Foolish Special
[ Friday, December 17, 1999]
A Foolish Year -- The Motley Fool looks back at 1999
By Stuart Watson (TMFTiger)
Licence to Thrill
There's a new game in town. Well, to be honest, it has been kicking around for a little while already. But it really came into its own in the second half of 1999. The game in question is building a business around the concept of licensing your technology and ideas to other people. It is often referred to as the intellectual property (IPR) business model.
To date the key exponents of this art have been:
Mkt Value Increase in
in £m price this year
ARM Holdings 6,500 +996%
BTG 830 +147%
Imagination Tech. 690 +714%
NXT 880 +267%
Torotrak 300 +197%
In the last year this combination of companies produced licensing revenues of some £80m, yet together they are valued by the market at approximately £9b. Many of these names are well known to those who travel the message boards. ARM (LSE: ARM), Imagination (LSE: IMG) and NXT (LSE: NTX) have attracted the most interest so far. The boards for BTG (LSE: BGC) and Torotrak (LSE: TRK) have been less busy.
A Brief Rant
A lot of these price gains have occurred in the last two months. In fact with the exception of ARM, the vast majority of these gains have occurred since November. A lot of press comment has attributed the recent rises to increased investment from individuals. From where we sit that looks to be misplaced. Our company message boards for companies like ARM have been busy for most of the year and a lot of Fools bought these shares prior to their recent gains.
The introduction of techMARK in early November has undoubtedly been a catalyst but it looks to be belated demand from institutions that has caused the recent increases. The retail investor gets a lot of bad press, being accused of jumping on bandwagons, but it is the financial institutions that look to be the guilty parties here. Very few individual investors will sit down, look at the market and say 'I am underweight in tech stocks therefore I must buy ARM, Psion and Baltimore'. We suspect that institutions are scared of presenting portfolios on December 31 that show a lack of tech stocks. The rush of demand in the last few weeks in companies where few shares are available looks to be the real cause of the recent increases.
Why IPR?
Rant mode off. So why is the idea of licensing technology to others rather than doing all the dirty work yourself proving such a successful business model? There are a number of reasons. Firstly, it allows companies to concentrate upon what they do best. In this case it is not the nuts and bolts of manufacturing but merely the initial ideas and designs behind a product. This means that new companies do not have to spend millions on building expensive production facilities. They can piggyback on someone else's.
In fact they can piggyback on several or even hundreds of other companies. This way they reduce both the risk to themselves and full production of their designs can proceed far more quickly. In the world of technology, where staying ahead of the curve is the name of the game this can be the difference between a successful product and an also-ran. ARM is the best example to date, licensing its low-power chip design to manufacturers of mobile phones, automobiles and many other applications.
Of course there are still downsides. Because other parties are taking on some of the risks the licensing firms end up with a smaller return for each unit produced. They also lose some control over the whole process. But for many firms the ability to come to market as quickly as possible overrides these negatives.
There is also the thorny issue of how to protect your ideas. The registering of patents in as many countries as possible is a key step necessary in such business models. In the UK patents typically last 20 years. Therefore many of these ideas and the revenues flowing from them have a fixed life span. Unless, of course, new designs or upgrades can be developed which can be registered as separate patents.
In fact it seems that having ideas and designs is worth more than producing the actual goods these days. In fact there was a recent discussion on the message boards about a new hot share, oldsocks.com. Foolatlarge said: "I've been doing some background research on this company, and my mate who actually works for oldsocks.dom tells me that don't make the holes themselves but they license the intellectual copyright to the pattern of the holes. This obviously makes them a lot more valuable. Would any of you lucky devils who got in earlier still buy at these levels?" Tongue in cheek, but also a neat illustration of how perceptions are shifting.
The Players
So far there appear to five companies leading the way with this business model. Let's have a brief look at each of them.
ARM Holdings
The big daddy of this revolution. ARM designs Reduced Instruction Set Computing (RISC) chips, which use less power than traditional chips. ARM has signed licence agreements with companies such as Intel, 3Com and Ericsson. Mobiles, cars and PCs are seen as the main applications that will benefit from ARM's designs. Its chairman, Robin Saxby, sees the growth in the share price as a virtuous circle, with employees being both retained and attracted by the possibility of options. But a few years down the track, given the growth in ARM's share price, quite a few of its employees could be millionaires. In fact a number probably are already. Will they stay motivated?
BTG
BTG, the British Technology Group, was the first listed company to employ this business model. It describes its strength as the commercialisation of intellectual property rights (IPR) -- not only in managing and protecting IPR but also in identifying and realising the commercial significance of inventions and technology, and in finding the best route to bring the technology to market. The group has about 40 'core' technologies, the majority of which relate to medical applications. Since coming to the market in mid-1995 the share price has grown at an annual compound rate of almost 120%.
Imagination Technologies
Imagination used to be called Videologic. It designs 3D graphic chips, currently used to great effect in Sega's Dreamcast games console. Further potential is seen in the use of these chips in set-top boxes. Its share price has spent most of the past five years oscillating between 50p and £1. A quick name change and an shift of emphasis away from manufacturing onto design and hey presto, the share price leaps to over £4.
NXT
NXT has designed a revolutionary flat speaker that can be made out of a wide variety of substances. It is also developing a see-through speaker that can double up as the screen of a PC or mobile phone. Last month it signed an agreement with DERA, relating to speech recognition technology, and its share price rocketed as a result. A group from Fool HQ visited the head office of NXT back in October. And it was also the second purchase for the Motley Fool Staff Investment Club, earlier this month.
Torotrak
Torotrak started life as part of BTG. In mid-1998 it was spun out as a separate company. It has developed an Infinitely Variable Transmission (IVT) system that revolutionises automatic gearboxes used in cars and other vehicles. Torotrak believes its design could account for 80% of all automatic transmissions by 2010. Although its share price is up by 200% this year, this hides the fact that it collapsed from around 250p when it was demerged from BTG to around 70p by the end of last year.
In Closing
Perhaps it is surprising that, given the success of these companies, there are so few of them on the market. No doubt we can expect to see many more IPR-based companies floating in the next few years. At least this is one area of technology where the UK appears to be taking a lead.
As far as the individual investor is concerned, news flow for these companies tends to be significantly higher than for ordinary companies with a regular flow of information relating to product developments and new licensees. Once the idea moves into production the revenue flows should be easier to predict as well. With set prices for each unit delivered the cash flows should be less susceptible to fluctuation due to, for example, increasing costs.
Let's take Torotrak as an example. Out of these five stocks it's the one I know best because I have some of their shares myself. Torotrak have said that the revenue they will receive from each unit will be approximately $30. Currently 55m vehicles are manufactured in the world each year and 40% of these use automatic transmissions. That gives a potential market of 22m units a year. If Torotrak were to capture their target share of 80% this would equate to annual revenues of 17.6m units at $30 a piece, a total of $528m per annum.
Unfortunately this is a simplistic view. Potential investors also need to consider that the total market of 55m may change and the proportion of automatics to manuals may also shift. At the moment it appears that automatics are gaining in popularity, particularly in Europe where they only account for 15% compared with 80%+ in the US and Japan. Of course the biggest variable is the market share that Torotrak will capture -- 80% looks very optimistic.
In order to estimate the potential profits these companies may make you also need to consider the ongoing costs. This is very difficult at this stage as there is no company at an advanced stage of development to base any assumptions on. ARM is the furthest down the line and is making pre-tax margins of almost 30%.
On top of the potential earnings from existing ideas, should investors also be paying for the potential of future ideas? There are some incredibly bright people at these companies and given their ideas to date it seems reasonable to assume that they have a better than average chance of coming up with another winner. But how much should investors be prepared to pay for that potential? Bears will tell you nothing at all. Bulls will say that this should account for the majority of the firm's value. As always, it looks like the truth is somewhere in the middle.
So assuming you think these companies have potential, what is the best way to get involved? There has been a lot of interest recently in managed tech stock funds. This seems pretty sensible and I have to confess that I have one myself. But like all managed funds they all seem to suffer from over-diversification. They place a large number of small bets. It seems much more sensible to focus on perhaps a dozen companies which seem to have the best potential. That way if you do pick some star performers they actually have the chance of having a significant impact on your portfolio. It strikes me that the ideal way to do this might be through our old favourite, the investment club. No wonder the numbers of clubs seem to growing so rapidly recently.
Related Links
The Year In Review
Introduction
1. TMFEagle looks at the gold medallists of 1999.
2. TMFMayn visits the kennel: who were the dogs of the past year?
3. TMFEssex ruminates on a sector by sector basis.
4. TMFNigel thumbs through the year on the World Wide Web.
5. TMFTiger reviews the rise of intellectual property companies.
