ANALYST WATCH: Edelstone blows Rambus call

COMMENTARY--Morgan Stanley's Mark Edelstone finally cut Rambus shares from a "strong buy" rating to "neutral" this week, but only after a U.S. district judge threw out one of the company's many patent infringement suits and a federal jury found it guilty of fraud.

Those of you who haven't been paying close attention to Rambus (Nasdaq: RMBS) or its stock price in the past year need a little background to appreciate not only how crushing these recent legal decisions are for the memory-chip technology maker, but also how big of a gamble Edelstone and presumably his firm's clients were taking.

Last week, U.S. District Judge Robert Payne ruled in favor of Infineon Technologies' (NYSE: IFX) motion for a summary judgment dismissing Rambus' patent infringement lawsuit against the German chipmaker.

Judge Payne didn't buy any part of Rambus' claim that Infineon used some of its patented technologies to manufacture synchronous dynamic RAM chips (SDRAMs) and double data rate (DDR) chips.

That was bad news--especially since it was the company's first attempt to defend some of its key patents--but not nearly as damning as Wednesday's verdict from a federal jury in Richmond, Va.

The jury found that Rambus had fraudulently participated in industry meetings to set standards for memory chips without disclosing that it had filed patent applications on designs that it was promoting as standards.

Oh by the way, the jury ordered Rambus to pay $3.5 million in punitive damages.

Infineon's attorneys were able to convince the jury that it and other chipmakers were deceived by Rambus during standards meetings in the early 1990s held by the Joint Electron Device Engineering Council (now known as the JEDEC Solid State Technology Association). At those meetings Rambus lobbied for specific technologies--already patented by Rambus--to be used throughout the industry, creating an instant source of royalty revenue for years to come.

Had Infineon and other chipmakers known Rambus had already filed for patents on these technologies, it's highly unlikely they would have chosen them as standards.

Rambus Chief Executive Officer Geoff Tate said the company was "obviously disappointed" by the verdict and plans an immediate appeal. He also pointed out that Virginia has a cap on punitive damages of $350,000, and that he would ask the judge to reduce the damage award.

"Rambus abided by JEDEC's rules," he said, "despite the fact that these rules have been shown to be confusing, conflicting, poorly communicated and generally not complied with by other JEDEC members."

Regardless, chipmakers feel Rambus pulled a fast one, and so far at least one American jury agrees. That sense of mistrust could end up costing Rambus a lot more than $3.5 million in the long run.

Following Judge Payne's ruling, Edelstone immediately downgraded Rambus from a "strong buy" rating to "neutral," saying the stock "has lost its catalyst for now." He also erased his 12-month price target of $80 a share and did not assign a new target price.

Last quarter, 76 percent of the company's total sales were derived from royalty payments. But let's keep that number in perspective; Rambus only recorded sales of $31.2 million last quarter and $23.6 million of that total came from royalties.

Not too long ago, Edelstone said Rambus could get its hands on as much as $1 billion a year in royalty fees from chipmakers if these patents were upheld.

During those optimistic days, Rambus shares exploded. The stock soared to a split-adjusted, 52-week high of $127 a share last June shortly before a 4-for-1 stock split was announced.

The stock's now languishing below $12 a share.

Facing the likely prospect of losing a significant portion of its royalty revenue if other patent infringement lawsuits are thrown out in the next year, Rambus must fall back on its Rambus DRAM (RDRAM) technology, which is not in dispute, to drive future growth.

Major original equipment manufacturers (OEMs) such as NEC, Mitsubishi and Samsung were willing to pay the $1 million or $2 million in royalty fees to Rambus each year rather than simply using the technology and engaging in a prolonged and expensive legal battle. For these companies, Rambus' memory-interface technology is just a small piece of their multibillion-dollar memory business.

Rambus won't say that this was their plan, but then again this is a company that pushed for standards that would use technology it had already patented and didn't tell any of the other participants at the time.

Memory chipmakers had two choices: Pay the royalty fees or spend as much or more in legal fees fighting the patents.

But they are also the companies that license Rambus' RDRAM technology. Considering chipmakers have been locking antlers with Rambus in courtrooms from Virginia to Germany and paying royalty fees that at least one jury said Rambus wasn't entitled to, it's safe to say Rambus' relationships with major chipmakers have been damaged.

"They've pissed off everyone in the industry," said one analyst. "Eventually these OEMs are going to stop paying the royalty fees, especially after these judgments. Then all Rambus has is its RDRAM royalties, not to mention the possibility of having to pay back all the royalties they've collected in the past few years."

Rambus spent $7.3 million in legal fees last quarter and figures to spend at least as much in the third quarter. That's no small chunk of change for a company that recorded only $72.3 million in sales in all of fiscal 2000.

Up until this week, it's been in Rambus' best interests to engage in or threaten litigation against its customers. As Tate said back in March, "the wheels of justice grind very slowly."

In the meantime, its customers keep paying the royalties.

But not for much longer.

It came to light this week that Samsung's royalty agreement with Rambus contains a clause that says if the patents are held to be unenforceable, the royalty gravy train comes to a screeching halt.

Unlike Edelstone and J.P. Morgan H&Q analyst Eric Chen, who maintains a "long-term buy" recommendation on the stock, SG Cowen Securities analyst Drew Peck has been leery of the Rambus story and maintains a "hold" recommendation.

"I can't be anything but cautious at this point," he said back in March. "Every time I've tried to (predict how the courts will rule) in the past, I've gotten my head blown off. It's not easy to guess what a judge or a jury will do, especially when it's a technology issue. That's the scary part."

Edelstone, who was unavailable to comment this week, apparently wasn't too concerned about the impact of unfavorable rulings on Rambus' future. But a "strong buy" rating on a company embroiled in numerous lawsuits of this kind smacks of incompetence, arrogance or both.

Perhaps Rambus executives and attorneys brainwashed Edelstone into believing it was impervious to the countersuits and that its own infringement claims were airtight.

Or maybe Edelstone was betting the courts would deliver favorable outcomes and spark a resurgence in the moribund stock, a gamble that could have made him look like a genius.

More likely, he was just being loyal to a company that he and his firm helped take public in the first place.

Whichever way, Morgan Stanley clients who listened to Edelstone as the stock kept falling lower and lower and lower in the past year must feel pretty stupid and take little solace in the fact that he downgraded the stock this week only after Rambus got its clock cleaned.

Great call, genius.