Published: August 13, 2010

When communications software firm VirnetX Holdings (AMEX: VHC) released quarterly results last Monday, investors may have thought the company's press release had a glaring error. Sales, which had never exceeded $21,000 in any prior quarter, suddenly exploded to $200 million. It was no misprint. VirnetX finally got a nice payoff after several years of lawsuits regarding patent infringements.

Other companies that sue to get royalties are also hopeful for similar windfalls. And when these companies prevail, profits can grow quickly, as patent and royalty income often flow straight to the bottom line.

So how can investors profit from companies with potentially lucrative patents? I've uncovered three companies sitting on potential gold mines in terms of their intellectual property.

1. VirnetX Holdings
In the next 12 months, consumers should see an array of new smart phones offering super-fast download speeds. [See: The Time is Ripe to Short this Wireless Upstart]

Yet as more and more personal and corporate information is sent out over the mobile broadband airwaves, the risk of data theft also rises. To tackle that, VirnetX has developed a range of software encryption tools to keep that wireless data secure. Many companies, including the major wireless carriers, are working to come up with their own fixes. But this little-known company has a hunch that any solution these companies come up with might impinge on its patents. So they've gone to court.

Lawsuits are never easy -- until you've won a major one. That's why VirNet's victorious lawsuit against mighty Microsoft (Nasdaq: MSFT) is so important, possibly setting a precedent for future legal activity. In early March, a jury awarded the company $106 million for Microsoft's unlicensed use of a pair of VirnetX's patents. Two months later, Microsoft not only agreed to that decision, but agreed to pay a total of $200 million for the use of all 46 of VirnetX's patents. Shares quickly soared to $8 back in March when the news was first announced, but have since fallen back to $6. Now, VirNextX is gearing up to secure other licensing agreements for its technology. On Thursday, the company filed fresh lawsuits against Apple (Nasdaq: AAPL), Cisco Systems (Nasdaq: CSCO), Japan's NEC, and others.

Action to Take --> It's impossible to predict if and when those suits will be resolved, but VirNetX's $270 million market value appears to sharply discount the prospect of a few more major legal victories. Shares could meander in coming quarters, but could spike sharply higher of any of those defendants choose to settle the lawsuit.

2. Rambus (Nasdaq: RMBS)
With a mountain of technology patents under its belt, Rambus (Nasdaq: RMBS) has a long history of successfully suing any firm that appears to use its Intellectual Property (IP) without permission. Friday morning, the company secured a licensing agreement for a few of its patents with NVidia (Nasdaq: NVDA), pushing Rambus' shares up +5%. During the past decade, the company has waited for its patents to be broadly used before seeking legal remedies, which has usually netted between $100 million and $200 million in annual revenue.

Rambus doesn't always take the aggressive legal route. In late June, it showed it can also play nice, using its considerable IP to help develop a market, rather than pounce once a market is developed. Although Rambus is best known for its IP in the area of semiconductors and telecom, it also has an impressive array of LED lighting patents, which it acquired and then augmented with its own IP.

The new LED division, which uses back-light technology to provide sharper illumination, has already found its first major customer: GE (NYSE: GE). Rambus announced in late June that they were teaming up to develop a range of newly-developed architectural lighting products. This looks like a win/win for Rambus, as it will require no capital outlays, and the company can simply share in the profits.

Yet Rambus is mostly still focused on litigating when necessary. The company has recently had a string of legal victories with firms such as Sony (NYSE: SNE) and Samsung, which are expected to result in steadily rising royalty payments in coming quarters. And Rambus' legal momentum looks set to continue. The company is expected to imminently win a patent case with Japan's Elpida Memory, which could net close to $500 million in an upfront license, and then more revenue from ongoing royalties. Taiwan's Hynix, along with Micron Technology (NYSE: MU), are also in Rambus' crosshairs after a recent preliminary legal decision in its favor.
 

As is the case with all "intellectual property plays," there's no way to peg any sort of value created by some of these deals. (Details are sometimes limited for legal reasons.) So how do you place a value on a company that has erratic, but bounteous earnings streams? A P/E ratio doesn't apply. Rambus lost nearly $1 a share last year, will likely make more than a $1 a share this year, and it's anybody's guess what will happen next year on the earnings front.

In this instance, enterprise value (market capitalization plus debt minus cash) is a better gauge. The company has about $600 million in net cash, implying an enterprise value of around $1.6 billion. Yet the company could snag up to $2 billion or more in fresh patent agreements over the next several years.

Action to Take --> This is all very imprecise, which explains why most Wall Street firms simply avoid trying to even value and follow the stock. But with each passing year, it's apparent that Rambus' team of 290 engineers (out of 350 employees) are on the right track, developing patents that turn into major money makers. Over the next 12 months, investors should see further large checks being mailed to Rambus.

3. Interdigital (Nasdaq: IDCC)
With more than 12,000 patents and patents pending, Interdigital is seen by some as the grandfather of the technology patent movement. Interdigital, like VirnetX, focuses on wireless technology. The company's software is used in the majority of all 3G cell phones and wireless networks, helping to manage bandwidth constraints, network capacity issues and security.

In contrast to Rambus with its lumpy, occasionally massive one-time payments, Interdigital likes to secure long-term revenue streams. As the company has secured new long-term licensing arrangements, the company's sales -- and profits -- have steadily risen. By 2009, the company generated a company-record $284 million in free cash flow.

Although Interdigital's sales and revenue have been remarkably steady for this type of company, a few one-time payments are nevertheless spiking sales and profits this year. Analysts expect revenue to rise more than +20%, and earnings per share (EPS) to surge more than +80% to about $3.20 in 2010. That surge also means next year's results will show a bit of a pullback.

Action to Take --> With that kind of financial performance, coming up with a fair value for the stock is indeed tricky. Dougtherty & Co. uses a weighted average of the next 10 years of cash flow, arriving at a target price of $36 -- roughly +40% ahead of current levels.

Analysts at Hilliard Lyons think shares are worth $34, or 12 times Interdigital's 2010 profit forecast. They also note that the company's growing cash balance is also of interest. Interdigital now has $486 million in cash ($12 a share), and analysts wonder if a share buyback, a one-time large dividend, or even a bid to go private might be in the offing -- all usually good things for shareholders.

Note: All three of these companies appear to be racking up impressive licensing deals that will, over the long-haul, generate compelling free cash flow growth. Other licensing companies to research include Qualcomm (Nasdaq: QCOM), Digimarc (Nasdaq: DMRC), Tessera Technologies (Nasdaq: TSRA) and Acacia Research (Nasdaq: ACTG).

-- David Sterman
Staff Writer
StreetAuthority