Xpel Technologies Part 2: The Lawsuit

Last week I gave an overview of Xpel Technologies (DAP.U, $1.10). If you missed it, I recommend starting there before reading on. This post reviews the patent infringement lawsuit filed on December 30th by 3M (who owns one of Xpel’s competitors). Before starting, I want to emphasize that I am not an expert in patent law, and while I have talked to professionals who do specialize in this area, I have almost certainly misinterpreted at least some part of what they’ve told me. This stuff isn’t simple.

3M’s patent 8,765,263 (hereafter: ‘263) for “multilayer polyurethane films” was issued July 1, 2014 and given a priority date of April 29, 2005. If you’re thinking nine years is a long time to get a patent issued, that’s because it took a detour to the Patent Trial and Appeal Board in 2013 because of a dispute with the claims in the patent. Thus, the USPTO (US Patent and Trademark Office) already did a more in-depth examination of the ‘263 patent than what a normal application goes through.  Eventually the Patent Trial and Appeal Board ruled 3M’s film was a novel improvement over previous automobile films and they issued the patent.

While Xpel is dealing with 3M’s ‘263 patent in the US, there’s a separate case in Europe I want to review first. Patent 1,874,541 (‘541) is a European patent issued to 3M on November 16, 2011 and is almost identical to US patent ‘263. On August 11, 2012, Kay Automotive Graphics and Tesa jointly challenged the ‘541 patent before the European Opposition Division for 3M’s failure to disclose prior art that would have rendered it invalid.

[Side note: Kay sells what they refer to as “gravel and abrasion films” that “offer protection for painted surfaces on flexible fascias, rocker panels, wheel openings, and other areas that are subject to stone and gravel impingement.” It appears that Kay primarily (or only?) sells directly to the major automobile manufacturers (Ford, GM, etc). They have locations in Michigan, Mexico and the UK. Tesa manufactures temporary film that protects cars during transport from manufacturing plant to dealership. You’ve probably seen new cars on the highway getting towed on a large trailer (heading to a dealership) and all the cars are wrapped were a white film. That is what Tesa makes.]

On August 25, 2015 (note this is after the US patent was granted on July 1, 2014), the EU court issued their decision on patent ‘541 which read “The Opposition Division considered it proven in a complete chain of proof and thus within the necessary standards that ‘Kay films’ were sold and delivered to Nissan and thereby made available to the public. In addition, the Opposition Division came to the conclusion that the subject-matter of claim 1 as granted was not novel in view of D2.” What the hell is D2?

3M is currently appealing the decision (shocking) and their argument mostly rests on Document 2 (D2) which refers to the Japanese patent application H6143506. The Opposition Division felt this Japanese patent proved that 3M’s ‘541 patent, as issued, was not novel. However, the EU court still ruled the ‘541 patent is valid, but the patent needs to be made more specific before being re-issued. The ultimate result will be 3M maintaining their European patent, but it will cover a more narrow scope than it originally did. When the appeals process is over, a new EU patent will be filed with the new claims which they appear to be in the process of deciding on. I’ve seen four versions of proposed claim changes, but can’t tell if any of these are the final changes. Most of the proposed changes seem pretty meaningless to me (change numbering, change minor wording, etc), but a few stuck out. If you’re unaware, claims are the parts of a patent that describe exactly what the patent covers.

There is only one proposed change that is consistent across all four proposals and that is to switch one of the descriptions of the film from  “wherein said diisocyanate comprises bis (4-isocynanato-cycblexyt) methane” to “wherein said diisocyanate comprises bis (4-isocyanato-cyclohexyl) methane.” Part of me thinks this is just fixing a typo that was in the original patent because that previous chemical comes up with nothing in Google (besides the European patent). The corresponding claim in 3M’s US patent ‘263 does have that compound listed as “4-isocyanato-cyclohexyl.” On the other hand, maybe it’s a super rare compound (not even known to Google!) that does make a difference.

Another notable proposed change is adding the following to claim 1: “wherein said second layer has a thickness in the range of from 150 to 300 µm.” Xpel’s second layer does fall within this range (theirs is 152.4 µm), but maybe Kay and Tesa’s films don’t? The last proposed change that caught my eye is to remove the claim that says “wherein said pressure sensitive adhesive is tacky at room temperature” which just seems overly vague to me. What constitutes “tacky”?

In summary, 3M has an almost identical patent in Europe that’s been challenged in court. Last year, the EU court ruled against 3M and that patent (assuming 3M doesn’t win the appeal) will be altered in some way that is not yet known. However, the patent will remain valid. Back to Xpel’s patent case.

In theory, the US court could rule that the US patent claims were invalid based on the Opposition Division’s decision, or more likely, that the US patent needs to be amended as per the changes that the European court eventually decides on. The problem is the European case is very much based on D2 (the Japanese patent) which the USPTO already examined and signed off on before granting the US patent. So if the EU court upholds their current decision, but that decision is based on D2 which the USPTO already examined, it’s unlikely to have an effect on Xpel’s case. The USPTO had a different opinion on D2’s effect on the patent’s novelty and the Opposition Division’s opinion isn’t going to change that. Because the USPTO examined D2 in their initial decision, nothing Xpel presents as evidence can be based on D2. Once the USPTO examines a piece of evidence and makes a decision on it, there is no going back. If Xpel is going to invalidate 3M’s US patent or alter it in any way, they’ll have to present new evidence the USPTO has never seen before. So if the European case most likely won’t have an effect on Xpel’s case, why did I spend seven paragraphs talking about it?

First, it’s important to note that the European court ruled that the patent is valid, just on a more specific scope. The fact that the Opposition Division ruled the patent is valid (with some changes) and the US Patent Trial and Appeals Board already looked at 3M’s US patent closely, it seems highly unlikely the US court will completely invalidate the US patent.

The US court could still rule the US patent was not novel if Xpel finds new prior art. And even though the European decision wasn’t final when 3M’s US patent was issued, the US Patent Trial and Appeal Board did review the EU case and the evidence within it. This means Xpel needs to find new prior art that Kay and Tesa never found. I want to emphasize this point because I think it’s very important. Kay and Tesa have spent nearly four years fighting almost the identical patent in Europe that Xpel is now fighting in the US. I think it’s safe to assume that Kay and Tesa would have been seeking out as much prior art as possible to increase their chances of winning the case. Now, Xpel needs to find prior art that has never been discovered by Kay and Tesa. While that is of course still possible, I think knowledge of the European case decreases those chances.

Also, I find it odd that Kay didn’t challenge 3M’s US patent. Kay is an American company and they sell to US auto manufacturers. If the European patent affects their business, I assume the US one would as well, but of course that’s just a guess. Did the D2 thing cause them not to pursue a case in the US? Or maybe they do far more business overseas so the US case wasn’t worth the effort?  I have no idea.

Finally, note the timeline of the EU case. Kay and Tesa filed on August 11, 2012 and a decision wasn’t made until August 25, 2015. Now they’re in appeals. From start to finish that court case is closing in on four years. From my understanding, that timeline is pretty standard in US patent cases as well (3-5 years is specifically what I’ve been told).

Xpel’s options

Xpel has a few options going forward:

  1. Present new prior art that convinces the USPTO to reexamine the ‘263 patent.
  2. Prove they’re not infringing on the patent as is.
  3. Settle with 3M.

The cheapest option is probably #1. Of course that is only an option if they find new prior art as that’s the only way the USPTO will agree to a reexamination. If Xpel does find prior art and the USPTO agrees to reexamine the patent, the court case would be put on hold until the USPTO makes a decision. I’ve been told a reexamination can easily take 3-4 years. Doing some Googling, it appears the cost for a reexamination is in the low tens of thousands (plus court costs).

The next option is to show their film does not violate the patent. This requires knowledge on the differences between the two films on a chemical level. I’ve spoken to several polymer chemists and am under the belief this option would be a lot faster (1-2 years max) and not significantly more expensive than a reexamination. The court case would also be put on hold while the labs analyze and compare the films.

Finally, Xpel could settle with 3M (if that option is even on the table). I’ve modeled scenarios where Xpel gives up a 5% royalty to 3M and I think they’d still be able to survive and thrive, but I doubt they can handle much more than that.  A small royalty (again, if that’s even an option) may be my preferred result assuming it happens sooner rather than later. It would remove a massive cloud of uncertainty overhanging the stock and it’d let management get back to focusing 100% on growing the company.

I think lack of management focus is one of the biggest non-obvious issues with these types of lawsuits. As long as the lawsuit is ongoing, Ryan Pape (CEO) and his top managers will be distracted by it. And as long as the lawsuit is ongoing, the lawyer bills will be piling up. I don’t know the cost of that four year European case, but it’s not cheap. Xpel currently has $2.8 million in the bank plus a $3.5 million revolving line of credit (that is already drawn to $3M). If this lawsuit is dragged out, equity dilution to raise funds wouldn’t surprise me.

Nothing much appears to have happened in the court case so far. Xpel requested 3M to specifically name what films of theirs were infringing (since they have several models) and 3M named the Ultimate film. This eliminated the small hope that Xpel was infringing via an older or less popular film, but Ultimate is the vast majority of their current sales. 3M filed two days ago a demand for trial by jury.

Conclusion

If you’ve read the last two posts, you probably noticed a lack of valuation discussion. That’s because fair value is a complete shot in the dark at this point. If Xpel gets out of this lawsuit relatively scot-free, the stock is going to be a major home run. If they decide to fight this to the end, spend millions defending themselves, and ultimately lose, the stock could be a $0.

As a testament to my wonderful timing, I started a small position in Xpel in late 2015 with all intentions of increasing it to one of my core holdings. Shortly thereafter, the patent infringement lawsuit was filed and that plan went out the window. I sold my small position after doing the above research. The multi-bagger potential is still there, but the time line is long and the uncertainty is too high for my taste. While uncertainty is often a source of opportunity in stocks, I don’t like investing in situations where I think a $0 is a realistic possibility. The one lesson I learned from this is to always check for competitor patents before investing (already added that item to my investment checklist!). I may have still invested even if I did know about the 3M patent, but to be blindsided by something that is publicly available on the Internet was a lazy mistake on my end.

With all that being said, if the lawsuit is thrown out tomorrow and Xpel’s stock jumps back to $2.00, I’ll happily buy back in.

As of this writing, Wiedower Capital does not own shares in DAP.U. This is subject to change.

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19 thoughts on “Xpel Technologies Part 2: The Lawsuit

  1. “Once the USPTO examines a piece of evidence and makes a decision on it, there is no going back.”

    What are you talking about? You seem to suggest that USPTO decisions are set in stone and can never be changed. That is simply not true! I would refer you to a 2005 publication in the Journal of Economic Perspectives (http://faculty.haas.berkeley.edu/shapiro/patents.pdf);

    “The risk that a patent will be declared invalid is substantial. Roughly half of all litigated patents are found to be invalid, including some of great commercial significance”

    Liked by 1 person

    • That comment of mine is only referring to D2, not the patent in general. If the USPTO evaluates a piece of evidence (D2) as part of the initial application review, that same piece of evidence cannot be used as grounds for a reexamination (because they already considered it in their original decision).

      Like

  2. “Xpel has a few options going forward:

    1. Present new prior art that convinces the USPTO to reexamine the ‘263 patent.
    2. Prove they’re not infringing on the patent as is.
    3. Settle with 3M.”

    There is also a fourth option, which is that Xpel could start using another type of Paint Protection Film that is a “work-around”, that is specifically designed so that it falls outside 3M’s claimed patent, whether that patent is valid or not.

    This “work-around” solution wouldn’t change the fact that Xpel could still be liable for damages and have to pay a licensing fee from July 2014 until they create the work-around, but it would remove their liability going-forward.

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  3. Great Research, Travis!
    You have done a great job at reading through patents and gathering other relevant 3M infringements. As a value investor and auto-aftermarket enthusiast, I found the post quite enjoyable to read.

    Did you manage to get any details on XPEL’s reply to the lawsuit. I heard they had to get back by May 11th ?
    Thanks,

    Like

    • Yeah, they responded how I expected them to (denying 3M’s allegations). Xpel specifically stated their film’s first layer is not a polyester-based polyurethane which is one of 3M’s claims. Overall the response seemed pretty standard to me because of course they’re going to deny the allegations.

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      • Thanks, Travis. Ryan Pape briefly touched upon the same in the earnings call today. As you said, I don’t expect to hear much from either parties. We will just have to wait and see how this pans out.

        XPEL would have a great growth opportunity though especially with their advancement into Window Film business. I know a thing or two about the window film industry and do think they have the right infrastructure and the team needed for this business….

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  4. Very nicely written in an easy to ready style. Bravo. You captured the fact that in spite of headline gross revenue announcements, margins have steadily declined.

    XPEL AS MICRO-LENDER
    Not covered in your report is an important competitive factor that helps explain Xpel’s installer loyalty that transcends Xpel PPF product characteristics such as clarity, thickness, digital patterns and ease of installation. In any case, unlike Eastman and 3M, Xpel does not actually manufacture the film, it is a branding, marketing, distribution and micro-lending business. Yes, micro-lending.

    Xpel’s real competitive advantage is its willingness to be a “Working Capital Substitute” for its customers. Xpel’s hand-to-mouth installer customers have a deep understanding of ROE, ROA and Turnover!

    Xpel’s operates like a pay-day lender for its micro-business installer customers who are able to order small quantities of PPF for overnight delivery, (on COD, credit card or very short payment terms), needed to complete their customer’s job. For example, Customer car comes in on Monday and the installer receives a $200 deposit; the installer orders the PPF needed for the job and gets the material COD or on a credit card, for $150 on Tuesday; and on Wednesday the job is finished earning the installer $800. Xpel’s under-capitalized installer customers are loyal because Xpel enables them to stay in business.

    Perhaps 3M would be interested in owning Xpel as a direct to installer fulfillment and training center for 3M’s small PPF installer customers.

    THE 3M SUIT
    Below is a dropbox link containing the June 2016 3M v Xpel case filings. Its important to note that 3M’s original pleadings in December included a request for jury trial, but more importantly, 3M seeks an injunction restraining Xpel from selling its primary product.

    https://www.dropbox.com/sh/12822aej6uywjtm/AAC0BFJua5gXNEfNQ_Gm4a9ta?dl=0

    The June 2016 case management plan indicates this dispute will remain a shadow over the company for more than a year unless there is a settlement. Given 3M’s comparatively unlimited resources versus Xpel’s, 3M has little incentive to settle, or at least settle early prior to inflicting upon Xpel a measurable level of financial pain in the form of defense costs and disruption.

    On the other hand, 3M could file anytime to obtain an injunction against Xpel that would turn up the heat and ramp up Xpel’s legal fees and survival risk…

    Unfortunately, the entrenched. insider board directors, (each drawing $3,000 per month, for doing what?), comprising a watch dealer and two long time business partners with backgrounds in selling medical malpractice insurance and running a multi-level nutritional beverage company, may be ill-suited to advise a CEO with limited experience navigating the complex headwinds of the 3M lawsuit and under-performance related to among other reasons, the ill-timed Canada subsidiary acquisition.

    A new board, composed of a majority of independent directors, with relevant backgrounds would benefit outside shareholders.

    Like

    • Insightful comment Seth. I haven’t checked PACER this month so hadn’t seen those filings yet. Looks like Xpel has to file a prior art statement by December 15, 2016 which should be telling. Fact discovery not completed until May 26, 2017 and who knows how long after that. An injunction would be a major blow to Xpel, almost guaranteeing they have to issue equity to cover cash expenses. No idea what the likelihood of that going through is though. You mentioned 3M potentially acquiring Xpel, I definitely think there’s a non-zero chance of that happening. If 3M has that idea in the back of their mind, they’d want to beat up Xpel (and their stock price) as much as possible before making an offer.

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  5. Travis, Not sure if you saw but 3M has put a Stay on the proceedings and discovery process? Also, CFO and Director have been buying shares (40k) which is incrementally positive. If Settlement which would need to happen before March 1, 2017 is reached, the stock is an immediate double from here (possibly triple) with the removal of the 3M overhang. Set-up just got very attractive! Thoughts?

    This matter comes before the Court on Plaintiffs 3M Company and 3M Innovative
    Properties’ Motion to Stay Proceedings [Doc. No. 44]. That motion is GRANTED as follows:
    1. The proceedings and pending discovery in this lawsuit are stayed until March, 1, 2017.
    After that date, the scheduling order below will take effect;
    2. The parties are ordered to appear for a status conference on March 14, 2017 at 9:00
    a.m. in Courtroom 3A, Warren E. Burger Federal Building and United States
    Courthouse, 316 North Robert Street, St. Paul, MN

    Like

    • I’ve loosely kept up with the situation this year, I check PACER every couple months. The settlement talks don’t excite me as much as it has others. Settlement talks are a natural part of lawsuits, doesn’t mean they’ll actually settle. And a settlement doesn’t guarantee the equity is currently undervalued on a go-forward basis. The few patent agents and lawyers I talked to about the Xpel case all had the same opinion–predicting these cases is impossible (even for them) and a tiny company going up against a huge one generally isn’t the best side to be on.

      So all things being equal, I’m more likely to invest after the case is thrown out/settled and the stock is higher vs right now where, in my opinion, the upside and downside are both a lot bigger. I truly hope Xpel wins and current shareholders make a boatload of money over night, but it’s not currently my type of investment.

      I’ve also continued to watch the gross margin erode which worries me a lot. It’s looking like 2016 will be the sixth straight year their gross margin has declined. That tells me I initially overestimated how strong their competitive position is.

      Again, I’ve only checked in on Xpel on and off this year, so if I’ve missed anything let me know. Appreciate the comment.

      Like

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