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 has a few options going forward:
- Present new prior art that convinces the USPTO to reexamine the ‘263 patent.
- Prove they’re not infringing on the patent as is.
- 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.
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.