Will PANL Pay Off?

[This article was updated on 12/19/02 to correct the amount of Motorola's ownership and clarify the statements about Universal Display's contract with the Army. Thanks to the many readers who e-mailed!]

Remember that Web-based fold-up device in Minority Report? It was the dream of Princeton, N.J.-based Universal Display (Nasdaq: PANL), one of a few companies toiling in the OLED -- that's organic light emitting diode -- realm. Check out this recent CBS News report (RealPlayer required, broadband connection works best) on the company's flexible OLED technology. Then come back to earth.     

OLED 101
Current flat panel technology is LCD, or liquid crystal display, and requires backlighting. Because this is power hungry, it's less than ideal for mobile commercial and military uses from laptops and cell phones to PDAs that all depend on battery life. Also, as screens become tinier, LCDs aren't as sharp. OLEDs promise an end to glass and glare and neck craning, because they are viewable from any angle, though some experts say that they can be hard to see in sunlight and degrade with use.

OLEDs can be applied to flexible surfaces, leading companies to predict all manner of sci-fi products, such as wearable displays, rollable always-current newspapers, walls that change colors, car windshield displays, and the folding device in Minority Report. Or, wait, not so sci-fi. The latter device, a low-power, flexible OLED, or FOLED in Universal Display-speak, is the basis for the company's plan for a Universal Communication Device and for a new cooperative research and development agreement with the U.S. Army. You can learn all you want about OLEDs by checking links that investors have posted on our Universal Display discussion board (30-day free trial to read; subscription required to post). 

With a flat panel market today estimated at between $25 billion to $30 billion, some industry observers estimate an OLED share at 10% by 2007. We are talking the future, but we are also talking some bucks.

The players
With a market opportunity that size, several dozen companies toil in OLEDs. They include Eastman Kodak (NYSE: EK), DuPont (NYSE: DD), Sanyo, and Pioneer, as well as smaller Universal Display and privately held Britain-based Cambridge Display Technology.

Cambridge Display and Universal Display seek to commercialize work begun in the labs of professors at Cambridge and Princeton Universities (and later the University of Southern California), respectively. Each university retains an ownership share of its spinoff. I'm picking today on Universal Display because it's publicly traded and I'm familiar with the company through owning shares for almost three years. It's also the kind of small, scrappy outfit that we like to examine in our search for Rule Breaker Portfolio investments. But no one should mistake this company for an investment. It's a rank speculation, a development-stage company without profits or cash flow from operations. As such, it's a very small part of my own portfolio. Foolish investors limit their Rule Breaker stocks to 20% or less of their holdings.

Is it any good?
We've written here extensively over the years on the excitement of new technology, but the problem is that few investors have enough familiarity with the complex science involved. But if you intend to wade into unfamiliar technology, one way to avoid disaster is to clearly understand the business model. One critical element is to watch how many big players with large marketing machines buoy the company through alliances in the form of equity stakes or licensing. The larger the bet taken, the more confidence the partner has and the greater its incentive to include the technology in products and push them.

Please view that CBS report with skepticism, as you dig behind every company's hype machine. Investors know well that the marching hordes of most company press releases tout deals but can mislead. For example, take Universal Display's recent Army deal. [See also clarification following.] The press release trumpets Universal Display's "$2 million Two-Year U.S. Army Research Labs Contract." It's no such thing -- at least not what the headline intends to communicate. The Army funds $1.2 million of the company's research while the company pays $813,725. That sure looks to me like net of $386,275, or $193,138 per year -- a far cry from two million. A bit better is a possible third-year extension. This is allegedly $2.85 million, with the Army at $2 million and Universal Display contributing $850,000, for a net to the company of $1.15 million. The $1.15 million for a year is real money for a company with $1.8 million in trailing-12-month sales, but $193,138 a year for the next two years is much less so.

[Author's clarification: Several readers pointed out to me the obvious -- this is a good deal for the company. After all, this is research funded with government dollars, research the company may or may not be able to fund alone, with all sorts of possible future benefits. I agree, and in that sense to balance the two parties' contributions is inapt. I also did not mean to say that Universal Display is a hype machine any better or worse than others, but I do strongly mean to say that there is a lot of hype around OLEDs and around this company (no matter who caused it), and that investors should assume that every press release is shaded to show the company in the best possible light. That's what the PR people are paid to do, at this and every company. Investors should stick to the SEC filings and treat press releases with skepticism.]        

A tangled OLED web
The business model is this: Universal Display is and will be primarily a research and development company that licenses its intellectual property and processes to manufacturers and collects royalties on products sold that incorporate the technology. Piece by piece over the last two-and-a-half years, the company has laid the groundwork for a virtual full-service OLED empire.

If you want large manufacturing and consumer products businesses to license your OLED technology and pay you royalties on future products, you must have pretty solid control of the patents (intellectual property, or IP) or they will squash you like a bug. The realities of business are that no one pays you to license your patents unless they have no choice -- you must have unassailable IP and the resources to sue to enforce it. Few  know this better than Universal Display founder, chairman, and CEO Sherwin Seligsohn, the digital radio pioneer who formed InterDigital Communications (Nasdaq: IDCC) to exploit a cache of TDMA and CDMA wireless communications technology patents. Beyond strong IP, a company must ensure that potential licensees can buy commercial quantities of the OLED building blocks and the equipment to turn the raw materials into OLEDs themselves.

In the second half of 2000, Universal Display disposed of these obstacles within just four months. Motorola (NYSE: MOT) contributed sole licensing rights to its OLED patent estate to Universal Display in exchange for an equity stake. PPG Industries (NYSE: PPG) joined up to produce OLED materials, and Germany's Aixtron AG allied with the company to develop next-generation OLED production equipment, using organic vapor deposition (OVPD) technology.

Then came the deals aimed to produce commercial products with the company's OLED technology, notably with Samsung for portable OLED devices, Sony (NYSE: SNE) for OLED TV monitors, and just last week, in what may be the most bullish sign to date, an upfront licensing fee and royalty deal with the DuPont Displays division of DuPont, which also has a licensing deal with Cambridge Display. DuPont Displays' Steve Quindlen reportedly told Dow Jones that Universal Display technology addresses some limitations of using OLEDs for full-color displays. Pretty important, considering that neither you nor I would likely go back to monochrome screens just to have them smaller, sharper, or even folding.

Cash burn and survival
Investors in development stage companies know that the lifeline is cash -- especially today when capital markets are wary. How is Universal Display positioned?

At the end of 2001, the company's balance sheet sported $15 million in restricted cash and $12.4 million in cash and short-term investments. In August 2001, it sold preferred stock and warrants raising $4.5 million, and also issued convertible debt for $15 million. The $15 million was restricted and thus unavailable because it was pledged as collateral for the letters of credit securing the convertible debt.

Things didn't look great. This was the situation over the next nine months:

         Unrestricted    Net Cash From     Capital
Quarter  Cash & Equiv.     Operations    Expenditures
Q3 2002     $20.3 mil.       (1.4)          (0.1)
Q2 2002       7.3            (2.6)          (0.2)
Q1 2002      10.1            (1.5)          (0.8)
Q4 2001      12.4            (1.2)          (1.1)

At Q2's burn rate (net cash from operations minus capital expenditures) of $2.8 million a quarter, the company had about three quarters of life left. 

What happened?
But the thick plottened. In Q3, the convertible debt holders agreed to convert $7 million of the $15 million into Universal Display shares at $5.09, while the company paid them (from the previously restricted cash) $8 million plus interest and prepayment premium for the rest. Then it issued $2 million in stock at $5.41 a share. Presto change-o, the debt was gone and the rest of the restricted cash -- about $6.2 million -- became available for corporate uses. The downside was dilution of current shareholders, but I'll speak for at least one shareholder to say that it's well worth the debt-free, cash-richer balance sheet.     

Today, the company has about two years of cash at its current burn, increasing revenue, and some great consumer electronics and advanced materials partners. Its execs have been quoted as predicting revenue growth leading to profitability in a year or two, but I discount such statements in the absence of concrete signs of rapidly increasing revenue and cash flow from operations.

This is a risky, speculative investment, and even if the company's technology hits the big time in millions of products sold, it may not pay off handsomely for investors. No, it's not the stock option grants, with net dilution ranging from 2.6% to 3.3% in the last three years -- under the 5% warning level for a development-stage company. It's more that the IP model is newer and unproven. Many business and investing analysts maintain that the greatest success stories have been companies that had manufacturing control over their products. Universal Display does not. It travels the IP company road with the likes of Rambus (Nasdaq: RMBS) and ARM Holdings (Nasdaq: ARMHY), and there are few maps, ditches, and highwaymen lying in wait. We shall see.

Updated portfolio returns appear below, showing that the Rule Breaker Port is ahead of both the S&P 500 (with and without dividends added) and the Nasdaq for the week, month, and year, since inception in August 1994 and since christened the Rule Breaker Portfolio in October 1998. Nice. Have a most Foolish week!

Tom Jacobs (TMF Tom9) presents great stock ideas for the year ahead in Stocks 2003 -- available now -- and goes behind the hype each month in The Motley Fool Select. Start your 30-day free trial today! At press time, he owned shares of Universal Display, Rambus, and ARM Holdings. To see his stock holdings, view his profile, and after clicking your heels three times, check out The Motley Fool's disclosure policy.

Rule Breaker Portfolio Returns as of 12/16/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week        2.45%     2.06%    --      2.43%
Month      -0.94%    -2.77%    --     -5.31%
Year      -19.70%   -20.70%    --    -28.20% 
CAGR 
 using IRR**
 since 
 8/4/94*** 21.45%     8.54%   11.15%    8.27%
10/20/98*** 2.80%    -6.34%   -3.32%   -8.15%