the Boeing litigation; (2) 25% vest upon a successful transaction which unlocks the value of the company's NOLs; and (3) 50% vest over four equal annual installments.

In July, 2011, Wolff and PCO's CSO both received additional grants of restricted shares and options.  Wolff received an additional 900k shares of restricted stock and 900k options.  The options are set above the current share price and vest over 4 years.  The restricted stock has the following vesting triggers:

(1) 25% upon PCO trailing 12-month net income reaching $50 million

(2) 25% upon PCO trailing 12-month net income reaching $100 million

(3) 25% upon PCO's share price closing at $4.50 or higher for any 20 consecutive trading day period

(4) 25% upon PCO's share price closing at $6 or higher for any 20 consecutive trading day period

The CSO has a similar long-term compensation plan, as do the three recent hires.  I believe the plan is indicative of management's confidence in the trial outcome and in its ability to create long-term shareholder value.

ContentGuard - A Cheap Call Option?

In October 2011, Pendrell acquired a 90.1 percent equity interest in ContentGuard for $90.1 million from Microsoft and Technicolor.  Time Warner will continue on as a minority partner with Pendrell.

ContentGuard is an inventor, developer and licensor of digital rights management (DRM).  The company owns of a portfolio of 260 issued patents and has another 160 pending patent applications worldwide.  Pendrell CEO Ben Wolff believes that ContentGuard’s DRM technologies are being used in “…virtually every instance where content is transferred to a connected device – from mobile phones to tablets, set top boxes, e-readers, game consoles, DVD players, personal computer and televisions."

Currently, 50 percent of all global handsets have licensed ContentGuard’s IP.  The company’s licensees include LG Electronics, Microsoft Corporation, Nokia, Panasonic, Sharp, Sony, Sony Ericsson, Toshiba, Casio, Hitachi, Technicolor, Time Warner, and Xerox Corporation. 

For perspective on the potential market opportunity, Microsoft alone paid ContentGuard competitor InterTrust $400 million to settle a three-year DRM dispute in 2004.   Pendrell believes ContentGuard’s portfolio is as robust as InterTrust’s.

PCO management believes that its expertise in the wireless industry combined with the depth of IP knowledge obtained from its acquisition of patent advisory firm Ovidian Group (June 2011) will allow PCO to substantially improve the monetization of ContenGuard’s IP portfolio.

Management has suggested that fair value of ContentGuard could easily be a multiple of PCO's purchase price.

Valuation - Sum of the Parts

We value PCO using a sum of the parts approach, with base case, bear case and worst case valuations.  The valuation is composed of several pieces.

The Boeing judgment.  In our bear case scenario, we only assign value to the breach of the satellite contract award ($279 million + simple interest at 10% annually.)  In the base case outcome, we assume the Trial Court judgment is upheld in full at $603 million + simple interest.  In the worst case scenario, we assume the company only recaptures the amount of the satellite launch deposit that has not been repaid, estimated at $96 million, plus interest. 

Notably, PCO’s legal counsel participates in the upside of a positive trial outcome.  The first $250 million are subject to a 3% incentive fee.  Beyond $250 million, the incentive fee ratchets up to 5%.  These parameters suggest a valuation range for the Boeing judgment (as of March 31, 2012) ranging from $123 million to 

$774 million.

Tax loss carryforwards.  Pendrell will soon have NOLs estimated at $2.95 billion.  $2.6 billion of NOLs will be triggered upon DISH exercising its option to purchase the MEO satellites.  If that option is not exercised, the NOLs will be released following the decommissioning of PCO's in-orbit MEO satellite.  At this point, the satellites could be sold for $1, triggering the NOLs.  This should play out by June 30th, if not before. 

In our analysis, we take the $2.95 billion gross balance of the NOLs and adjust for the $325 million in proceeds from DISH Network.  That balance is further reduced by the portion of the Boeing net award that is taxable.  We assume a 40% effective tax rate on the NOLs, suggesting $900 million to $1.1 billion of undiscounted future tax benefits in our three scenarios.  In our worst case scenario, we assign zero value to the company's $1.1 billion of undiscounted tax benefits.  For the bear case and base case scenarios, we assume a 15% utilization factor (15% of the actual tax savings).    

ContentGuard.  We value ContentGuard in all scenarios at its purchase price of $90.1 million.  We are hopeful that management will be successful in unlocking substantially more value from this asset over time.   On February 27, 2012, the company  filed a patent infringement suit against ZTE - the first time that ContentGuard has sued anyone.  Notably, the company has filed in the US District Court for the Eastern District of Virginia.  This is a very well respected court and speaks to the company's confidence in winning this case. 

Cash.  Gross cash balances, including the $10 million remaining portion of the Dish receivable, as of September 30, 2011 stood at $238 million.  We assume no cash burn from operations, as ContentGuard should generate enough cash to fund operations.  We ignore debt balances, which stand at $15 million, representing capital leases that are associated with the residual satellite assets.  This liability is non-recourse to the parent.  In our base case scenario, we also include $54 million in option proceeds and the associated 14.7 million shares of additional dilution, based on weighted average exercise price of $3.68.

Risks

Capital allocation.   PCO has more than 35% of its current market cap in cash and this balance is likely to grow substantially in the event of a successful legal outcome against Boeing.

Litigation outcomes are unpredictable.

PCO has already won a jury trial against Boeing (in 2008).  We are now approaching the very end of the Appellate Court process, with oral arguments having taken place on January 25th and the three-judge Appellate panel having 90 days from the completion of oral arguments to render a verdict.  Accordingly, the Appellate Court will deliver its verdict no later than April 24, 2012.  Our scenario analysis values the Boeing award, net of legal fees, between $0.47 and $2.82 per share, respectively.