A Dangerous Gamble You Should Avoid

So far in my life I have based my decisions on "worst-case scenario" results and found that this line of thought has stood me in good stead. All those investors who bet on Rambus (NAS: RMBS) "winning" a legal tussle against Micron Technology (NAS: MU) , must have been in a heart-in-mouth situation when the ruling went the other way, and should have prepared for the worst.

The stock shed almost two-thirds of its value when a San Francisco jury ruled in favor of the defendants last month. Now, let's go deeper and see why investing in Rambus is nothing short of a gamble.

The ruling that went awry
The company's business of licensing technology is such that it is regularly involved in one litigation or the other. Rambus had won an identical suit against NVIDIA (NAS: NVDA) and Samsung earlier in the year wherein Samsung has to pay Rambus almost $700 million as license payments and invest another $200 million in the stock over a period of five years.

This case must have been playing in investors' minds as they waited for the jury to come in on the Micron case, under which the company would have won as much as $12 billion under California law -- a very hefty amount considering Rambus' market capitalization is just around $860 million. But it proved to be nothing more than a damp squib.

So what's next?
Rambus has pursued this case for seven long years and probably will appeal accordingly. But even then, considering the outcome of the previous ruling, one should not have high hopes this time. Moreover, it means that Rambus will have to shell out more millions on litigation expenses, squeezing its profits further.

The profit-generating mechanism -- litigation
It seems that the company focuses on generating earnings more from lawsuits than its core business of licensing chips. Rambus has spent around $300 million on litigation since its inception 21 years ago and has brought to court various semiconductor giants over the years. There is a distinct relation between the movement of its profits and legal settlements.

It's clear that litigations have played an important role in driving profits for Rambus over the past three years. When income from litigations is on the negative side, we see profits also sticking along. And profits spike when the legal settlement has turned out in the company's favor. This business of generating revenues and profits from legal tangles rather than focusing on licensing agreements, which should ideally be its bread and butter, makes me uneasy.

As far as the core revenue-generation activity of licensing deals is concerned, the company has entered into an agreement with an established smartphone company, but again, the stress has always been upon what the outcome of the litigations is rather than core business activities. Hence, if you are looking for a semiconductor company with good fundamentals to invest in, Rambus will probably not make the cut.

To stay on top of the legal ramblings at Rambus, add it to My Watchlist.

At the time thisarticle was published Fool contributor Harsh Chauhan owns none of the stocks mentioned in the article. Motley Fool newsletter services have recommended buying shares of NVIDIA. Motley Fool newsletter services have recommended writing puts in NVIDIA. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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