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IP, Patent, RPX

Is Patent Aggregation A Good Investment For The Shareholder? Analyzing the RPX IPO

Continuing in my series of articles about the RPX IPO, I finally had some time to take a look at the audited financials, attached to the S-1. I was curious how a company that spent $250 Million to acquire patent assets while taking in just under $100 Million in subscription fees could be described as profitable.  I’ll preface my comments by noting that I am not an accountant, and I would welcome anyone else’s opinions about the scenarios discussed below.

What I did find, not surprisingly, is that RPX’s accounting methods contribute more to their illusion of profitability than their relative successes and failures in signing up new clients. As it turns out, if the question is whether RPX is profitable or not, the answer basically depends on what you mean by “costs.”

Diving into the numbers, RPX claims to have spent over $250 Million to acquire its 1500 or so patents and patent rights, from inception in 2008 through late last year.  Meanwhile, it’s audited financial statements show a total revenue of around $100 M over that same period.  In addition, RPX’s claimed profit in 2010 is about $10 M (through September 30). So how could RPX claim to have made $10 M last year when it hasn’t made enough in its lifetime to cover the original investment?

Amortization is the answer. RPX is amortizing the expenses associated with acquiring patent assets over the shorter of the patent’s useful or statutory life.  (Note: there really isn’t a distinction between the two. If a patent has outlived it’s statutory life, then it really isn’t very useful, is it?). It should be mentioned that amortization is nothing new, and there’s no reason (at this point) to think that RPX is doing anything wrong, or that PwC messed up its audit.  It’s very common to amortize the cost of acquiring patents, and RPX probably should amortize for a number of reasons.

In fact, the amortized patent expenses are accounted for as “Cost of revenues” on the financial statements, and were reported to be $30 M for 2010. Add in about another $5 M in miscellaneous expenses and taxes, and you get down to the $10 M of net income for the year (again, through September 30). To a simple mechanical engineer-turned lawyer, this type of discussion makes my head spin.  If I buy a stick of gum for $0.20, I recognize immediately that I now have $0.20 less than I did a moment ago, rather than recognizing that I’ll lose $0.01 per minute for the next 20 minutes.

Accounting for RPX’s patent purchases the same way, and assuming half of their subscription revenue goes to new acquisitions, they would need to add 25-30% per year just to start to recover that investment seven years from now.  Admittedly, this would basically account for RPX on a cash, rather than accrual basis, and is highly oversimplified. However, their current accounting practices are equally unreliable in the opposite direction.

In most ordinary businesses, transactions that consist of a huge up-front cost, followed by a multi-year useful life and a depreciating book value work out, over time.  The value of the patent on the balance sheet goes down as amortized expenses are accounted for each year, until the patent expires and becomes (in relative terms) worthless. But RPX isn’t an ordinary business. They’re not buying a fleet of airplanes that depreciate year-to-year with the knowledge that in any given year, they can sell that airplane on the secondary market and shut down operations.  The licenses granted to RPX members vest after (reportedly) a 2 year period of time, and become perpetual.

Using the airline analogy, this would be like telling your passengers that after 10 flights, they can fly anywhere in the world on any of their airplanes for free, and bind any future owners of that aircraft to the same promise. How many bidders do you think are lining up for the fleet at that point?

In reality, a much shorter amortization period is going to provide a much more accurate picture of RPX’s financial position.  If 100% of the relevant licensees obtain a vested, perpetual license within 2-4 years after RPX acquires the patent asset, then amortizing the cost over 15 years makes very little sense. However, suppose we assume that, on average, a patent in RPX’s hands lasts for 3 years until all relevant licensees are fully vested.  Under this model, RPX would still need to match the aggressive growth rate assumed above to start seeing a return on its patent investments 4 years from now.

As I’ve mentioned before, however, RPX will need to keep acquiring patents in order to maintain its existing clients beyond the vesting period. If RPX spends half of its annual subscription revenue just to retain its existing clients, then recovering its original investment is about as slow a process as the “cash” accounting option described above.  Nevertheless, by continuing to use a long amortization period, based on the statutory enforceable life of the patent, RPX can manipulate its financial statements to create the illusion of a substantial amount of future wealth that will, in all likelihood, never materialize.

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Discussion

10 thoughts on “Is Patent Aggregation A Good Investment For The Shareholder? Analyzing the RPX IPO

  1. You seem to be ignoring the revenue side, the actual revenues not the GAAP revenues. As of 12/31/10, RPX had over $80 million in collected deferred revenues that are not part of GAAP 2010 revenues. It works both ways, yes they amortize patent purchases for 24-60 months, however they also recognize collected subscription payments over the term of the subscription meaning they’ve more cash to work with than GAAP shows on the revenue side. RPX generally collects the annual subscription fee up front at the beginning of that clients term.

    you cannot ‘fake’ cash flows..Please look at page 51 of the most recent prospectus. On a real inflow/outflow monies basis, RPX was solidly cash flow positive in 2010.

    Yes, RPX will need to continue to acquire patents that is part of their business plan…as long as their clients feel they are getting a worthwhile deal/service, the business plan is sound on a cash flow basis. Time will tell on client retainment, but one can say that about any company.

    Cash flow wise since inception, RPX has done well. Not an illusion, they’ve been actual cash flow positive in each of 2009 and 2010.

    Posted by Bill | April 30, 2011, 5:32 pm

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