Patents are notoriously difficult to value but it is clear that patents are becoming a viable asset class in themselves. Taking the cue from many other asset classes, could there be a way to “securitize” a portfolio of assets? This could be a fun and challenging opportunity to address. One approach is Nathan Myhrvold’s Intellectual Ventures, a “venture fund” that invests in patents by acquiring those invented by others and developing some internally. There are many in the technology industry who fear Intellectual Ventures will evolve into the best funded and organized patent troll.

Below is an essay I wrote for an investment newsletter published in February 2007 distributed to high net worth clients.

Patent Bridge is Falling Down

Horror of horrors! We almost lost service for our Blackberry communication devices early last year. Also known as Crackberries for their users’ incessant finger-pounding of emails during company meetings, on the subway, and even on vacations, a patent infringement lawsuit filed against parent company Research In Motion (RIMM), threatened to sever the umbilical cord between the gadgets and their addicted users. NTP, Inc., a patent holding company, claimed that RIM infringed NTP’s wireless email patents. Legions of squinty-eyed telecommuters were relieved when RIM finally settled with NTP by paying an extortionary sum of over $600 million.

The Blackberry episode underscores the growing importance of an emergent business model. Disdainfully described as “patent trolls” by detractors, patent holding companies assemble portfolios of patents and wait for other companies to develop infringing products. Profits are then won in the courts and not in the arena of market competition. This form of intellectual blackmail has the potential of drastically altering the economic landscape and the development of innovative new products.

Innovation is the Holy Grail. Harvard Business School professor Clayton Christensen assured us of that universal truth with the publication of a couple of business bestsellers. Large corporations pursue innovation with a newfound zealousness. However, the editors of this publication submit that the innovator’s dilemma is no longer about large corporations’ inability to recognize and take advantage of disruptive technology; it is now about navigating the field of patent landmines.

Who takes the risk? Innovation is inherently a risky endeavor. Impactful advances in technology seldom occur at low cost. Invention, experimentation, testing, and prototyping can require large sums of capital. Furthermore, product evangelism often dwarfs the cost of research and development. Thus, the founding fathers created a patent system to reward the risk taker and incentivize risky behavior resulting in benefits to society in the form of improved goods. They must now be spinning in their graves. Patent trolls are, in essence, excellent risk arbitrageurs, because they have found a way to extract profit without undertaking the bulk of the risk. In the case of NTP v. RIM, although Research In Motion incurred the cost of developing the Blackberry device and bringing it to market, the patent troll almost succeeded in removing a winning product from the marketplace. Who loses? Ultimately, the consumer.

How does one spot a patent troll? Like the monsters of childhood tales, they hide and wait under a bridge until someone attempts to cross. Trolls then exact a toll from the weary traveler for use of the bridge. Only in the real world, the bridge or asset was built or developed by the traveler! Patent trolls are, in the words of the legal cognoscenti, “nonpracticing” patent holders. They have no intention of ever developing and commercializing their patents.

“But we are all patent trolls!” Panglossian defenders of the current patent system point to the huge patent portfolios of large corporations like General Electric (GE), International Business Machines (IBM), Intel Corporation (INTC), and even mundane consumer goods powerhouse Procter & Gamble (PG). In this world of limited resources and talent scarcity, even the most imposing corporate behemoths can ill afford to commercialize all their patents. Yet when the blue chips’ patents are infringed, they pursue legal recourse as vigorously as any litigant. Defenders of the status quo place the burden of diligence on manufacturers. All who aspire to make the next iPod (AAPL), Blackberry, Viagra (PFE), or toaster oven must search the United States Patent and Trademark Office archives for all prior art – just as it has always worked for the last two centuries. They have a point. If manufacturers are not thorough with their homework, why shouldn’t they be sued?

The problem is not whether large or small inventors are practicing or not. The editors submit that the problem is what we call the Goldilocks Paradox. Currently, too many overly broad patents are being awarded. When that occurs, it becomes very difficult to innovate around such widely defined intellectual property. When patents are too narrowly defined, it becomes very easy for competition to design around them.

“Yum yum, these patents are not too broad and not too narrow, they’re just right!” To get to this happy equilibrium, we humbly suggest a remedy. To curb trolling behavior, set a time horizon for making infringement claims. The deliberate strategy employed by patent trolls of waiting for another company to develop a market for a product to then sue for damages is diametrically opposite of the approach taken by most large corporations armed to the teeth with attorneys. After a certain amount of time, claims will either have no merit or will win reduced compensation. We believe this would put a significant chill on trolling behavior and allow everyone to get on with the business of making our lives better.

For all the Blackberry users out there, cling tightly to your beloved devices. On May 1, 2006, Research In Motion was sued by another patent troll, Visto. Ah, as Candide implied, “All is for the best in this, the best of all possible worlds.”

Optimism abounds with the market resolutely shaking off bad news while focusing myopically on the good, or relatively good, news. The cheerleaders on CNBC (GE) can scarcely be heard uttering the dreadful words of inflation, recession, stagnation, credit crisis, and foreclosures. Happily, they talk about earnings beats. Surprisingly, there are a number of really substantial earnings beats that seem to justify the current sanguine tone of the market.

A lot of the beats thus far have come from blue chip companies that dominate their industries and sectors. Logically, this makes sense. If we are in a recessionary environment, only our very best companies will be able to capture market share. Secondary companies or second tier competitors will lose market share in tough environments. I suspect that the cash coffers of the Fortune 500 will soon start to be deployed, resulting in a nice pickup in mergers and acquisitions activity and the buying of market share. Beware the rash of earnings reports coming from the middling middle of our corporate roll call.

Now, on with the ceremony:

Intuitive Surgical, Inc. Q1 2008 Earnings Call Transcript – The maker of the revolutionary da Vinci robotic surgical system, this has been a growth stock for the future and the recent past, but apparently not for the present. After hours, Intuitive Surgical (ISRG) reported EPS growth of 81% and sales growth of 65%. These numbers actually beat estimates, something this company has become habitually good at doing. However, the beat was not as large as previous beats and the stock dove 8.6% in after hours trading. Come again? Kudos to the boys at Bespoke Investment Group for calling the potential for a “bad beat.” Full Disclosure: I currently have a long or short position in ISRG in one or more of my private investment partnerships.

IBM shares rise to highest price in 6 years after earnings – Big Blue (IBM) is one of the primary drivers of this recent rally. While everyone was gloomily expecting credit crisis-sickened earnings, the House That Watson Built comes out with an outstanding report. Net income rose a whopping 26% while revenue grew 11% during the first quarter. I have to quibble here with the unalloyed euphoric reaction. The ability to cut or manage costs is exactly what is needed in a recessionary environment and while revenue grew healthily, this is not a case of sales growth keeping in line with profit growth. Everyone else is taking this bellwether stock as indicating unexpected strength in the technology sector. Extrapolation is a dangerous game to play. IBM’s domestic business represents only 35% of total revenues. Unless your small-cap technology stock has a global presence, you may be disappointed yet.

Russia’s White Gold – Cramer is an entertaining fellow. He’s onto the story of how American food conglomerates are beginning to crave Russian food makers. Gobble, gobble, gobble, buying on acquisition speculation is for turkeys. Wimm Bill Dann (WBD) is one such Russian food maker and has benefited from the worldwide inflation of food prices. I’ve mentioned before that food inflation will make us all a little hungrier and Ben Bernanke’s job a little harder.

Crown Holdings sets high following jump in 1Q profit – Population growth in emerging countries is one of the main drivers of the growing demand for food. Someone’s got to package all that food to meet exploding demand from a burgeoning global marketplace. Crown Holdings (CCK) has been a big beneficiary of the demand for food and thus the derivative demand for packaging for food. Beware the toxic balance sheet. Beware even more the equally strong inflation in raw materials. Basic metals for beverage cans have seen strong price advances. Oil’s record-setting price march will surely increase the cost of plastic packaging.

Amphenol raises 2008 profit, sales outlook above estimates – My skepticism of IBM and the rest of the technology sector is made to look silly as smaller player in technology also beats comfortably. Amphenol (APH), a maker of fiber optic cables and connectors reported that sales rose 18% while income saw a 25% jump. Demand for bandwidth remains strong as countless millions waste precious minutes watching stupid videos on YouTube for free. Someone has to produce the digital pipes that make our devolved entertainment needs possible. Oh, did I mention that Google (GOOG) also pleased Wall Street with a rosy earnings report? I’m looking stupider and stupider by the minute.

Since my current work is in new media and social networking, I am keenly interested in the turbulence facing the newspaper industry. Clients, ranging from Fortune 2000 companies to small innovative startups, come to my team at SocialOptimize to gain an understanding of the new media landscape and to develop an actionable strategy for building a meaningful presence in social networks. They ask about their traditional marketing budgets and I tell them that we will see the disappearance of many old model newspaper, radio, and television companies as they struggle and fail to adapt to the reality of new media on the Web. Consumers are spending less time watching television, listening to radio, and reading newspapers. Instead, they are spending more and more time on the Internet for their news and entertainment needs. Very few traditional media companies will emerge stronger from this “dislocation” but the opportunity exists for several to transform themselves into new media leaders.

As an investor, I train my eyes on public companies that report the news who are also making headlines themselves. During periods of disruption, large sums of value get destroyed but great opportunities arise at the same time. Thus my ears perked up when I learned that Harbinger Capital, playing the role of activist investor, initiated a proxy fight by nominating four candidates for the New York Times (NYT) board of directors. The New York Times, being one of the leaders and most important assets in traditional media, has been causing great anxiety and nervousness in shareholders. Newspaper subscriptions and newspaper advertising revenue, the old metrics of success, are steadily declining and this has caused a panic in investors. I argue that newspaper subscriptions can no longer be relevant in the evaluation of this company. While advertising revenue of course remains the lifeblood of media companies, revenue from the printed page should diminish in priority. The company needs a dramatic rethinking of what it means to be relevant and influential and how to reconfigure its revenue base. Harbinger seems to be on the same page as it calls for “bold action” in the form of selling off business units and increasing investments in online efforts.

If Harbinger succeeds in placing its nominees on the board, I think it will have its greatest impact by helping the company allocate capital in a more logical manner. The company should start by deemphasizing or changing its editorial makeup. Americans perceive mainstream media outlets like the New York Times as “out of touch” and severely biased in favor of liberal policies and politicians. Whether this bias is true or not matters little, one can only respond to the marketplace with logic and logic dictates that the customer is always right. This presents an opportunity to drastically cut the expensive editorial staff and balance it with editors of more conservative leanings. In no way am I advocating for a government mandated Fairness Doctrine. I’m pushing for a market-mandated, self-regulated, fairness regime that satisfies what consumers and readers are asking for. This will go a long way in maintaining relevance and influence while generating substantial cost savings at the same time.

As for overhauling its revenue base, I think that the New York Times has taken good steps towards improving its online efforts. Only Rupert Murdoch’s News Corporation (NWS-A) has arguably done a better job at shifting revenue streams online. It doesn’t get a lot of press for its investments in the Internet, but some of the companies it has invested in are very compelling. As with all new businesses, patience is required for a few of these to work out and become substantive revenue generators. Many of these have ambiguous business models to begin with and it will take some time to adjust to the market and settle on a viable strategy. I expect some of these will not gain traction and will fail, but that is the perilous, creative, and destructive nature of our evolving online business environment. Here are some of the company’s more notable recent investments in a portfolio style overview:

Earlier this year, NYT co-invested with a few venture capital funds in San Francisco-based Automattic. Automattic’s primary product is the blogging platform known as WordPress. WordPress software can be downloaded for free and hosted on private servers. WordPress.com is a hosted blogging solution that many major media outlets are turning to as a cost-effective solution for serving blogs and other content. Large media companies such as CNN, Fortune, and Fox are paying for the company’s WordPress.com services to host their blog content. WordPress is one of the leading content serving platforms on the Internet and continues to grow in popularity. I think Automattic will carefully find other ways to monetize the technology including serving advertising.

The Internet is a medium that is conducive to the convergence of different types of media such as text, video, and audio. The clean divisions between newspapers, radio stations, and broadcast television that existed before the rise of the Web no longer apply. In early 2007, the New York Times joined with other media companies such as Time Warner (TWX), GE Global Media & Communications (GE), Hearst Interactive Media, and IAC/InterActiveCorp (IACI) to fund Brightcove, a developer of IP video technology. Brightcove technology hosts and serves content published by professional media businesses. Brightcove has emerged as one of the more successful alternatives to YouTube for consumers of video content.

Just earlier last month, NYT partnered with Sam Zell’s Tribune Company, Gannett (GCI), and Hearst to form a joint venture called quadrantONE. Yet another in a long line of advertising networks, quadrantONE will sell localized online advertisements, primarily display or banner ads. Given that this network will include many regional and national newspaper organizations, it stands a reasonable chance of achieving success. The challenge will be to educate smaller, more localized marketers about this differentiating factor. Many small marketers are still only aware of Google’s (GOOG) advertising platforms. The real opportunity here belongs to the regional and local metro papers. Consumers will return to demanding more quality localized news and content. If the local news agencies can meet that demand, they can create the inventory necessary to make a localized ad network like quadrantONE a viable competitor online.

NYT has also invested in Federated Media, an ad network for blogs. There will always be a place in this world for professionally produced news content. I certainly don’t want an amateur giving me the scoop on a tightly guarded political scandal. Most amateurs don’t write well enough to convey the juiciness of the drama. And if an amateur suddenly stumbles upon a juicy scoop and is capable of writing cogently about it, that person immediately becomes a professional. Such has happened in the world of blogging. The new world certainly has space for an army of amateurs sharing their opinions regarding everything under the sun. This distributed rather than centralized model of content creation opens up opportunities for a talented few to break into the ranks of influential professionals. The good ones generate a relatively large following. Federated Media helps this top tier of bloggers monetize their audience and content. A recent rumor has management at Federated Media rejecting a $100 million buyout offer.

The rise of Craigslist, partially owned by eBay (EBAY) has devastated the classifieds advertising market for newspapers. Job listings revenue, usually the most lucrative segment in classifieds advertising, has fallen way down. The migration of job listings off news pages to online job boards such as Monster (MNST) only worsens the situation. The New York Times hopes its investment in Indeed, a search engine for jobs, will help it recapture some of those lost revenues. Indeed promises to give job hunters access to millions of job listings aggregated from online job boards, corporate websites, and newspapers.

I did not know there was a New York Times Research & Development Group. I hope the boys at Harbinger don’t look at this little skunk works team as a waste of scarce capital. Innovation and breakthrough business models take time and freedom to develop. I already look upon corporate-directed incubators with skepticism but when the parent company accepts that it is in crises mode, there might just be a chance for the mad scientists and geeks to make an impact. Shifd is a new mobile Web application that allows users to share content between their desktop computers and mobile devices. Shifd, pardon the pun, is a paradigm-shifting idea. It makes possible a future in which we don’t have discreet devices separate from each other. All our information lives on the Web and is available to us from any device and custom-configured to our needs. Your cell phone and your desktop computer will have roughly the same utility and functional profile.

Daylife calls itself a “news site and distribution platform.” It is a different take on the aggregation of related news items and competes against the likes of Digg and Reddit. Instead of relying solely on a community of users to vote news stories up popularity rankings, the company appears to utilize its own search technology and algorithms to organize related news articles. Daylife also offers Web widgets that help other publishers expand their news content. The New York Times invested in this startup in late 2006. If I had to short one of these startups, Daylife would be the one. I love their user interface design; these guys are definitely in tune with the modern aesthetic. However, the competitive landscape for news aggregation is simply too crowded and the company does not offer anything so different and compelling to suggest that it can take users from Digg, Reddit, or even Google News.

WideOrbit provides software systems that automate and manage the sales, traffic, and billing of advertising. It sells its products to radio stations, television broadcasters, cable networks, and data centers. This sounds like a wonderful product as I am sure that relatively few people are putting their minds to solving the billing management needs of content publishers. Most entrepreneurs are focused on the deservedly hyped Web 2.0 space. This may not seem core to the business of the New York Times, but any model that puts the company in the middle of revenue flows will create value. Non-core businesses such as Federated Media and WideOrbit may create value for the company as they are sold off at rich multiples and for handsome returns. But in this uncertain time, who really understands what is core and what is non-core?

Again, Harbinger Capital is spot on with its call for a dramatic rethinking of the New York Times’ business model. Much capital can be allocated away from traditional business activities to online efforts that can significantly change the structure of the company. New profit centers will arise and the company’s recent investments in Web startups give it a good chance to navigate the future. What the New York Times needs right now is a stable of patient investors.

Update 3/17/08 – The New York Times came to a compromise with activist hedge funds Harbinger Capital and Firebrand Partners by expanding board seats by two outside directors. Scott Galloway of Firebrand and James Kohlberg of Kohlberg & Company are the two outside nominees slated to join the board of directors.

Last week you may have encountered some colorful uses of the lexicon from Sam Zell that we are not used to hearing at the Times…But of course we still have the same expectations at the Times of what is correct in the workplace. It’s not good judgment to use profane or hostile language and we can’t tolerate that…In short, nothing changes; the fundamental rules of decorum and decency apply…Sam is a force of a nature; the rest of us are bound by the normal conventions of society.

He recently appeared on CNBC to talk about the economy, the housing market in particular, and his plans for his recent investments in newspapers and the Chicago Cubs. Watching the guy speak, you can’t help but be impressed by his dry humor, his uniquely cantankerous tone, and the unmistakable impression that he has had a fire in his belly for a long time. Here are some interesting tidbits (paraphrased):

• On selling the Chicago Cubs: “We own the Cubs and we intend to sell on our time frame and manner in which we choose, many others have opinions on how we should do this, but I don’t care. Excuse me for being sarcastic, but the idea that others are debating about what I should do with my assets leaves me questioning the integrity of that debate. There are a lot of people who want to buy the Cubs, and they would like to buy under their terms and conditions. Unfortunately, they have to deal with me.”

• On politics: “We have two Democratic candidates who are vying with each other to describe the economic situation worse. The reality is that if you live on Wall Street and you’re in the credit markets the world couldn’t be worse. If you’re a farmer and you’re getting $25 for your wheat, you’re having a great time. If you’re a CEO and you’ve got a balance sheet that’s bullet-proof, you’re in a great position. This whole thing is way out of control, way out of hand.”
  • I tend not to get involved in political campaigns.
  • “Logic can overcome Liberalism.”

• On investing: This is where I get the most value out of listening to this guy.
  • “We have been professional opportunists, when there is dislocation, that usually creates opportunity.”
  • “I never call or time markets – I only try to respond to what I think is logic.”
  • “My decision to sell Equity Office was not based on crowds, was not based on euphoria. Someone made me an offer I couldn’t understand and I thought it was a Godfather offer.” Another classic line.

• Two old dogs: Jack Welch, former CEO of General Electric (GE) was on the show and got to ask Zell a couple questions. It was a little heartwarming to see two great businessmen sharing a little camaraderie. You just know these guys are tough bosses to work for, but they keep it honest and straight.
  • Jack Welch: Sam, you’re the master of timing.
  • Jack Welch: These guys (CNBC crew) accuse me of being a cheerleader, but they wouldn’t dare say that to you.
  • Jack Welch: Sam, can we play what you’re saying every half hour (because it’s so positive)?
  • Sam Zell: You guys are opining every half hour so what do you need me for?
  • Jack Welch: Sam, thank you so much.
  • Sam Zell: Good to see you again Jack.

Watch the video here: