Because I hold mostly sleep-at-night investments -- 70%-80% dividend-payers and dominant companies, as well as small-cap value stocks and the S&P 500 index -- I feel comfortable taking on some risk with the rest.
That means informed speculations in biotech drug makers, technology companies (I defined this necessary evil of financial writing last week), and unproven but promising Internet e-commerce outfits. I'll also dabble in strategies such as shorting and options. By putting high risk in its place, I hope to experiment, learn and have fun, without jeopardizing my future. And -- I hope -- enhance my returns.
For example
Consider Rambus (NASDAQ:RMBS), which like last week's ARM Holdings (NASDAQ:ARMHY), is an intellectual property company composed primarily of engineers. (Nothing against management, which, best case, takes the heat and makes hard decisions. It just too often spends too much to entrench its own interests, which, as we've seen, are often but loosely aligned with shareholders'.)
To make money, Rambus patents its inventions, licenses them, then collects royalties on the sale of products that use the patented technology. Simple business model -- complex technology. Rambus' research and development team toils in the arcane but important area of memory interfaces -- the speed-critical, chip-to-chip connections in computers and networking gear. Rambus first marketed RDRAM (Rambus dynamic random access memory) intent on dominating the next generation of PC memory beginning with Intel's (NASDAQ:INTC) Pentium 4 microprocessor, while at the same time forging the future of game consoles in the Sony (NYSE:SNE) PlayStation 2.
Great expectations
Of course the market went nuts over a debt-free, cash-comfy company that would earn royalties from the next Intel PC chip standard and the highest-tech video game console to date. (Just the type of Hidden Gem you might find in Tom Gardner's Motley Fool Hidden Gems or Rule Breaker his brother David might pick in Stock Advisor.)
But there was more to the story. Many investors bet that Rambus, based on its patents, would not only obtain royalties on RDRAM, but also on the then-standard PC memory SDRAM and looming competitor DDR SDRAM. Outperforming even in the last leg of the bull market, Rambus jumped over 600% in early 2000, as relentless buying led to the mother of all short squeezes.
Bloom off the rose?
Then the stock market and semiconductor market headed south. Intel turned fickle, relegating RDRAM to the high-end performance PC market and embracing other memories for mass-market PCs. For proof, check the computer ads in the newspaper. Invariably, the DRAM listed is DDR SDRAM.
And while DRAM manufacturers like market leader Samsung agreed to pay Rambus royalties on SDRAM and DDR SDRAM memory, Micron Technology (NYSE:MU), Infineon (NYSE:IFX), and Hynix Semiconductor balked. Amid a flurry of lawsuits, Rambus stock dropped like Wile E. Coyote's anvil, plunging more than 85% before hitting canyon bottom.
Yet like the resilient Road Runner, Rambus' business kept speeding along, producing positive free cash flow every quarter save one, while its research and development machine launched three new product lines, leading to new licensees.
Beep beep!
Business performance
As you can see, while the semiconductor market suffered one of the worst cyclical downturns ever, Rambus revenues declined and then recovered, while EPS and free cash flow per share remained stable:
Quarter Revs. FCF/ Stock Ending ($mil.) EPS* Share Price*** Current [7/7 close]03/03 $28.1 $0.05 $0.02 $13.2112/02 $25.7 $0.06 $0.18 $ 6.7109/02 $24.6 $0.06 $0.12 $ 4.3406/02 $23.7 $0.06 $0.05 $ 4.0903/02 $23.5 $0.07 $0.07 $ 7.7912/01 $24.9 $0.06 $0.06 $ 7.9909/01 $28.1 $0.06 $0.01 $ 7.3606/01 $23.3 $0.04 none $12.3103/01 $31.2 $0.07 $0.06 $20.6012/00 $34.7 $0.12 $0.02 $36.12 *Using diluted sharecount
**Excluding tax benefit (detriment) from stock options
***Last day of quarter
No great momentum, to be sure, but as with ARM, holding one's own in lousy times is a sign of strength. But neither that virtue, nor general market trends, explains a four-fold increase in stock price from the lows last June. One word does: lawsuits.
Legal matters
Ongoing lawsuits affect Rambus' valuation in two main ways. First, their outcomes determine whether Rambus collects millions in royalties. Second, the legal process alone costs money, draining cash that might otherwise be invested in the business.
Indeed, the stock first jumped on a legal victory. Rambus had sued holdout Infineon to collect SDRAM and DDR SDRAM royalties, and in 2001, suffered a devastating negative trial court ruling. This January, an appeals court reversed on all counts, encouraging investors that the company's collection plate might finally reach Infineon and the other holdouts. Rambus shares jumped more than 57% that day and kept on running. Court Victory! Stock on Sale? recaps the case and its import (and provides handy links to the 15 prior Motley Fool articles on the company since April 2000). But the procedural battles continue and Infineon isn't paying Rambus yet.
Second, any possible end to or reduction in litigation could increase free cash flow by as much as 100%. The company estimated expenses of $5 to $8 million for legal battles in the quarter just ended -- roughly $0.05 to $0.08 per share for one quarter. It's not irrational that the stock would rise on the potential that this cash might be better used.
On the flip side, while juicing the stock, the legal situation highlights that litigation is very much a part of the Rambus story, and risk. That uncertainty persists, most notably in an ongoing Federal Trade Commission trial of its anticompetitive conduct case against the company. For a lawyer's inside look at the legal issues, enjoy NicdaGreek's Initial Thoughts on FTC and where we are, on our Rambus discussion board. (There's no better place to learn about these products and issues, including the lawsuits.)
Rambus today
There's more to Rambus today than royalties from current-generation DRAM. Three new products offer additional opportunities:
- Redwood: parallel bus between logic chips. To be used in new "Cell" processor developed by Sony, Toshiba and IBM (NYSE:IBM) and expected in 2004 or 2005.
- Yellowstone [Post publication note: Rambus renamed Yellowstone with the spiffy "XDR" on July 10, 2003]: next generation high speed DRAM using differential signaling -- Octal Data rate and FlexPhase. Can transfer up to 100 gigabits per second, three times faster than current high speed memory. Company believes all DRAM will ultimately migrate to differential signaling and its technology from current standard Double Data rate (DDR) DRAM. Licensees: Sony, Toshiba, Elpida, Samsung.
- RaSer: serial link between logic chips. Eighteen licensees as of March 31.
These three buzzwords alone should tell you why Rambus carries tech risk. Will DRAM manufacturers provide enough supply of memory containing Rambus' new memory technologies? And if they do, will companies include it in their products? Will this happen fast enough to sustain and grow Rambus business sufficiently to provide returns given that the company's enterprise value is now 53 times its free cash flow minus interest? And what is a RaSer, anyway? Clearly, these new technologies are nowhere near the acceptance, say, of ARM Holdings'.
Valuation
The first run up on the appeals court decision put the stock at $11.65, or 45% to 60% below my then-estimated $20-$30 range for intrinsic value. Monday's $17.94 close offers a much lower margin of safety. Not only that, but my valuation was based on the very optimistic -- and it turns out prematurely enthusiastic -- view that Infineon would settle quickly and start paying royalties a quarter later. Hasn't happened, so the intrinsic value range is lower. If this were strictly a value investment, I'd likely sell half when the stock reaches the low estimate of intrinsic value, but Rambus hardly fits that category.
All the same, at some point, growth had better pick up or that multiple of 53 times enterprise value to free cash flow (minus interest) is going to present some serious valuation risk.
Time to part?
I've had a long affair with Rambus, but it's time to reevaluate. The technology risk requires a substantial margin of safety, and I'm not convinced that there is explosive upside from the current prices to justify that risk. Other investments (such as ARM, with a more clearly visible value chain) appear to offer more understandable and attractive rewards for the risks.
All this leaves me leaning -- but not absolutely determined -- to sell all or some of my stock (though not within five days of this publication, due to our best-in-class trading guidelines and disclosure policy). I did buy some put options as a hedge against the stock falling after its quick rise, but that may just have been putting off a decision that must be made. Share your thinking on our Rambus discussion board!
Tom Jacobs (TMF Tom9) has no margin of safety. Find his columns in this handy archive. He owns shares of Rambus and ARM Holdings, as well as others you can see in his profile . Check out The Motley Fool's tasty disclosure policy,which comes in only one flavor.
