Description

Overview

Crossroads Systems (CRDS) is litigation-centered investment that offers the potential to return 30x its current stock price while providing real downside protection to the current valuation. The potential outcomes have a wide dispersion, but given the very asymmetric payoff profile, we believe that the idea certainly warrants consideration if appropriately sized. The idea has been significantly de-risked in recent days and now stands catalyst rich over the next 12-24 months, although plenty of uncertainty still remains.  We also take comfort in that the company‘s board is run by one of us (a deep value investor) with real skin in the game.  Crossroads will present to investors for the first time in March at Roth and we wanted to get ahead of their coming out event.

A great part of the upside is litigation focused around Intellectual property.  If you were burned by ParkerVision or the like, this probably isn’t for you, although we passed on that one we think this situation is very different.  

Disclaimer: It is actually a fairly liquid stock relative to the market cap, but even still this is only appropriate for smaller funds or larger funds that really believe it has 30x potential.  The company has put in an NOL preservation plan which would limit holders to 5% of the company.  The current market cap is < $60M, so if a $3M position isn’t considered actionable, I would stop reading.

History

Crossroads is based in Austin, Texas and was a dotcom highflyer run by an ’entrepreneurial’ CEO, Richard Sims.  Sims raised a ton of money, striving first to create storage technology and intellectual property that was world class, and then hire a direct sales force to take the big boys on head-to-head.  Well he was able to achieve one part of that vision, which was to build an IP bank that really was world class and underpins the bones of today’s storage area networks.

As happens too often, profitability and rational capital allocation evaded Sims, and the investor base grew so fatigued that they invited Lone Star Capital to take the reins.  Lone Star is an activist fund, but they didn’t need to do a proxy fight to gain control.  In fact, the shareholders begged them to take over, and they did, with one condition – complete autonomy.  This all happened in March of 2013 and Lone Star reconstituted the entire board and appointed Rick Coleman as interim CEO.

Their first order of business was to assess the situation, which they did quickly.  Based on some past litigation success, they believed that the company owned some highly valuable IP.  They focused their efforts on two tracks.  The first was the rationalization of the operating business and product set, and the second would be to focus on the monetization of the IP through litigation.  Let’s discuss each of these pieces.

Operating Business

I’ll start with the operating business since that is simplest and most familiar to folks here.  As I alluded to earlier, the company’s strategy under Sims was to go direct, and they had built a sales force to do it.  However, they were out resourced by IBM, Oracle/Sun, EMC, and the rest of the lot, demonstrating the more rational strategy would have been to give up margin while selling through partners.  Soon after Lone Star took control, they slashed the sales force, brought on two key partners (Hitachi and Fuji), and focused on getting the operating business to profitability.  To do so, they needed to have a product to sell into the channel that was truly game changing.  While the company has a bunch of legacy products, I won’t discuss them as they aren’t too relevant to the story and are effectively in runoff (generating good high-margin revenue as they decline).  The game changing product they came up with is called StrongBox, a near-line storage system that is effectively a NAS built on top of a tape drive array.

StrongBox

Why is this an awesome product?

Put simply, it solves a real problem for a very large end-market.  Namely it creates accessible, near-line storage that is economical as data needs scale.  As we all know, information creation has led to the archival needs for businesses growing rapidly.  While storage prices have come down dramatically, the volume of what needs to be stored has skyrocketed much faster, making it hard for IT budgets to keep up.  Things like Flash address a high-performance need and Cloud addresses convenience, but neither is really economical for the 90% of data a business produces.  This data, such as email archives and large video/media assets for example, is what they need to store/archive, but only occasionally access or use.  For this information, a high latency offering that retrieves the data in seconds is sufficient, whereas hours (to retrieve a tape offline) is not.  Actual latency is not seconds though.

The StrongBox solution marries the familiarity of the NAS structure with the economics and reliability of tape.  For those who think tape drives are arcane, think again.  While slow, they are highly reliable, cheap and last 20+ years. DVDs last 5-10 years. Hard Disks are expensive, spin, and fail.  Flash is fast, but very, very expensive. StrongBox is scalable, open, non-proprietary, multi-user, reliable and cheap storage.

It took Crossroads a few iterations to get it right, but I think they finally have, as evidenced by the revenue line at the company.  It remains small today, but is growing at a clip that shows promise.  This product alone, I believe, represents at least the current market cap of the company to a strategic buyer.  Additionally, I believe revenue growth for StrongBox will shortly push the company into a cash flow breakeven position.Read all the whitepapers you want here, and hear about the product.  Pay special attention to the videos at the bottom, especially CyArk and ProductionFor, as these should more than convince you that StrongBox is legit and valuable.

http://www.crossroads.com/data-archive-products/strongbox

StrongBox revenues came in at $1M for the quarter, with a high growth velocity, despite a recent re-launch.  We believe these revenues will continue to ramp at a healthy clip going forward.  The company has also slashed R&D and sales by 50%.  For the year, product revenues came in at $11M with $9M of gross margins.  Total operating expenses are at about $14.5M (down from $22M the prior year), and I don’t think there is much more they can remove without cutting into the muscle.I am assuming that existing revenues will have a decent trail, and thus StrongBox basically needs to ramp by $5.5M in annual revenue to get this whole business to break even (given the high gross margins), and then grow at least at the same rate as the legacy revenue declines.  This is hardly a herculean task for what I believe is a game changing technology with a huge TAM.  I will circle back on valuation later but wanted to lay out context first.StongBox is exciting but it is the least exciting part of this story. Let’s move on.

IP Assets

As I mentioned earlier, all the paid-in capital to the company wasn’t entirely for nothing.  They have produced an enviable set of patents, of which some have been litigation-tested with positive outcomes.  Furthermore, the non-litigation tested patents have been appraised by credible third parties.  The IP assets fall into two buckets - the 972 assets and non-972 assets - each of which we will describe separately.

972 Patent Assets

First from the 10-K:

The ‘972 Patent Family

The ‘972 patent family has been the focus of years of litigation and current licensing campaigns. As of October 31, 2014, approximately 50 companies have licensed ‘972 patents from Crossroads. Of these, 17 companies licensed our patents without litigation and the remaining companies took licenses as a result of litigation-related settlements. All lawsuits have been filed in the U.S. District Court for the Western District of Texas. One of the litigated cases in the Western District Court of Texas went through a jury trial. The jury reached a verdict that the asserted patents were valid and infringed by the defendant. The jury awarded damages to Crossroads which consisted of 3% and 5% of product sales as reasonable royalties on two different infringing products made by the defendant. The case was appealed to the U.S. Court of Appeals for the Federal Circuit, and the jury’s verdict was affirmed. In another case, we received a default judgment against the defendant and were entitled to an award of royalties. In another case, the U.S. Patent and Trademark Office was asked and conducted are-examination of certain patents within the ‘972 Patent Family. The U.S. Patent and Trademark Office examined over two hundred prior art references and ultimately re-certified the patentability of the claims of those patents. In the course of our lawsuits to date, The U.S. District Court has construed the meaning of several terms within the claims of the ‘972 patent family and in each instance the rulings were in favor of Crossroads.

Sims, the old CEO who started the litigation program, only chose to focus on smaller infringers.  His reasoning for doing so was that he didn’t want to step on toes of the big boys since he wanted to partner with them in some way.  Well the new board sees it differently and has chosen to bring a full-court press on these parties.  In October 2013, they filed suit in their hometown against a bunch of ‘big boys’ such as Oracle, EMC, IBM, Dot Hill, etc.  The docket # are in the 10-k.

There are a few important aspects here:

• The 972 portfolio has already been litigation tested, with different defendants, and has survived on both the initial verdict and appeal
• The USPTO did a review of the patents and upheld all of them without modification
• The litigation happened in Texas, in front of the same judge that is hearing the current cases
• The previous litigation program has produced $50-60M of royalty revenue (against the small guys) which is more than the current market cap of the company
• A Markman hearing happened in October of 2014, and a preliminary ruling has been issued in the last 15 days that is very favorable to Crossroads and will likely be adopted by the sitting judge who appointed the Master Examiner
• The Markman ruling is key as it effectively defines how the patent claims will be construed and I believe a favorable ruling will likely cause all the parties to settle - to date Oracle, Cisco and the like have been trying to litigate Crossroads into a corner and I think the tide has turned.
• In a nut shell, a Markman means that a judge decides what the patent claims mean, and a jury decides whether they have been infringed - the Markman is of critical importance in swaying the outcome and it is widely believed that the decision will define the outcome of IP cases
• For the first time, management stated that damages from the 972 cases will in their estimation result at least $200M of basic damages excluding enhanced damages, attorney fees, and interest etc.
• The case is being tried with home field advantage in Texas against the thieves of the east and west, stealing from the entrepreneurial 48 person company - I think the law and sympathy are on their side in what looks like Goliath stealing from hard working Texans
• In past litigation the courts awarded 3% and 5% as royalty rates

The Non-972 Patent Assets

The non-972 portfolio is, as its name implies, all the other IP, and none of this has been through litigation.  To understand what may lay here, the company engaged a third party on a fee basis to do an assessment of this IP and its potential.  Short of pulling all the patents themselves and doing our own analysis here is what we know:

• The study looked at all potential infringing revenue streams
• They excluded ALL international revenue
• They excluded all revenue from anyone involved in the 972 litigation
• The non-972 patents have been incorporated into industry standards -  anyone who claims to be standards compliant is de facto infringing (RAID for example).
• Then they took another set of conservative hacks to hone this number in and investors were guided that somewhere in the neighborhood of $82 Billion of revenue has probably infringed on the non-972 portfolio
• They have hired an IP firm in NY (Markman Advisors) to lay out a monetization plan on the non-972 portfolio – they are now determining whether to self-fund, partner, or sell , and we will hear more on this in 2015
• Fortress lent  $10M against this portfolio and continue to hold a lien (currently less than $5mm)
• This was the guy who did the assessment/appraisal, who is basically the gold standard in the IP space  - http://www.iam-magazine.com/blog/detail.aspx?g=ffb0bd3d-0890-4ca1-87fd-a81406ec106b
• The company intends to pay down the Fortress debt, so as to be able to capture all of the economics of the non-972 portfolio – Fortess has a $2M exit premium beyond the face value if the company wants to exercise the provision, which I think is a given. They were also awarded warrants.

Net Operating Losses

The company has $128M of Gross Federal NOLs.  These become relevant if there are large settlements, which I presume would shield the tax liability associated with those settlements.  That said, my expertise here is very weak.

Management and the Board

In a situation with so many moving parts that requires such a judicious use of resources, we think the company stands out with its leadership.  While the entire board seems excellent, we would highlight Rick Coleman, the Interim CEO who ultimately became the permanent one.  He is a seasoned big company tech executive who is also a great turnaround guy.  We have seen him involved in many other value turnaround plays and believe we are seeing his skill set at work here too.  His first steps were to focus the company on the product side and to right size the cost structure.  Mark Hood is another executive who runs the shop day-to-day and comes across as measured and excellent.  Jeff Eberwein is the chairman of Crossroads and the head of Lone Star Value.  He is one of us,   a deep value guy that has Austin roots as a UT grad, and then a Wharton MBA.  He went on to work at Soros and Viking before opening up an activist fund of his own.  He owns 20% of the company but seems to love it so much that he is buying hand over fist with a 10b-5 buying plan in place.  He also participated in a recent raise the company did to the tune of $805k.  We feel like this is the best possible board and management alignment we could hope for.  We also believe there is no empire building here and shareholder value is the sole objective, but in a patient and measured way to maximize the end game.

Recent Equity Raise

The company is still burning cash and had weak hands on the litigation front, so they were trying to raise some capital in the cheapest form possible.  They tried floating a perpetual non-dilutive preferred and it didn’t work, so they had to go straight common with 50% warrant coverage.  It wasn’t ideal, but I am not sure they had other options. I think it was important for a few reasons:

1. They want to buy out Fortress
2. They need to have credibility in litigation/negotiations, i.e. staying power
3. They need capital to drive the product side to profitability

We think the upside is so potentially big that we are glad the company did it.  They raised $7M (6 mm net) at the end of January 2015 with 50% warrant coverage.  We suspect some settlements this year will be able to fund the rest of the business plan without significant dilution moving forward.

Valuation

The signal to noise ratio is high here, and without the budget to get independent appraisal on the patents, it’s hard to do anything but a broad strokes approach to this idea.  However, we believe broad stokes are just fine given how we would size it, and through which pieces define the downside and upside for us.  We underwrite the downside largely though the operating business, and non-972 Fortress loans which we feel like we understand well (enough), and the upside through litigation, which is less in our wheel house but where we can get a directional handle.  In the end, with Eberwein and Lone Star owning 20% and other major holders holding another 20% and climbing, we feel aligned and in great hands.

Current Capital Structure

Future Valuation

Assumptions

I won’t go through every cell of the assumptions, but will rather highlight the ones that I think either move the needle or are important.

• For the operating business, we believe that in a low case it is worth 1x current revenues.  If it scales, however, it could be worth substantially more to a strategic buyer.  In the most optimistic case we think it is worth $100M.  If it were to grow to $30-40M in a few years, that is a number very much in reach.
• For the 972 portfolio we are relying on past royalties as well as guidance from management.  The company has historically been very conservative, and I think if they put a $200M number out there, they think it is on the lower end of the probability range.  In the low case, we assume they get only a fraction of this.
•  For the non-972 portfolio, the low and base cases assume it is worth basically what the recent loans have put a lien on them for, or a slight premium.  Given they have been able to borrow at these levels we don’t think it is a stretch.  For the higher cases, we use 1%, 3%, and 5% Royalty rates on the $82B revenue number management put out there.  On the 972 portfolio they have historically received 3% to 5%, so we used those as starting points.
• There is a Series F Convertible Preferred out there, we assume it gets converted along with most of the outstanding options and warrants.
• In the ‘Other’ line, we assume it takes another $5M to get this all to profitability, and ultimately legal fees are reflected in the net awards in the respective litigation wins.

We know the higher cases seem far-fetched, and they probably are.  We just wanted to put it all out there and hear any thoughts and criticisms.  We did a weighted expected value for fun, but mostly tried to just present the facts so people can make their own assumptions.  Considering we don’t think this is a goose egg on the downside, is multiples higher on the upside, and is in the hands of smart capital allocators, we have put our chips on the table and are optimistic about where the roulette wheel will stop.

Earnings and earnings call is tomorrow after the close.

Risks

·         Litigation is always a crap shoot

·         The litigation is in Texas!

·         Anything that sounds too good to be true usually is

·         Dilution along the way

·         If a patents falls and there is no one to hear it does it infringe ?

·         We are long this

·         Did we mention we are long this?

Catalyst

Litigation Wins

Officila Markman decision

Settlements

Strong box traction