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These 2 Stocks Are Royalty Machines

David Sterman

Forget what you may have heard: The United States has not lost its way as an industrial power. Although many have lamented the country’s multidecade shrinkage in the manufacturing sector, the most important pockets of product design and development are still taking place right here in the U.S.

How do we know this? A study by France-based INSEAD, a world-class business school, conducted a vast study on innovation and noted that although China is gaining ground, the United States is still home to the most innovative companies in the world. INSEAD used a variety of factors to come up with a numerical ranking, and only the United States received a score above 1,000.

The key takeaway: Don’t ignore companies that spend a large amount of money on research and development (R&D). 

To that point, analysts at Merrill Lynch studied three decades’ worth of data and found that "companies that spend on R&D … have generally created both short-term and long-term shareholder value."

"The U.S. spends more on R&D than China, Japan, South Korea and Taiwan combined, and more than the entire European continent," the analysts reported.

I’ll be looking at high R&D spenders in another column, but I want to take a closer look now at a group of companies that can certifiably profit from innovation. These firms own a trove of patents and can garner upfront licensing fees or ongoing royalty streams as their intellectual property is licensed by product development firms.

I reviewed the outlook for these patent-owning firms back in 2010, and as a basket they have performed reasonably well.

Virnet X Holding (VHC) is a poster child for the wild swings this industry has been through. Shares surged from around $6 when I profiled Virnet in 2010 to more than $40 in the summer of 2012 but have since fallen back below $20.

The company controls patents that help provide security when transmitting data over high-speed wireless telecom networks. High-profile legal wins against companies like Microsoft (MSFT) and Apple (AAPL) helped catapult this stock to fresh highs in 2012, but a more recent legal setback in a lawsuit with Cisco Systems (CSCO) has led investors to question whether the company will find any other patent licensees.

The fact that patent stocks often trade on legal outcomes represents the greatest challenge for investors. Virnet had never generated any meaningful sales until recently, although licensing revenue is expected to start rising at a fast pace in coming quarters: Analysts are targeting $40 million in sales this year and more than $125 million in 2014.

Still, the future of this stock will hinge on further licensing agreements, not on sales trends alone. Gilford Securities, which has a $65 price target, notes: "The key to maintaining investor confidence will be (Virnet’s) ability to establish legitimate licensing arrangements in the coming months/quarters. Assuming it is able to do so, (the recent Cisco legal decision) will not be viewed as material in due time."

Translation: Other tech firms are likely to avoid major legal tangles with Virnet, given that the company has already prevailed over Microsoft and Apple.

The mature patent play
While companies like Virnet scramble to establish the validity of their core patents through legal challenges, investors can opt for a safer path in this sector by focusing on patent plays that already generate robust sales and profit streams. Case in point: Acacia Research (ACTG), which controls 250 patent portfolios in a wide variety of industries. (A patent portfolio is set of patents typically targeting a particular type of product or protocol.)

Acacia has already signed up many licensees, which has helped revenue to rise at least 35% in each of the past four years to a recent $250 million. That figure should approach $350 million by 2014, according to analysts, yielding earnings per share of more than $2.50. In the context of Acacia’s profits, its shares appear reasonably priced at the current trading level of around $30.

Part of the charm of this business model is a focus on reinvestment in new patents. Acacia takes its profits and identifies fresh new patents to acquire. During the course of 2012, the company acquired 55 new patent portfolios, which should help to generate enough revenue to offset the loss of any expiring patents. Acacia signed up 138 new patent licensees in 2012, up from 125 in 2011, and judging by a recent string of press releases, the company appears set to sign up a similar number of new licensees this year.

Although Acacia has historically focused on the technology sector, "We see the potential for a major expansion of our business as we move into the medical technology, automotive and energy sectors," President Mike Vella noted in a recent call with analysts.

Risks to Consider: These stocks can slump sharply if key patents expire, which has been the case with Rambus (RMBS), a company once viewed as the top patent-controlling firm.

Action to Take -->
Patent players such as Virnet are quite speculative because they still face legal challenges. However, if these companies are successful on the legal front, their shares might zoom upward. Acacia Research looks like a steady player in this field, with a broad set of patents targeting a widening range of industries. Management has delivered solid growth in all of the company’s key metrics in recent years, and further solid gains appear to lie ahead.

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