Why Selling Patents Won’t Help AOL Inc. (NYSE: AOL)

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The tech sector “patent wars” heated up again yesterday, with AOL Inc. (NYSE: AOL) announcing that it had sold 800 of its patents to Microsoft (NasdaqGS: MSFT) for $1.056 billion.

After the deal closes later this year, AOL will be left with 300 patents, which Microsoft will still be able to access under deal. AOL Inc. will also hold a license to the patents it sold to Microsoft.

Investors roundly applauded the deal: shares of AOL Inc. soared 43.3% on the day, closing at $26.40.

The sale will leave the company with $15 a share in cash—more than half its stock price. AOL Inc. says it will return much of the money to its shareholders. It hasn’t yet said whether it will do that through share buybacks, a special dividend or some combination of the two.

AOL Inc. Deal Is the Latest in a Flurry of Patent Purchases

The purchase is the latest move in what’s been referred to as an arms race between tech companies as they hoard patents to protect themselves from infringement lawsuits—and give themselves a tool to trip up new innovations from competitors.

As Investing Daily editor Jim Fink pointed out in “Patent Trolls and NPEs: Eastman Kodak Wishes it Were One,” the deal that kicked off the latest round of patent stockpiling was the auction for 6,000 patents held by bankrupt Canadian telecom company Nortel Networks in June 2011.

The winning bid, $4.5 billion paid by a consortium that included Microsoft, Apple (NasdaqGS: AAPL) and BlackBerry smartphone maker Research in Motion (NasdaqGS: RIMM)—more on RIM in a moment—amounted to an eye-popping $750,000 per patent.

Google didn’t participate in that auction, but it played catch up a couple months later when it bought Motorola Mobility, which came with 17,000 patents, for $12.5 billion. The move gave Google’s Android operating system protection from infringement lawsuits from rivals, particularly Apple.

AOL Inc., Microsoft and Facebook Were the Big Winners in the Latest Patent Deal

The companies didn’t say what the patents involved in yesterday’s deal related to, but they could be very important, according to David Joyce of New York brokerage Miller Tabak. Quoted in a MarketWatch.com article entitled “AOL Gets $1 Billion for Selling Instead of Suing,” he said:

“AOL has a lot of patents dating back to when they were helping to create and build the infrastructure of the Internet. Microsoft evidently wants direct access to some patents that are more valuable to Microsoft than to AOL, such as some aspects of advertising and web mail.”

In any event, patents related to online communication, in which AOL Inc. was one of the pioneers, would have enormous implications in today’s social-media-driven world. That caught the attention of Florian Mueller, an independent intellectual property analyst and consultant. In an article on CNNMoney, he said:

“Besides the two deal partners and shareholders, Facebook is the number-one beneficiary. An independent AOL or any other buyer would have picked Facebook as the first target, but Microsoft is a friend. Google once again missed out on a unique opportunity.”

AOL-Microsoft Deal Drew Attention to Other Patent-Rich Tech Stocks

The news pushed up the shares of other companies with large patent portfolios yesterday, including Research in Motion, which rose 2.76%.

The press in Canada, where RIM is based, has paid particular attention to the company’s struggles as it continues to give up market share to Apple and Android devices. The Globe and Mail was quick to point out the similarities between RIM and AOL:

“RIM looks a bit like AOL, except sped up: RIM’s revenue declines have been much sharper. According to Bloomberg, AOL’s revenue has fallen 29 per cent since the company was spun off from Time Warner in 2009. Research in Motion shareholders have watched revenue fall 25 per cent in the past four quarters.”

The takeaway for investors? A huge patent portfolio is a plus when investing in companies in the hotly competitive tech sector. But you’ll want to look for other signs of value, as well, including rising sales and earnings, steady or increasing market share and a reasonable ratio of price to earnings, to name a few.

AOL—whose p/e ratio is a sky high 220—has seen its outmoded subscription-based Internet access service continue to shrink. That has increased its dependence on online advertising, where it also faces an uphill battle: the company’s share of the U.S. online ad market has slipped to 2.7% from 7.2% in 2005.

The cash from yesterday’s deal, while a welcome bonus for AOL shareholders, offers no answers to these problems. Growth investors would be well advised to find better opportunities elsewhere right now.

Article orginally posted here.

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