Rambus (Nasdaq: RMBS) is back. Every time I think I've got a good reason to avoid it, it cries even louder for attention. I don't want to look, because its business model makes me really uncomfortable, but I've got to. It's too compelling -- especially after this week's news. At the very least, Rambus presents a fascinating case study for our second Rule Breaker criterion: sustainable advantage through, among other things, patents.
The Rambus story is long and complex. We've documented much of it in our News area. Rambus designs Dynamic Random Access Memory (DRAM). It doesn't manufacture it, however. It makes money by licensing its technology to DRAM manufacturers and taking a percentage of revenue. At first, Rambus only had contracts covering the manufacture of its Rambus DRAM (RDRAM), a new type of DRAM that promised to open up a bottleneck and transfer data up to 300% faster than standard Synchronous DRAM (SDRAM).
The trouble with RDRAM
Trouble is, not many products use RDRAM. Intel (Nasdaq: INTC) partnered with Rambus years ago to design a chipset around RDRAM, but the relationship has turned rocky. Intel has delayed, recalled, and canceled production of chipsets. The Financial Times recently quoted Craig Barrett, Intel's CEO, as saying, "We made a big bet on Rambus and it did not work out. In retrospect, it was a mistake to be dependent on a third party for a technology that gates your performance."
As an Intel shareholder, I watched these developments unfold and began to conclude early on that Rambus wouldn't go anywhere. It turned out, however, that Rambus had another card to play. It has asserted that its patents also cover essential elements in the production of SDRAM and next-generation double-data rate (DDR) SDRAM. That means that Rambus may be able to collect royalties on all of the DRAM manufactured in the world.
That was a $20 billion market in 1999, and growing by leaps and bounds. If Rambus can skim 1% off of that pot (which is what it seeks from SDRAM sales), that's $200 million a year -- for doing essentially nothing. No cost of goods, no marketing, no nothing but research. We're talking about 80% profit margins. At least. If it can gather more (it seeks 2.0-2.5% for RDRAM and 3% for DDR), why, that's all the more gravy.
Now it just needs to get it. Rambus has deals with five of the top 10 manufacturers -- including number one Samsung. That gives it a grip on over 40% of all DRAM sales, though it's hard to know how much that means in profits, since Rambus doesn't disclose the terms of those contracts. Rambus has lawsuits pending with three other memory makers, having already gone to court to force Hitachi (NYSE: HIT) to pay up.
Is Rambus a Rule Breaker?
How well does Rambus satisfy our Rule Breaker criteria? As DRAM licenser Numero Uno, Rambus can justifiably be called the top dog. Cutting-edge DRAM is certainly important and ever emerging. Rambus has had strong price appreciation, with a relative strength around 92. It's had smart backing from Intel, and its management gets kudos for signing a contract with Intel on favorable terms early on. Management has also proven capable of leveraging its proprietary advantages.
Rambus doesn't have much of a consumer brand, but check out the trade magazines and you'll find Rambus in every issue. It's dominating the buzz in Semiconductorville. As a result of the various controversies and the skyrocketing stock price, plenty of media minds have questioned its high valuation -- including yours truly. (Particularly noteworthy -- though dated -- is Forbes' mention of Rambus as "this year's Iomega (NYSE: IOM)." Isn't the world spooky sometimes?)
That just leaves sustainable advantage. Here's the criterion:
Sustainable advantage gained through business momentum, patents, visionary leadership, and/or inept competition.
Rambus must have this one sewn up, right? After all, its whole business is based on patents.
Aye, there's the rub. This is why Rambus makes me uncomfortable. Rambus is its intellectual property. Its business is not built on customer loyalty -- in fact, its customers would be delighted not to be its customers. They go to court to try to avoid it. Having an adversarial relationship with your customers is a tough way to live.
In a sense, Rambus' patents actually prevent its advantage from being sustainable. Its customers will work in the future to bypass the patents. Since the customer base is small -- only a handful of companies -- and based not on loyalty but on necessity, Rambus may have a hard time sustaining the advantage it has. And, if and when the competing technology comes or the court decision goes against them, it will be a sudden and precipitous blow to Rambus' business model.
Rambus is doing more research and development, trying to stay ahead of the curve, and patenting every move along the way. It may well succeed in doing so, and profit enormously along the way, but its business doesn't have a lot of protection in a storm. As a going concern, I'd prefer to have a business built on customer loyalty and manufacturing know-how. Philip Fisher wrote in Common Stocks, Uncommon Profits, "When large companies depend chiefly on patent protection for the maintenance of their profit margin, it is usually more a sign of investment weakness than strength."
That's my feeling anyway. I'm too uncomfortable with its competitive position to invest in it, despite its highly profitable business model. Lots of people who know much more about the industry disagree with me, however. You'll find a lively and extremely well-informed conversation taking place on the Rambus discussion board.
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