SmicroCaps

As Don Clark’s WSJ blog entry noted earlier this month, many Rambus shareholders form “an active community that buzzes in online forums over each twist and turn in the company’s complex legal battles.” These passionate shareholders, sometimes referred to as “Ramboids”, have strongly expressed their disagreement to my earlier contribution on Rambus. Lead Ramboid and fellow Seeking Alpha contributor “Prufrock” has loosely tossed around the word “fact” in his contributions. I’m sorry, but to say that an activist shareholder website like Rambus.org is full of “facts” or is “independent” is simply absurd. Ramboids use sites like this and message boards to try to tell their side of the story and the reasons why they believe that RMBS shares are a good investment. Their efforts and dedication are to be admired, but insults and unwillingness to hear an opposing viewpoint are not. Here’s a fact: that contradictory view so far has been the correct one. The performance of RMBS shares has been, particularly on a risk adjusted basis, simply awful.

In one, two, three and five year time periods, Rambus shares have significantly underperformed the NASDAQ 100 Trust Shares. In a ten year time frame, performance is better. Considering that the volatility of Rambus shares is much, much higher than the relevant indices and the historical Sharpe ratio is much lower, the risk adjusted returns of Rambus shares are poor even in the ten year time frame. However, as most mutual funds will tell prospective investors, past results are not necessarily indicative of future performance. Without a doubt, litigation and possible settlements will play a huge role in the direction of those results. I have expressed my bearish view on the direction of RMBS shares and I’ll add a couple of additional points before offering an alternative strategy.

First, there’s the legendary JEDEC saga that started it all. The Ramboids’ beloved Judge Whyte did confirm the March 2008 jury decision that found Rambus “not to have unfairly withheld information from other JEDEC members.” I don’t agree with this decision and JEDEC’s need to change industry specification development to prevent “gaming” supports this view. Harvard Business School professor Josh Lerner describes what happened this way:

"Ultimately, however, the centralized appellate court for patent cases in the U.S., the Court of Appeals for the Federal Circuit, decided that Rambus' behavior was acceptable. In effect, the appeals court did not dispute that Rambus tried to commit fraud, but ruled that they didn't succeed: Despite Rambus' best efforts to craft their patent claims around the elements of the standard, it was, in the court's judgment, possible to comply with the standard without infringing any of the Rambus patents. And the court ruled that, as a legal matter, there could be no fraud in this case because the JEDEC policy only required disclosure of patent applications on inventions necessary for the standard. Rambus was thus free to sue—and demand huge settlements from—rivals who took part in the JEDEC's standard setting process in good faith."

The FTC didn’t agree with the court that it was possible to comply with the standard without infringing on Rambus patents and so began the FTC’s anti-trust action, referred to by Ramboids as a “witch hunt.” The FTC’s mission is to protect consumers, not Rambus shareholders, and that is why they took this action as far as it could go and conceded to the recent Supreme Court decision. The European Union has similar action in progress, though that action may certainly lose momentum given the FTC’s concession.

As much as Ramboids love San Jose District Court Judge Ronald Whyte and his wishes to push settlements through to end this dispute, they loathe Delaware District Court Judge Sue Robinson and her decision that Rambus’ patents are unenforceable. An excerpt from this Bloomberg bulletin summarizes:

U.S. District Judge Sue L. Robinson in Wilmington said today the patents are unenforceable because Rambus destroyed documents in the infringement lawsuit. She called Rambus’s litigation conduct “obstructive at best, misleading at worst.”

“The very integrity of the litigation process has been impugned,” Robinson said in the decision. Rambus said it would appeal, saying in a statement “we respectfully, but strongly disagree with this opinion.”

This ruling led to a 39% single day drop in RMBS shares and added to the long list of double digit percentage moves that I mentioned earlier.

As Bloomberg again notes, the opinions of Whyte and Robinson are inconsistent and will likely result in a long legal stalemate. In the meantime, the many “new innovations” that Rambus offers aren’t leading to increased sales. Revenue fell 7.8% in 2007 and 20.8% in 2008. The company has made efforts to adjust its cost structure and reduce its annual cash burn rate of $38M, which is roughly 36% of Rambus’ net cash position ($345M cash and equivalents - $240M face value zero coupon convertible issue). If that burn rate remains constant, the company can fund eleven quarters of operations with its working capital.. In terms of future revenue, even Rambus’ most senior engineer expressed concern about real industry support for its technology in this New York Times piece. If there are cash flows from settlements, they are likely to be delayed and will need to come in at some point before working capital dries up. In the bearish view, which is likely shared by the staff at MaximumPC who have also referred to Rambus as a patent troll (because Rambus doesn’t manufacture anything and new “innovative” patents are not gaining market acceptance), this legal stalemate will persist and cash will continue to dwindle until the company is insolvent. In the contrary Ramboid view, settlements could be as high as $13B. In the financial world, we discount cash flows according to their timing. Roughly speaking, at a cost of equity of roughly 20% (a WACC approach will be slightly different), the present value of these cash flows in two years is just over $9B, which, given a 100% certainty of these cash flows, would imply that Rambus is priced at a 89% discount to its “true” value. That’s the uber-bull case. For the moderately bullish, even at a 25% probability plus present tangible book value, this valuation method would infer a price of $25/share. Adjusting probability according to individual assessment of the likelihood of these settlement dollars will produce various valuations.

Whether you’re a Rambus bear, a bull or a Ramboid uber-bull, be aware that either a long or short only position on the stock involves significant risk. As “Prufrock” suggests, RMBS could indeed bubble to $100. I’m more inclined to believe that it could fizzle to $2. In the middle of these two possible outcomes, investors who are moderately bullish on the prospects of Rambus may prefer owning the company’s zero coupon convertible bonds rather than its equity. These converts provide significant downside protection and equity like performance in the uber-bull scenario. A convertible arbitrage style strategy, however, can make money in either scenario.

Given the recent surge in volatility in RMBS shares, over 4x the implied volatility shown by the VIX, now might be the best time to implement such a strategy: This 4x multiple is actually far from the peak of its two year range, but the absolute spread in volatility between RMBS and the VIX has not been higher in that period.

Using the zero coupon conversion ratio of 37.26, the following returns could be generated by buying these convertible notes and selling January 2010 $25 strike calls to offset the long equity component of the bonds. The returns are calculated using the holding period yield to the date of maturity due February 1^st, 2010 at the specified convertible price levels plus the collected option premium.

Provided that the notes are held to maturity, this strategy results in an extremely low risk, but not entirely risk free return. Despite these notes being unsecured, default risk is very low due to the cash on Rambus’ balance sheet. Those dollars will almost certainly be returned to bondholders provided that the company’s cash burn rate does not greatly accelerate in 2009. There’s also some risk to these returns if RMBS shares fall between $25 and $26 at expiration. For example, collecting an option premium $0.80 and having RMBS shares at $25.76 at expiration would essentially erase that collected premium from the return. Finally, since standard options contracts are being used, the options don’t provide a perfect delta (strike mismatch) or theta (Jan 2010 contracts expire on the 15^th) hedge.

In terms of the viewpoints, I’ve stated the bear and “Prufrock” has taken care of the bull. This convertible arbitrage strategy sidesteps the volatility that is sure to move Rambus shares in one direction or the other as the company’s ongoing litigation saga continues and the Ramboids rejoice or despair over each new development.

Disclosure: The author does not hold positions in any of the mentioned securities at the time of this writing.