One of the cheapest stocks in our Small & Micro Cap – Stock Screener is Network-1 Technologies Inc (NYSEMKT:NTIP).

With a market cap around $89 million, very few investors have ever heard of this great little company. Network-1 Technologies Inc (Network-1) has a remarkable record of taking on and beating technology behemoths like Apple and Microsoft in court.

Network-1 is engaged in the development, licensing and protection of its intellectual property assets.  The company presently owns twenty-eight (28) patents including:

(i) The Remote Power Patent covering the delivery of power over Ethernet (PoE) cables for the purpose of remotely powering network devices, such as wireless access ports, IP phones and network based cameras.

(ii) The Mirror Worlds Patent Portfolio relating to foundational technologies that enable unified search and indexing, displaying and archiving of documents in a computer system.

(iii) The Cox Patent Portfolio relating to enabling technology for identifying media content on the Internet and taking further action to be performed based on such identification.

(iv) The QoS Patents covering systems and methods for the transmission of audio, video and data over computer and telephony networks in order to achieve high quality of service.

A quick look at the company’s share price (below) over the past twelve months shows that the price is up 104% to $3.80 from $1.86 in March 2016. That is 10% off its 52 week high of $4.15, but closer inspection shows that the stock remains undervalued.

(Source, Morningstar)

According to the company’s latest Q3 2016 earnings report dated September 30, 2016, Network-1 had the largest quarterly revenues in its history with revenue of $34.3 million for the three months ended September 30, 2016 compared to $3.0 million for the previous corresponding period (pcp). The significant increase was due to additional licensing revenue of $31.0 million from settlement and licensing agreements entered into with Apple Inc. and Dell, Inc. during the quarter.

Total revenue for the nine months ending September 30, 2016 was $60 million compared to $10.4 million for the pcp due to the same settlement and licensing agreements, plus a $17.5 million settlement of a professional liability claim. As a result, the company reported net income of $0.98 per share (basic) and $0.93 per share (diluted) compared to just $0.07 per share (basic and diluted) for the pcp.

Network-1 is a company that spends a great deal of time in court defending its patents and has a great track record of winning.

The Remote Power Patent (U.S. Patent No. 6,218,930)

Network-1’s Remote Power Patent (U.S. Patent No. 6,218,930) has been a power-house for the little company generating licensing revenue in excess of $100 million from May 2007 through September 30, 2016.  More that twice that of the company’s Mirror Worlds Patent Portfolio acquired in May 2013, which has generated licensing and other revenue of $47.2 million through September 30, 2016.

A quick look at Network-1’s litigation history shows just how well the company has performed against some of the biggest data network equipment manufacturers in the world.

In September 2011, Network-1 initiated patent litigation against sixteen (16) data networking equipment manufacturers (and affiliated entities) in the United States District Court for the Eastern District of Texas, Tyler Division, for infringement of its Remote Power Patent.  Named as defendants in the lawsuit (excluding affiliated parties), were Alcatel-Lucent USA, Inc., Allied Telesis, Inc., Avaya Inc., AXIS Communications Inc., Dell, Inc., GarrettCom, Inc., Hewlett-Packard Company, Huawei Technologies USA, Juniper Networks, Inc., Motorola Solutions, Inc., NEC Corporation, Polycom Inc., Samsung Electronics Co., Ltd., ShoreTel, Inc., Sony Electronics, Inc., and Transition Networks, Inc.

In March 2012, Network-1 reached settlement agreements with defendants Motorola Solutions, Inc. (“Motorola”) and Transition Networks, Inc. (“Transition Networks”).

In October 2012, the company reached a settlement with defendant GarretCom, Inc (“GarretCom”).

In February 2013, Network-1 reached settlement agreements with Allied Telesis, Inc. (“Allied Telesis”) and NEC Corporation (“NEC”).  As part of the settlements, Motorola, Transition Networks, GarretCom, Allied Telesis and NEC each entered into a non-exclusive license agreement for Network-1’s Remote Power Patent pursuant to which each defendant agreed to license the Remote Power Patent for its full term (which expires in March 2020) and pay a license initiation fee and quarterly or annual royalties based on their sales of PoE products.

In March 2015 and July 2015, Network-1 reached settlements with defendants Samsung Electronics Co., Ltd. (“Samsung”), Huawei Technologies Co., Ltd. (“Huawei”) and ShoreTel, Inc. (“ShoreTel”).  Samsung and Huawei each entered into a non-exclusive fully paid license agreement for the Remote Power Patent for its full term.  ShoreTel entered into a non-exclusive license agreement for the Remote Power Patent for its full term and paid a license initiation fee and agreed to pay quarterly royalties based upon its sales of PoE products.

In June 2016, Network-1 reached a settlement with Sony Corporation and affiliated entities (“Sony”).  With respect to the settlement, Sony received a non-exclusive fully-paid license for the Remote Power Patent for its remaining life.

In July 2016, Network-1  reached settlement agreements with Alcatel-Lucent USA and Alcatel-Lucent Holdings, Inc. (collectively, “Alcatel”) and ALE, USA.  Under the terms of the settlement agreements, Alcatel and ALE, USA received a non-exclusive fully paid license for the Remote Power Patent for its remaining life.  The aggregate consideration to be received by Network-1 from Alcatel and ALE for the fully-paid license was $4.3 million of which $2.3 million is payable in three equal quarterly payments contingent upon a ruling to be issued by the U.S. District Court of Texas with respect to a pending motion finding that any asserted claim of the Remote Power Patent is valid.

In July 2016, Network-1 also reached a settlement with Dell, Inc.  Under the terms of the settlement, Dell received a non-exclusive license for the Remote Power Patent for its full term, Dell is obligated to pay a license initiation fee of $6 million and royalties based on its sales of PoE products.

In October, 2016, Network-1 reached a settlement with Polycom, Inc. Under the terms of the settlement, Polycom licensed on a non-exclusive basis the Remote Power Patent for its full term (expiring in March 2020), and is obligated to pay a license initiation fee of $5 million for past sales of its Power over Ethernet (“PoE”) products and will also pay ongoing royalties based on its sales of PoE products.  $2 Million of the license initiation fee has been paid and the balance will be paid in three annual installments of $1 million beginning in October, 2017. Payments due in October 2018 and October 2019 need not be paid by Polycom if all asserted claims of the Company’s Remote Power Patent have been found invalid.

So that means Network-1 has now reached settlement and license agreements with twelve of the original sixteen defendants for the licensing of its Remote Power Patent.  The remaining four defendants are Avaya Inc., AXIS Communications Inc., Hewlett-Packard Company, and Juniper Networks, Inc. The litigation is currently scheduled for trial in 2017.

The Markman Ruling

Back in November Network-1 received more good news regarding the remaining four defendants.

In a recent Markman Ruling – the court hearing a patent infringement case interprets and rules on the scope and meaning of disputed patent claim language regarding the patent at issue.  In the Markman Ruling, the court adopted a number of constructions proposed by Network-1, while also adopting constructions proposed by defendants.  As part of the Markman Ruling, the court also considered defendants’ motion for Summary Judgment that all claims of the Remote Power Patent are invalid for improper claim broadening.  The court found that all of the original asserted claims of the Remote Power Patent survived the challenge, and only one claim (Claim 23, obtained during a Reexamination of the Remote Power Patent at the USPTO in 2014) was invalid due to improper claim broadening.

“We are very pleased with the Markman Ruling and remain confident in our position that the defendants infringe our patent rights”, said Corey M. Horowitz, Chairman and CEO of Network-1.  “A Markman Ruling that does not entirely adopt either the plaintiff’s or defendants’ proposed constructions is very common in patent litigation.  While the outcome of this and any legal matter is unpredictable, we believe the court’s Markman Ruling is another significant step towards the successful resolution of this litigation and further validates Network-1’s ongoing commitment to the enforcement of its intellectual property rights.”

This means is that Network-1 now has recurring revenues from quarterly or annual royalties associated with the company’s Remote Power Patent which expires in March 2020 and we can reasonably expect that revenues will be further boosted by favorable rulings from the four remaining defendants in Network-1’s Remote Power Patent litigation.

Mirror Worlds Patent Portfolio

Network-1 has also had success in terms of favorable rulings regarding its Mirror Worlds Patent Portfolio. As mentioned above, Q3 2016 saw the largest quarterly revenues ever generated in the company’s history due to a court ruling in favor of Network-1 against Apple Inc (Apple) for infringement of U.S. Patent No. 6,006,227 (the ” ‘227 Patent “).

Under the terms of the agreement, Apple received a fully paid up non-exclusive license to the ‘227 Patent for its full term, which expired in 2016, along with certain rights to other patents in Network-1’s portfolio. Network-1 received $25 million from Apple from the settlement.

The Apple settlement followed the November 2015 announcement that Microsoft had entered into a settlement agreement and non-exclusive license agreement with Network-1 for the ‘227 Patent.  Under the terms of the agreement, Microsoft can license the ‘227 for its full term, which expired in 2016, and received a fully paid up license, which covers Microsoft’s products. Microsoft customers are also covered under the license to the ‘227 Patent. Network-1 received $4.65 million from Microsoft from the settlement.

To summarize, Network-1 had revenue of $34.33 million for Q3 2016 compared to $3 million for the pcp.  The increase of $31 million in revenue consisted mainly of the litigation settlements from Apple ($25 million), Dell ($6 million) and Alcatel and ALE USA Inc. ($1.9 million). The company also had a $17.5 million settlement for a professional liability claim that Network-1 reported for the nine months ending September 30, 2016.

The Cox Patent Portfolio

Lastly, there’s the company’s two other portfolios, The Cox Patent Portfolio and The QoS Patent Technology, both of which have not generated any revenue to date. With that being said, Network-1 is currently in litigation with both Google Inc and YouTube, LLC over infringement of one of the patents in Network-1’s Cox Patent Portfolio.

Back in October 2016 Network-1 announced that the Patent Trial and Appeal Board (“PTAB”) of the United States Patent and Trademark Office (“USPTO”) issued its Final Written Decision relating to a challenge made by Google and YouTube to the patentability of one of the patents of Network-1’s Cox Patent Portfolio. In its Final Written Decision, the PTAB ruled that Google had failed to show that any of the thirty-four (34) claims of U.S. Patent 8,904,464 were unpatentable.

“We are extremely pleased with today’s PTAB decision,” said Corey M. Horowitz, Chairman and CEO of Network-1.  “We have worked very hard with Professor Ingemar Cox to develop and protect the value of his inventions and we will continue to do so,” he added.

With Network-1’s outstanding track record in favorable court rulings against tech giants like Apple and Microsoft it is reasonably safe to assume that the company is still on track to receive further revenues from Google and YouTube regarding its Cox Patent Portfolio.

Low Cost Operations

You may be thinking that Network-1 has significant resources to take on companies like Google, Apple and Microsoft but its surprising to note that Network-1 has just two full time employees which explains why the company is able to keep its cost base so low and margins so high.

Loads of Free Cash Flow

With its low cost base, high margins, and prudent management, Network-1 has shown it’s a company that can generate significant amounts of free cash flow. This is where I see the real value of the company.

A quick look at the company’s quarterly cash flow statements below for the trailing twelve shows Network-1 generated $39.8 million (ttm) in operating cash flow. At the same time, Network-1 had just $0.04 million (ttm) in capex, which equates to $39.8 million (ttm) in free cash flow. With a current market cap of $89 million that means Network-1 has a FCF/Price yield of 45% (ttm). The true value of the company is further realized when we consider the company’s balance sheet.

Fiscal Period (Amounts in millions) Sep16 Jun16 Mar16 Dec15
Net Income 10.83 8.23 3.82 2.39
Cash Flow from Operations 22.39 14.63 0.12 2.69
Purchase Of Property, Plant, Equipment 0 0 0 -0.04
Free Cash Flow 22.39 14.63 0.12 2.65

(Source, Company reports)

Valuation

A quick look at the company’s balance sheet ending September 2016 shows that the company had cash and cash equivalents of $59 million and zero debt. So, assuming you could buy the entire company for $89 million, you would get $59 million in cash and cash equivalents.

If we subtract the $59 million in cash and cash equivalents from the company’s current market cap of $89 million that means Network-1 has an Enterprise Value (EV) of just $30 million, and with $39.8 million in free cash flow (ttm), that means Network-1 has a FCF/EV Yield of 134%.

We favor EV over market capitalization as it includes additional liabilities–like debt, preferred equity and non-controlling interests–if you were to purchase the entire company. EV is calculated as:

Market Cap + Preferred Equity + Non-Controlling Interests + Total Debt – Cash and Equivalents.

With an Enterprise Value (EV) of $30 million and Operating Earnings* of $11 million (ttm), that means Network-1 is currently trading on an Acquirer’s Multiple of 2.62 or, 2.62 times Operating Earnings*.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

With a FCF/Price Yield of 45% (ttm), a FCF/EV Yield of 134% (ttm) and an Acquirer’s Multiple of 2.62, or 2.62 times Operating Earnings*, that places Network-1 squarely in undervalued territory.

Summary

Network-1 is a great little company with a impeccable record of winning litigation settlements against tech heavyweights Apple, Microsoft and Dell. With a market cap of $89 million the company is way too small for most institutions with just 10% institutional ownership. Network-1 clearly has a good eye for acquiring the right patents to add to its portfolio. Recent favorable settlements have included Apple ($25 million), Dell ($6 million) and Alcatel and ALE USA Inc. ($1.9 million). Current litigation with Google and YouTube is also proceeding well.

In terms of its patent runway, Network-1 has recurring revenues from quarterly or annual royalties associated with the company’s Remote Power Patent which expires in March 2020. It is reasonable to expect that these revenues will be further boosted by favorable court rulings against the four remaining defendants for infringement of the company’s Remote Power Patent.

Add to this the October decision by the PTAB in favor of Network-1 regarding the company’s Cox Patent Portfolio. The PTAB ruled that Google had failed to show that any of the thirty-four (34) claims of U.S. Patent 8,904,464 were unpatentable. The company continues to grow its patent portfolios highlighted by the February 2017 announcement that Network-1 had received a new patent from the U.S. Patent Office expanding its Cox Patent Portfolio to seventeen patents.

The company is an extremely low cost operation with a strong balance sheet and ability to generate a loads of free cash flow. A quick look at the Network-1’s balance sheet ending September 2016 shows that Network-1 had cash and cash equivalents of $59 million and zero debt. If you could buy the entire company at its current market cap of $89 million and you would get $59 million in cash and cash equivalents.

In terms of Network-1’s valuation. The company is currently trading on a FCF/Price Yield of 45% (ttm), a FCF/EV Yield of 134% (ttm) and an Acquirer’s Multiple of 2.62, or 2.62 times Operating Earnings*. Add to this the company’s P/E of 3.72, a P/B of 1.7 and a P/B of 1.44 and Network-1 remains clearly undervalued despite the 104% growth in the company’s share price over the past twelve months.

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