Network-1 Technologies, Inc. — Q3 2016 Form 10-Q
Reporting period: Three and nine months ended September 30, 2016. The company develops, licenses and protects intellectual property; results are unaudited. Its revenue is largely licensing-related and can vary materially with settlements and royalty timing.
Financial performance
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Revenue | $34.326 million | $3.008 million | $59.963 million | $10.382 million |
| Operating income | $16.084 million | $0.684 million | $31.573 million | $2.667 million |
| Net income | $10.832 million | $0.407 million | $22.882 million | $1.717 million |
| Diluted EPS | $0.43 | $0.02 | $0.93 | $0.07 |
| Operating margin | 46.9% | 22.7% | 52.6% | 25.7% |
| Net margin | 31.6% | 13.5% | 38.2% | 16.5% |
For the nine months, operating cash flow was $37.140 million, versus $2.941 million in 2015. Investing cash outflow was $4,000 and financing cash inflow was $15,000; cash and cash equivalents rose by $37.151 million to $57.759 million. Cash flow benefited from earnings and increases in accrued expenses and income taxes payable.
At September 30, cash and cash equivalents were $57.759 million, marketable securities $1.100 million, current assets $60.293 million, current liabilities $10.114 million, and working capital $50.179 million. Total liabilities were $10.114 million; the company reported no long-term debt. Accrued expenses were $5.572 million and income taxes payable were $4.080 million. Management said existing cash and projected licensing and other revenue should fund operations for the foreseeable future.
Material changes and notable items
- Q3 revenue increased $31.318 million year over year. The company attributed $32.9 million to licensing litigation settlements: Apple ($25 million), Dell ($6 million) and Alcatel/ALE ($1.9 million). Royalty-bearing license revenue, excluding settlements, declined 14% in Q3 to $1.426 million.
- Nine-month revenue rose $49.581 million. In addition to the $32.9 million in patent-litigation settlements, it included a $17.5 million settlement of a professional-liability claim. Royalty-bearing license revenue, excluding settlements, increased 1% to $8.663 million.
- Operating expenses were $18.242 million in Q3 and $28.390 million for the nine months, primarily reflecting settlement-related costs of revenue. Nine-month costs of revenue included $16.841 million in contingent legal fees, $3.345 million in other contractual payments and $3.996 million in CEO incentive compensation.
- Income tax expense was $5.276 million in Q3 and $8.741 million for the nine months. The company said it fully utilized its net operating loss carryforwards; deferred tax assets declined from $4.958 million at year-end 2015 to $0.415 million.
- The company has 28 patents. Its Remote Power Patent expires in March 2020; Mirror Worlds patents expire from August 2017 to February 2020, and the QoS patents expire in June 2019. Patent amortization was $0.760 million for the nine months.
Outlook, risks and contingencies
- No specific earnings or revenue guidance was provided. Management expects a significant portion of revenue to continue coming from one or a few licensees. Three licensees represented approximately 96% of Q3 and 90% of nine-month revenue, excluding the professional-liability settlement. Cisco represented 17% of nine-month revenue, down from 71% in 2015.
- Revenue depends on patent licensing and enforcement, and the company warns that invalidation of key Remote Power Patent claims could materially harm results. Five defendants remained in the Remote Power litigation at September 30; trial was scheduled for March 2017. A November 2, 2016 court ruling, after quarter-end, upheld the original asserted claims but invalidated one reexamined claim.
- In October 2016, Polycom agreed to a $5 million license initiation fee plus ongoing royalties; $2 million was paid and the balance is payable in annual installments, with certain payments conditional on patent validity. Alcatel/ALE’s remaining $2.3 million settlement balance was also subject to scheduled future payments. These are post-quarter developments, not Q3 revenue.
- Google and YouTube litigation was stayed pending patent review proceedings. The PTAB ruled for the company in a covered-business-method review; Google appealed the IPR decisions. The filing states that none of the asserted claims in the pending litigation were found invalid in the IPRs.
- Cash is concentrated at financial institutions: $57.109 million exceeded FDIC insurance limits at quarter-end. The company reported no off-balance-sheet arrangements and no material change in internal controls. Patent monetization and legal outcomes, royalty concentration, and the potential personal holding company tax are key risks.
- The CEO’s employment agreement includes incentive compensation tied to patent-related receipts and 750,000 restricted stock units subject to employment, vesting and stock-price conditions; certain termination or change-of-control events accelerate vesting.
Important facts for investors to verify
- How much of reported revenue and operating cash flow is recurring royalties versus settlements, and whether settlement receivables were collected as scheduled.
- Current status and outcome of Remote Power, Cox and other patent litigation, including the effects of appeals and the March 2017 trial schedule.
- Ongoing royalty receipts, especially Cisco’s payments and the company’s exposure to a small number of licensees.
- Remaining tax attributes, cash tax obligations and any potential personal holding company tax exposure.
- The filing contains differing references to the number of the Remote Power Patent claim invalidated in the November 2 ruling (Claim 13 in one passage and Claim 23 in another); verify against the court order.