The Compelling Reason To Short GoPro

Jan. 27, 2015

Summary

·Since our first article on GPRO was published, we have been made aware of a powerful analysis, performed by Devonshire Capital Funds, of GPRO's IP.

·The analysis has identified potentially significant trouble ahead for GPRO's current business model.

·We have quantified these concerns surrounding GPRO's IP, and have adjusted our financial model accordingly.

·We now value the stock at $36 per share, and recommend shorting it at any price above $39.

·We believe that the combination of Devonshire Capital's analysis and our analysis provide a compelling reason to short GPRO.

We recently published an article quantitatively analyzing GoPro's (NASDAQ:GPRO) present value, establishing apresent value rangeof $37-51. Naturally, we suggested longing the stock below $37 and shorting the stock above $51.

In response to that article, we were contacted by Devonshire Capital Funds, a Boston-based hedge fund focused on technology investments. On January 15, Devonshire Capital released a presentation that included a thorough assessment of GoPro's intellectual property, and which identified potentially significant trouble ahead for GoPro's business model. The presentation, which can be foundhere, was put together by Devonshire Capital Funds' founding manager Matthew Stack, a former venture capitalist, and waspublished on Seeking Alpha earlier this month.

After carefully reviewing the presentation and discussing its contents with Stack, we have revisited our quantitative model analyzing the company. The results of our new financial model have supported Devonshire's argument - GPRO is a short.

Considering the substantial amount of qualitative and quantitative evidence supporting the short case at GPRO, we suggest entering a short position in GPRO.

Summary of the Presentation

The presentation is essentially a warning that the Apple patent awarded last week, which knocked off more than 15% of GPRO's market cap in a single day, may just be the tip of the iceberg when it comes to GoPro's weak IP.

The multi-month analysis revealed at least 15 additional technology patents owned by Canon (NYSE:CAJ), Nikon (OTCPK:NINOY), Dell, Samsung (OTC:SSNLF) and Hewlett Packard (NYSE:HPQ) that are integrally used in GoPro devices, and numerous more patents held by competing entities which are directly applicable to GoPro's flagship products.

Further, Devonshire Capital discovered that a shocking few number of GoPro's patents pertain to the core technology of GoPro's products, like the electronic and camera technology underlying the HERO cameras. The majority of GoPro's IP, rather, consists of design and mechanical patents, like case shape, lens covers, and various housings, mounts and harnesses.

GoPro's key competitors such as Canon, Nikon and Dell own the majority of the technology patents that seem to be the basis for the HERO cameras' core features. Moreover, the analysis reveals that GoPro's products seem to predate any of GoPro's granted patents.

As stated near the end of Devonshire Capital's analysis:

If GoPro has infringed others' technology, it may be liable for hundreds of millions of dollars in damages looking backwards and hundreds of millions of dollars in royalties looking forward.

Since the release of the presentation, a series of lawsuits were announced, led by Contour, LLC, against GoPro. Contour joins eDigital, Z-Dimensional LLC, Dinkum Systems, and VStream Technologies as companies with outstanding infringement lawsuits against GoPro.

For more information, please refer to the presentation put forth by Devonshire Capital, available ondevonshirecapitalfunds.comand in a link provided above.

The L&F Model

To quantify these concerns over GoPro's intellectual property, we have analyzed the companies (provided in the Devonshire presentation) that were in a similar situation as GPRO over the past 15 years. We have taken the IP payment figure and calculated it as a percentage of the company's revenue at the time.

We see that companies in a similar situation as GPRO have paid, on average, 16.69% of topline on royalties/infringement payments. Eliminate the major companies (Microsoft, Intel, SAP) and re-examine only the companies with sub-$10 billion revenues (as GPRO is and will continue to be), and we see that the average royalties/infringement payment surpasses 31% of revenues.

Lets call this figure 30% for calculation purposes. Assuming operating margins and discount rates remain relatively constant (that is, short-term discount rate is constant but different from the constant long-term discount rate - derived from different Beta values for short-term and long-term) as we did in our original model, then we can account for this 30% growth hit by assuming a constant 6% growth hit over the next five years (30% / 5 years = 6% / year). For example, our 35% high-end short-term growth rate in our original model is now 29%, and our 5% low-end short-term growth rate in our original model is now -1%.

We then assume a Gaussian distribution of probabilities of short-term growth rates with mean of 14% and variance of 10.8, and arrive at our weights for each short-term growth rate, as seen in the chart below.

Using these Gaussian-derived weighted averages, we then calculate the weighted average for each long-term stable growth rate. For example, see the 6% stable growth rate chart below (important to note: we don't believe infringement/royalty payments will affect our projected long-term growth rates).

After repeating this for every stable growth rate, and then applying the same analysis to our 5 different stable growth rates (2, 3, 4, 5, and 6%), we arrive at a present value of $36 per share.

Applying a 10% uncertainty to this present value, we establish a new present value range of $32 to $39 per share.

Conclusion

Devonshire Capital Funds performed a thorough technical analysis of GoPro's intellectual property, and essentially concluded that GoPro went to market and sold billions of dollars worth of a technology product without owning any of the technology in the product. Further, as Devonshire Capital Funds remarks in their presentation, GoPro's S-1 filings identify competitors' larger intellectual property portfolios as potential risk factors and state that:

·[GoPro's] intellectual property rights and proprietary rights may not adequately protect [its] products …

·[GoPro's] business may suffer if it is alleged or determined that [GoPro's] technology or another aspect of our business infringes the intellectual property rights of others ...

·If [GoPro is] unable to maintain or acquire rights to include intellectual property owned by others in the content distributed by [GoPro], [GoPro's] marketing, sales or future business strategy could be affected or [GoPro] could be subject to lawsuits relating to [its] use of this content.

We performed a thorough quantitative analysis of GoPro's present value, taking into consideration concerns surrounding GoPro's IP, and essentially concluded that GoPro is a short at any price north of roughly $39 per share.

We believe that the combination of these two analyses constitutes a very compelling reason to short GPRO stock. In accordance, we recommend shorting GPRO at its current price.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

http://seekingalpha.com/article/2855266-the-compelling-reason-to-short-gopro