VirnetX Holding Corp. is a company that has no assets except $66.7 million in cash and 14 U.S. patents and 16 foreign patents covering primarily secured domain communications (e.g. Virtual Private Network (VPN) communications). It also has no significant revenue. Its business model is to sue large technology companies in order to compel them to license its technology. The company was founded in 2006 when the current management team acquired their patent portfolio from SAIC in exchange for a $35 million royalty earn out on any royalties the patents produced. It went public via an RTO on the Amex. The company then hired the best patent lawyers they could find, McKool Smith, to sue Microsoft in February 2007. Well, McKool earned their keep and VirnetX won on two patents covering Windows, Messenger, and a host of other Microsoft products to the tune of a $105 million judgment in March 2010. VirnetX filed suit for some more Microsoft products on the same patents. Microsoft promptly settled this and all other litigation with VirnetX for $200 million in June 2010. Taxes, SAIC's, and McKool's take took VirnetX's net cash balance down to approximately $70 million. VirnetX then promptly sued Aastra, Apple, Avaya, Cisco, NEC, Siemens, Mitel (there are two suits in federal district court in East Texas -- Case 6:10-cv-00417 and Case 6:11-cv-00018 for you Pacer fans). VirnetX also told the 4G standards body that it thinks its IP is essential to the standard (not yet ratified), but now has to convince the major wireless players to take a license. The current cash burn rate is around $10-12 million per year. I have just explained the whole history of VirnetX Holding Corp. to you.
Investment Thesis:
VHC is unlikely to replicate their Microsoft success multiple times and even if they do, the stock seems to be more than discounting it with a $1.8 billion current valuation. The most likely outcome is that cases are held up in court for a long time and VHC's cash slowly dwindles. Even if they do win awards it should be much less than the current valuation.
Without further adieu here are the Top 10 Reasons to Short VirnetX:
1) Its patents are software patents. This makes them ultimately susceptible to workarounds.
2) Even if they win VirnetX will pay a fortune in legal fees and taxes as shown in the Microsoft case where they only kept $70 million of the $200 million they settled for (call it $105 million adjusting for SAIC's royalty).
3) If they ever lose a case or their patents are ever invalidated, the future value of the business is cash on hand.
4) The company has no products and likely won't have any. They claim to be starting a secure domain initiative, but this looks to be getting no traction. Instead the business model depends on often drawn out legal proceedings which are highly unpredictable for revenue.
5) Even if the company continues to win Microsoft like settlements (e.g. $100 million net of taxes and fees) every two years for the next twenty, it is still not worth $1.8 billion (I get $500 million at a 10% discount rate).
6) Similar business models have proven to be fraught with risk. Just consider RMBS, TSRA, ACTG, and IDCC with EVs of $1.2 billion, $330 million, $1.3 billion, and $1.4 billion respectively. All of these companies have been at the patent troll game for more than a decade and have a much larger portfolio of patents than VHC, yet the market values them at less than VHC? In the course of their history, all of these companies suffered numerous setbacks in court that would have allowed a short to cover at a tidy profit. Why should VHC be much different?
7) The key VirnetX patent from the MSFT case appeared to be the '135 patent. That patent was filed in 2000. It expires in 2020. The clock is ticking and there is no terminal value once the patent expires. Interestingly, Cowen, (the company's investment banker) has a research analyst who seems to not understand this terminal value problem as he uses a substantial terminal value to justify his valuation target via a DCF. Be wary of analysts with spreadsheets.
8) The largest enforced patent award of all time out of the courts was $910 mil (Polaroid vs. Kodak). http://thepriorart.typepad.com/the_prior_art/2009/06/centocor-v-abbott-ed-texas-jury-awards-largest-patent-verdict-ever.html This JNJ award got overturned. VHC is priced at roughly two of these awards which seems ridiculous.
9) The company has a no-name auditor (Farber Hass Hurley LLP) and recently had to restate their financials to correct problems in the way they accounted for warrants they issued.
10) The company has very real cash costs and is fighting expensive court cases. They will burn at least $10 million per year and probably quite a bit more. They had better hope it doesn't take them as long as it took NTP (5 years) to get paid by RIMM or they might not make it. Of course, they did file on the Eastern District of Texas "rocket docket" so they probably will not run out of money.
In short, this is a "business" fraught with risk and priced for perfection it is unlikely to achieve.
Key Risks:
- VirnetX gets an early settlement from one of the tech companies they sued just to make it go away.
- The company convinces someone to license their patents without suing them (perhaps via the LTE standards).
- VirnetX is somehow able to develop a real business besides patent trolling. Not likely with 11 employees, but possible.
- VirnetX is extremely promotional (visit its IR site to confirm this). Expect them to keep putting out favorable press releases which could drive the stock up.
- The market VirnetX talks about is large. They say they are owed a royalty on any 4G device and have submitted claims that their patents are essential to the yet to be ratified 3GPP LTE standards with ATSI and ETSI.
- Court cases are, in my opinion, impossible to predict. There will no doubt be surprises both positive and negative in the courtroom.
- The stock has been harder to borrow since the recent run-up.
- There is a lot of momentum here.
Why has the stock run recently?
1) Cowan initiation
2) MSFT vs. i4i ruling in the supreme court failed to make life more difficult for patent trolls
3) Recent sale of 6,000 Nortel patents to a tech consortium for $4.3 billion. That's $750k per patent. At that per patent rate (this, alas, is not how the world works) VHC is worth $22 million!
4) Cowan raises target from mid-30s to low 50s on increasing value of patents. How's he get there. He lowers the discount rate on the DCF to 10% from 13% and then uses a 3x instead of 1x terminal multiple. Nice work.
5) Notably, there is nothing going on with the cases on Pacer and there doesn't appear to be much going on until a markman hearing early in 2012.
6) Today there is an acquisition rumor. If it's true I hope it's an all stock deal so I can stay short the buyer.
Disclaimer: We are short and may change our position at any time. This idea is not investment advice and should not be construed as such. Please assume nothing stated here is reliable and do your own work.