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WiLan: Could Q4's Profits Be The Start Of A Turnaround?

Feb. 6, 2014 7:02 PM ET | by: Jim Mullin

Disclosure: I am long WILN, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

WiLan's (WILN) price significantly declined as a result of a negative outcome in their lawsuit against Apple (AAPL). Months later, WiLan's share price has yet to recover from the outcome of that trial. The company has a strong balance sheet, but earnings have been impaired by high litigation expenses. Q4 2013 saw WiLan turn a profit amid a major drop in litigation expenses. Results from subsequent quarters will be critical to evaluating whether or not WiLan has turned the corner towards long term profitability.

Overview

-Company Information

WiLan is an intellectual property licensing company headquartered in Ottawa, Canada. Currently, WiLan's portfolio includes over 4000 patents. They initially produced and licensed proprietary products in the wireless networking space. In 2006, after years of developing their own patents, WiLan branched out and began acquiring patents developed by others. WiLan would then license these patents to customers. WiLan also has a partnership program, Gladios IP, which allows patent owners to monetize their IP without selling the rights to it.

Once WiLan decided to focus on purchasing and monetizing patents, the company began growing at a precipitous rate. After beginning with only a handful of patents, WiLan now owns over 4000. In 2006, WiLan's market capitalization was around $25 Million. Even at the current low prices, the company sports a market cap of roughly $375 Million. Between 2006 and 2012, revenue increased 4400% from just under $2 Million to $88 Million.

WiLan typically uses litigation as a last resort when dealing with the infringement of their patents. They much prefer to negotiate a licensing agreement with the infringing party so that legal costs can be avoided. However, some companies refuse to pay licensing fees to WiLan and, as a result, WiLan must take the matter to court. Recently, WiLan has lost two well publicized lawsuits. As seen on the chart below, their most recent loss in October drove the share price down to $3. WiLan has continued to expand its patent portfolio and licensing agreements, but courtroom losses and mounting litigation fees have driven down the company's share price.

4th Quarter, WiLan had 131.9 Million in cash and cash equivalents. With a market cap of around $375 Million, cash comprises over 33% of WiLan's market cap. However, it should be noted that their cash balance has been continuously declining over the past several quarters. This large cash position has been integral in allowing WiLan to continue to acquire patents and return money to shareholders even through the losses they sustained over the past two years. To return money to shareholders, WiLan buys back shares and pays significant dividend. WiLan began paying a dividend in 2009 and the dividend has grown significantly since then. WiLan's dividend yield currently stands at 4.6%. This strong balance sheet will enable WiLan to weather the choppy earnings they are exposed as a result of litigation expenses and their sometimes irregular revenue.

WiLan's income statement is beginning to show signs of a turnaround. Revenue was down 12% to $59.0 Million for the first nine months of 2013. However, revenues for Q4 2013 came in at $29.2 Million. This gives WiLan total revenues of $88.2 Million in 2013 compared to $87.96 Million in 2012. In their guidance for Q1 2014, management believes WiLan will bring in at least $22.6 Million in revenue. While this may seem low, it is important to note that this amount does not take into account any future licenses that may be signed later in the quarter. Any agreements reached in the next two months would only add to this amount of revenue. Management has previously stated that earnings can vary significantly from quarter to quarter and year to year depending on the type of royalty arrangement in place. Further, due to the nature of licensing negotiations, there will not always be a steady increase in revenues.

Since they rely on long term licensing agreements, WiLan has sizable amount of future revenues already locked in. At the end of Q3 2013, management estimated the value of their order backlog to be between $325 and $350 Million. This backlog consists of estimates of revenue that have yet to be recorded from signed licensing agreements. This backlog serves as a base assumption for WiLan's future revenue in a worst case scenario. Most of the backlogged revenues are expected to be collected over the next four fiscal years. However, some of these contracts extend up to seven years into the future. WiLan's backlog is a valuable yet often overlooked part of the company.

WiLan's net income has also been problematic over the last two years. In Q4 2013, WiLan reported income of $2.43 Million on a GAAP basis. On a per share basis, this becomes a gain of $.02. In Q3, Q2 and Q1 of 2013, WiLan recorded losses of $.05 per share, $.06 per share and $.05 per share respectively. These recent losses are largely the result of increased litigation expenses. A graph of WiLan's earnings over the past few years can be found below. Management believes that adjusted earnings are a better indicator of the company's performance. For Q4 2013, WiLan generated $17.2 Million in adjusted earnings, or $.14 per share. This can be partially explained by a dramatic decline in litigation expenses. This compares favorably to Q3, Q2 and Q1 of 2013 where WiLan broke even, recorded a loss of $.01 per share and recorded a gain of $.01 per share respectively. The success seen in Q4 2013 seems likely to carry over into 2014 as management has guided for adjusted earnings between $10.6 Million and $12.6 Million. Investors should monitor WiLan's subsequent income statements to see whether this profitability continues.

-Financial Condition

WiLan's balance sheet shows strength. At the end of the 4th Quarter, WiLan had 131.9 Million in cash and cash equivalents. With a market cap of around $375 Million, cash comprises over 33% of WiLan's market cap. However, it should be noted that their cash balance has been continuously declining over the past several quarters. This large cash position has been integral in allowing WiLan to continue to acquire patents and return money to shareholders even through the losses they sustained over the past two years. To return money to shareholders, WiLan buys back shares and pays significant dividend. WiLan began paying a dividend in 2009 and the dividend has grown significantly since then. WiLan's dividend yield currently stands at 4.6%. This strong balance sheet will enable WiLan to weather the choppy earnings they are exposed as a result of litigation expenses and their sometimes irregular revenue.

WiLan's income statement is beginning to show signs of a turnaround. Revenue was down 12% to $59.0 Million for the first nine months of 2013. However, revenues for Q4 2013 came in at $29.2 Million. This gives WiLan total revenues of $88.2 Million in 2013 compared to $87.96 Million in 2012. In their guidance for Q1 2014, management believes WiLan will bring in at least $22.6 Million in revenue. While this may seem low, it is important to note that this amount does not take into account any future licenses that may be signed later in the quarter. Any agreements reached in the next two months would only add to this amount of revenue. Management has previously stated that earnings can vary significantly from quarter to quarter and year to year depending on the type of royalty arrangement in place. Further, due to the nature of licensing negotiations, there will not always be a steady increase in revenues.

Since they rely on long term licensing agreements, WiLan has sizable amount of future revenues already locked in. At the end of Q3 2013, management estimated the value of their order backlog to be between $325 and $350 Million. This backlog consists of estimates of revenue that have yet to be recorded from signed licensing agreements. This backlog serves as a base assumption for WiLan's future revenue in a worst case scenario. Most of the backlogged revenues are expected to be collected over the next four fiscal years. However, some of these contracts extend up to seven years into the future. WiLan's backlog is a valuable yet often overlooked part of the company.

WiLan's net income has also been problematic over the last two years. In Q4 2013, WiLan reported income of $2.43 Million on a GAAP basis. On a per share basis, this becomes a gain of $.02. In Q3, Q2 and Q1 of 2013, WiLan recorded losses of $.05 per share, $.06 per share and $.05 per share respectively. These recent losses are largely the result of increased litigation expenses. A graph of WiLan's earnings over the past few years can be found below. Management believes that adjusted earnings are a better indicator of the company's performance. For Q4 2013, WiLan generated $17.2 Million in adjusted earnings, or $.14 per share. This can be partially explained by a dramatic decline in litigation expenses. This compares favorably to Q3, Q2 and Q1 of 2013 where WiLan broke even, recorded a loss of $.01 per share and recorded a gain of $.01 per share respectively. The success seen in Q4 2013 seems likely to carry over into 2014 as management has guided for adjusted earnings between $10.6 Million and $12.6 Million. Investors should monitor WiLan's subsequent income statements to see whether this profitability continues.

Q3 2013 conference call that they believe there will be noticeably less legal activity in 2014 than there was in 2013. The company incurred $4.76 Million in litigation expense in Q4 2013. This is a significant decline from the $14.4 Million in litigation expenses incurred in Q3 2013. This trend of lower expenses seems poised to continue as management has guided for between $3 Million and $5 Million in litigation expenses for Q1 2014. If management is correct and litigation expenses return to more normalized levels, WiLan will benefit tremendously. Many misinterpreted WiLan's losses earlier in 2013 as indicative of a failing business model. In actuality, these losses were driven by WiLan pursuing exceptionally high levels of litigation. Once these cases settle, the associated expenses then decrease.

-Overreaction to Apple Loss

Following its loss to Apple in October, shares of WiLan sold off dramatically. The day after the verdict was announced, WiLan shares were down almost 25%. While this case was certainly material for WiLan, it seems hard to believe that the inability to enforce one patent cost WiLan a quarter of its market cap. In fact, this case may not even be over as WiLan has hinted that they may appeal the ruling. Regardless of any potential appeal, this lawsuit did not have an effect on WiLan's ability to generate revenue from other sources. Companies have signed license renewals and continued to settle with WiLan in the months after the Apple loss. WiLan has stated many times that one loss in court does not end the licensing discussion with a particular company. Despite this one win, Apple is still the defendant in additional upcoming litigation. The possibility of a settlement still exists in these cases. For instance, Alcatel-Lucent (ALU) recently signed a licensing agreement with WiLan despite the former having won a different trial early in the summer of 2013. Losing to Apple was certainly a negative for WiLan; however, the market appears to have overreacted to the news.

-Management and Strategic Review

As mentioned in the overview, WiLan has grown tremendously in recent years. This growth has occurred under the management of their current President and CEO. As we all know, past performance is no indicator of future results, but WiLan's managers have demonstrated that they can grow and sustain a business. This is important because while some companies are built to thrive regardless of who is managing, WiLan is not one of them. WiLan's business is very management intensive as wise decisions must be made nearly every day when negotiating to acquire and license patents. Management has announced to shareholders that they believe the company is extremely undervalued. To remedy this, they are considering several options up to and including a sale of the company. This strategic review is still ongoing and few updates were provided in the Q4 2013 conference call. WiLan's management may not be able to control the courts, but they are attempting to create value for shareholders.

Potential Problems

-Continued Losses at Trial

Recent losses in court have resulted in significant declines in share price, and this trend could continue into the future. The nature of WiLan's business all but guarantees trips to court, and court decisions are often difficult to predict. As a result of this, court decisions will not always go in WiLan's favor. This was very evident to shareholders over the course of 2013. Should WiLan suffer additional court losses, its share price is likely to decline.

-Litigation Expenses Stay Flat or Increase

The largest risk facing WiLan is the possibility that increased levels of litigation expenses will continue indefinitely. As mentioned earlier, legal expenses more than doubled in the first three quarters of 2013 when compared to 2012. Not coincidentally, WiLan has also seen losses on both a GAAP and non-GAAP basis in this same period. This demonstrates that the company could be materially affected simply by frequently appearing in court. Management has mentioned that they believe that legal expenses will be significantly lower in 2014. However, should this guidance prove incorrect and legal expenses do not decline as anticipated, WiLan may continue to struggle financially.

-Patent Troll Laws

There has also been speculation that laws targeting patent trolls will have an impact on WiLan's operations. A law aimed at patent trolls was passed by the House of Representatives in December of 2013. This bill aims to reduce frivolous lawsuits filed by companies that have dubious rights to the patents they claim. WiLan's business model is different than these types of companies and, as a result of this, their operations could potentially be unaffected by the law. However, there is no telling whether the passage of the bill will have an effect on the share price in the short term. There is also always the possibility that further legislation aimed at patent trolls will impact legitimate patent holders and affect their ability to profit from their patents.

-Risks Associated with Small Cap Companies

With a market cap of around $375 Million, WiLan is a relatively small company. Due to this, WiLan has risks that are nearly universal in small cap equities. Liquidity can be a concern with shares of smaller companies. Fortunately, WiLan has the benefit of being listed on the NASDAQ and this helps with liquidity. While not as liquid as most big name stocks, WiLan still trades regularly. Shares of smaller companies can also be more volatile than their larger counterparts. I do not consider volatility to be the same as risk, but it is important that those considering WiLan be comfortable with watching the price of their holdings fluctuate. WiLan has an elevated risk profile by virtue of being a small cap stock.

Conclusion

WiLan presents an interesting investing situation. Following recent litigation issues, WiLan has seen the price of its shares plummet. The company has a strong leadership, a large cash pile, and an expansive patent portfolio. Further, with their Q4 earnings announcement, the company has returned to profitability. WiLan is not without risk as its future profitability relies on the success of future licensing negotiations and a continued decline in litigation expenses. Investors with a suitable risk tolerance should take a closer look at WiLan.

http://seekingalpha.com/article/2002121-wilan-could-q4s-profits-be-the-start-of-a-turnaround?source=yahoo