Q3 – Visibility to 2013 Growth Improving

Wi-LAN Inc.’s (Wi-LAN) Q3 results were almost dead in-line with expectations and the outlook for Q4 similar (with maybe a little higher than modelled litigation costs). But the bottom line here is that the activity level on both the assertion of its large patent portfolio continues to increase and patent portfolio additions continue to strengthen the opportunity. On Wednesday, we expect to meet with management and will have a further update on the long-term picture. Below are what we think are the key investment points from the quarter:

- Results Nicely In-Line for Q3: Results of $21.3 million and $0.08 vs. $21.1 million, $0.08 expected.

- Q4 Outlook Positive, but Increased Investments Will Pressure EPS: Business booked to date is $20.7 million so expectations of $22.7 million look reasonable. As we warned, litigation costs are climbing in Q4. They are now expected to be about $8.7 million vs. our modeling of $6.5 million. BUT this can actually be considered a positive, as litigation costs often foreshadow settlements and given the aggressive litigation plan, this isn’t that big a surprise. We have lowered our EPS for Q4 to $0.07 to reflect the higher litigation costs.

Positives (details on following pages):

- The litigation schedule is stacked – revenue upside in 2013
- The patent portfolio is looking better each quarter and
- An OEM deal may still be in the works.

Challenges:

While this is moving a little slower than some of our original expectations, we believe this opportunity still exists and management indicated that discussions with more than one party continue. We suspect larger deals like this take longer than expected to close due to internal issues at the OEMs.

- Earnings Will Be Under Pressure Near Term Due to Litigation Expenses: Clearly, until major new licenses are signed, revenue will roughly remain at current levels and litigation costs will stay high, if not climb, at least for the first half of 2013. We have raised our estimate of quarterly litigation costs to $9 million for the first half of 2013 and then have it fall in the second half. But, note that a couple of years ago, when Wi-LAN was very active on four major actions, litigation costs were in excess of $12 million/quarter.

- We Like to Adjust the Adjusted Earnings to Include Patent Amortization: Just as a reminder, most patent firms, including Wi-LAN, like to exclude patent amortization from its adjusted earnings. We disagree and think of patent amortization as the "Cost of Goods" of the business. When we add back patent amortization to the adjusted numbers it can knock off about $0.20 (i.e., our 2013 number falls from $0.47 to $0.27).

Valuation

Our primary valuation tool is earnings power and the ongoing ability of this company to actively manage a patent portfolio to produce solid returns. And this is what our $7.50 target is based on – i.e. 15x what we think is the firm’s earnings power in the next couple of years (i.e., $0.50 EPS).

But when the stock trades down to $5.00 we like to pull out the sum-of-parts valuation. This is much more of a balance sheet approach that gives no credit to the current opportunities the company is chasing, and simply looks at the value of the firm if it were to be wound up tomorrow – i.e., a pretty draconian view. But, even this approach suggests support at $5.00.