Investors are always on the hunt for high growth companies that are capable of generating strong cash flows for reinvestment, regular dividends, or share buybacks. For instance, Visa (NYSE:V) maintains 80 percent gross margins by essentially licensing its name to banks and merchants; Dolby Laboratories (NYSE:DLB) maintains 90 percent margins by licensing its audio technology to audio equipment makers; and Immersion Corporation (NASDAQ:IMMR) maintains 97 percent margins by licensing its haptic technology to consumer electronics and automotive firms.
In this article, we will take a look at why licensing stocks are attractive to investors and explore one company that is transitioning from a product model to a licensing model.
Product Vs. Licensing Margins
The companies mentioned in the examples above all license their technology or brand to various end markets. Since they do not have to physically manufacture any substantial products, they have very little cost of goods sold (“COGS”) and high gross margins. Many times, these high gross margins translate to high net margins over time, as licensing revenues grow to overcome fixed costs (like selling, general and administrative expenses or interest expense). It is this high net margin that ultimately drives significant shareholder value.
High net margins generally equate to a greater amount of cash generated from operations, which can be used to reinvest in growth or redistributed to shareholders via dividends, buybacks or similar events. For instance, Visa has continuously upped its dividend yield over time, while Dolby Laboratories offered investors a special dividend in late-2012. High net margins can also justify higher P/E multiples and valuations relative to lower-margin peers, as seen in Figure 1 below, as long as the high margins are accompanied by strong top-line growth rates.
When looking for licensing plays, there are a few things to watch for:
- Large End Market. The company should be targeting a large potential end market with a unique technology that is gaining market share at a strong clip.
- Manageable Costs. The company should have a manageable cost structure, with a level of fixed costs that could be quickly surpassed by licensing revenue.
- Operating Cash. The company should be generating strong amounts of cash flow from operations that ideally leads to high free cash flow over time.
Immersion’s Successful Transition
Immersion Corporation is a great example of a company that has successfully made the transition from manufacturing products to licensing its haptic feedback technology. Essentially, the technology allows people to use their sense of touch more fully when operating digital devices, ranging from mobile phones to gaming controllers to medical devices. With over 1,200 patents, the company has entrenched itself as a leader in the industry, licensing its technology to companies like Nokia Corporation (NYSE:NOK) and Volkswagen AG (OTC:VLKAY).
In FY2008, approximately 39 percent of its revenues came from licensing and 53 percent came from product sales, which led to gross margins of about 66 percent. Management made the strategic decision to shift its focus from products to licensing and has since made massive improvements. By FY2012, approximately 88 percent of its revenues came from licensing and only 8 percent came from product sales, which helped boost its gross margins to nearly 98 percent. Meanwhile, free cash flow as a percentage of net income jumped from 0.75x to 1.53x.
The company’s stock has jumped about 127 percent over the past four and a half years, and its financial condition has dramatically improved and it’s drawing closer to generating a net income. The passing of this key milestone — surpassing its operating expenses — would provide management with additional flexibility to reinvest in growth or unlock value by instituting a regular dividend, special dividend, or share buyback to attract investment.
Profit from Guitammer’s Conversion
The Guitammer Co. (OTCBB:GTMM) is an interesting company that is undergoing this transition from manufacturing products to licensing its technology right now. Last year, the company’s gross margins amounted to about 40 percent from selling its low frequency audio transducer (ButtKicker®) technology to movie theaters and home users. But with the launch of ButtKicker Live!®, the company aims to bring its technology to broadcast television — enabling viewers to feel the impact of live sporting events and adding another layer of sensory experience. This move into licensing could significantly improve those gross margins.
According to the company’s most recent 10-Q filing with the SEC:
In 2012, field testing of our patented “ButtKicker Live!” broadcast technology took place in the first and second quarters of the year with a professional sports team. In 2013, the field testing of our patented “ButtKicker Live!” broadcast technology began in the second quarter with a professional sports team and is planned to continue through the remainder of the year.
Consumers have already embraced the ButtKicker® in theaters and at home, with the technology earning 4- and 5-star reviews on Amazon.com. With this market acceptance in place, broadcasters could utilize Guitammer’s broadcast technology to capture and add the tactile or haptic signal (the actually feeling of the live event) into their broadcasts in order to enable viewers at home to experience the “4D” effect. Many of these broadcasters, like DirecTV (NASDAQ:DTV) and Time Warner Cable (NYSE:TWC), are constantly looking for features that they can use to differentiate themselves and steal market share.
Guitammer also appears to fit the mold using the criteria mentioned above. With a focus on professional sporting events, the company is addressing an enormous end market that includes broadcasters seeking new features to offer subscribers. The firm has less than a half million in operating expenses that would only need to increase marginally to support the ButtKicker Live!® rollout. Over the long-term, the licensing model involves less capital investment and greater profit margins than its current hardware business. With the combination of these factors, the company could generate strong operating cash flows in relatively quick order following a signed broadcaster agreement.
Investors looking for high growth companies may want to consider licensing companies as opposed to product companies. With higher gross margins and lower capital requirements, these companies can rapidly scale revenues that spin-off significant cash flow for reinvestment, dividends, buybacks or other shareholder-friendly options. Visa, Dolby, Immersion and Guitammer represent opportunities across the risk spectrum from large-cap to micro-cap.
Originally written for SECFilings.com, a leading provider of SEC filings, real-time alerts, and in-depth analysis, with a team of experienced financial writers that cover quarterly/annual reports, insider trading/hedge fund activity, and IPOs, spin-offs, and other special events found within U.S. regulatory filings.