Patent Window Closing for LML

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( -- LML Payment Systems ( LMLP) is a small provider of payment transaction services to merchants providing products or services over the Internet.

The company has three divisions. The first is the Transaction Payment Processing unit, which accounted for 27% of sales in the fiscal year ended this March. TPP provides website and mobile developers a set of application program interfaces for credit card authentication, fraud protection, and payment clearing, in addition to hosted solutions (users are redirected to LML's Web site for payments). LML earns revenue from one-time setup fees for new merchants, monthly recurring gateway fees, and per-transaction fees. LML has over 10,000 merchants using its solutions in Canada.

The second division is the Check Processing unit. The business here is providing merchants a way to recover amounts on returned checks, including electronic checks. Revenue is earned when the firm is successful at recovering amounts, often based on a percentage of the principal. The CP unit accounted for just 5% of 2011 revenue, growing at just 6% over the prior year.

The real wild-card, and most of the value in the stock, is the Intellectual Property Licensing division. LML holds five patents pertaining to electronic check processing methods. One in particular, dubbed the RE40,220 patent, has earned significant returns.

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In 2008, the firm sued a whole roster of financial institutions for infringing on the patent. To date, LML has won settlements from Citigroup ( C), PayPal ( EBAY), PNC Bank ( PNC), Bank of New York Mellon ( BK) and several other large regional banks, pocketing over $30 million in the process. These nonrecurring settlements made up about 68% of LML's 2011 revenue and virtually 100% of operating profits. Given this, LML certainly raises the common Magic Formula "red flag" of showing up on the screen due to a nonrecurring, one-time revenue windfall.

In order to value the stock, though, we need to consider the IPL division's potential moving forward. Can they continue to pocket big gains by settling with even more banks? Certainly there is potential for more big payments this year. Two separate infringement trials involving heavy hitters JPMorgan ( JPM), Wells Fargo/Wachovia ( WFC), Deutsche Bank ( DB), and Capital One ( COF) are set to commence in October of this year. One of the defendants in those cases, Northern Trust ( NTRS), recently settled for $1.25 million.

Considering past awards, and considerable success getting settlements, I've modeled LML to generate just under $17 million from licensing the above firms for fiscal 2012 (ending March next year). The patent gravy train isn't going to derail just yet.

But this is also a short-line track for LML. All five of the company's patents expire on January 16, 2013. Additionally, they are not actively involved in developing new patents. Clearly, management is positioning this company to be a pure play payment processor, and not a so-called patent troll. The patent litigation strategy is devised to firm up the balance sheet for acquisitions in the TPP division, such as the 2007 purchase of Beanstream. After this year, I see little contribution from the IPL unit going forward.

To be sure, the TPP unit is growing nicely: 2011 saw a 31% jump in revenue and 34% increase in operating earnings. Given LML's small size, it is not inconceivable that TPP can grow at 15% to 20% rates over the next five years, possibly even faster if the company's $27 million in cash (LML has no debt) is prudently allocated in purchasing additional processing companies.

The Check Processing unit has been and will continue to be a declining business. The company has consistently reported "unallocated" (read: executive) compensation expenses (including stock) of around $3.5 million a year. That is largely a fixed cost that they can leverage with growth, but it is a significant hurdle for the core businesses of such a small company. It's important to note that the firm was unprofitable in three of the past five years before the patent licensing strategy became successful.

Over a range of growth scenarios, I can't see LML being worth much over $3 a share, except perhaps in an acquisition scenario. This is clearly a case of the "revenue fairy" tricking the Magic Formula into screening a stock that should probably not be there. MagicDiligence recommends avoiding the stock.

Steve owns no position in any stocks discussed in this article.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.