Description

THE HOOK

The SOLM patent, US 5,067,932 granted in 1991, describes a combination of electric motors and planetary gears somewhat similar to the drivetrain in every Toyota hybrid. With Toyota on track to sell a million hybrids by 2010 it's easy to see why investors get excited by this story. Unfortunately for SOLM bagholders Toyota's system is based entirely on a TRW patent (3,732,751) that predates SOLM's patent by 18 years. SOLM's '932 patent differs from the TRW patent, but in all areas of difference it appears Toyota follows the TRW design and thus infringes on no part of SOLM's patent.

THE TRIAL

In September 2005 SOLM filed a patent lawsuit against Toyota in US District Court. In January 2006 SOLM filed a Section 337 complaint with the US International Trade Commission, seeking an injunction to exclude importation of the offending technology. The ITC offers a streamlined process and a cheaper and easier route to an injunction. The trial portion of the ITC action is complete and the Administrative Law Judge plans to issue his initial finding by January 18, 2007. The full Commission then has 45 days to reject, modify or confirm the finding. If appropriate the ITC will instruct the Customs Bureau to block all offending imports. The US District action has been stayed pending resolution of the ITC action and may or may not be resumed at a later date.

Toyota has a straightforward defense based on the TRW patent. The TRW patent describes a hybrid drivetrain in which an internal combustion engine drives a sun gear, a generator connects to the planet gear carrier and a traction motor connected to the ring gear drives the car's wheels. The patent language clearly allows minor variations on this theme, such as the engine/planet carrier and generator/sun gear version Toyota chose. The TRW patent discusses hybrid car features used by Toyota such as the battery pack and reduction gears. SOLM's patent does not even mention internal combustion engines or hybrid drivetrains. All claims cover designs with two electric inputs instead of one electric and one mechanical input as in Toyota's hybrid design. SOLM's patent emphasizes integral motor/gear arrangements and in-wheel motors, neither of which Toyota's design uses. Also note that SOLM's '932 patent fails to cite the TRW patent as prior art, an omission which dramatically weakens their claims in this case.

Toyota has taken no actions which indicate they see this case as a threat. They have not moved meaningful hybrid production into the US or discussed other contingency plans. Section 337 defendents often present redesigns during the initial proceedings so they can quickly resume importation should they lose the case. I cannot see that Toyota has done this, though it's remotely possible a redesign is contained in a confidential filing. Finally, Toyota rebuffed SOLM's numerous attempts to force mediated settlement negotiations during the trial. Toyota is clearly "going for broke" in this case, a tactic that makes no sense if they see any risk at all of losing.

SOLM PROMOTION

Management is not egregiously promotional, but I count nearly 100 Form 4 filings during 2006. Many are sales by Pinetree, a 16% owner who frequently participates in common and preferred offerings and related party lending. SOLM regularly issues new shares to cover everything from legal fees to preferred stock conversions and concessions from related party lenders. Common share count ballooned from 8.5 million to 33 million during the first nine months of 2006.

SOLM is promoted by penny stock touts and on message boards. I've seen two tout "teasers" describing a microcap with a patent that covers 80% of all hybrid cars (subscribe and we'll tell you this exciting company's name!). SOLM has a few active message boards (e.g. Raging Bull) which are highly bullish. For example, a message by a "patent attorney" claimed that before SOLM's patent all planetary gearsets had one gear (e.g. ring gear) fixed to the housing. Such ridiculous claims routinely go unchallenged. The vast majority of SOLM investors have no idea what they actually own.

SOLM recently bought a couple of small, profitless businesses and signed a $10m, 20%-ish APR credit line to fund future acquisitions so they'll have something to promote when their '932 patent case collapses. I don't see these activities as a threat to shorts.

RISKS

I am not a patent attorney. This investment thesis is based on my layman's understanding of Toyota's HSD design and the relevant patents. I'm very confident Toyota's core hybrid design is well-covered by TRW's prior art, but there may be some small implementation detail that falls in the domain of SOLM's '932 patent. I strongly advise that you do your own investigation and/or hire qualified counsel to review the case.

Judges are unpredictable. Even if my analysis is correct there's a chance the ALJ will rule in favor of SOLM. I advise investors to pay close attention from now until January 18. Should the ALJ ruling favor SOLM it will be imperative to exit immediately.

The stock may not crash even after an adverse ruling. ITC rulings are not binding -- if SOLM loses with the ITC they may restart the currently stayed US District Court case and take a second bite at the apple. I think they lack resources to pursue such a dead end, but I expect an announcement which downplays the ITC ruling and highlights their remaining legal options.

One of the businesses SOLM recently bought may strike gold. Or uranium.

Catalyst