The Bear Case Scenario For Vringo

| About: FORM Holdings (FH)

Over the past several months, Vringo (VRNG) has electrified the airwaves. The unpredictable legal proceedings and erratic stock movements that have surrounded its lawsuit against Google (NASDAQ:GOOG) have stoked interest into a frenzied state, swelling the ranks of retail investors who zealously follow the stock. This growing interest has been satiated by two main channels of information: mainstream news publications and investment hubs like Seeking Alpha.

The first source has delivered objective summaries of facts as they unfold, but has left the interested many in desperate need of analysis. The latter avenue has filled this need. Yet it has done so in a very asymmetric fashion. The vast majority of articles, mine included, have dispensed the bull thesis in a variety of forms. Some analysts have constructed hypothetical scenarios, concluding that even under the most conservative estimations, Vringo is underpriced. In the rosiest case, such projections characterize Vringo as a unicorn of investments.

Amid this flood of euphoria, the risks inherent to the investment have received much sparser coverage, found almost entirely in the form of concerns articulated in the comment section of articles and forums. Intelligent discourse surrounding the company has characterized it as a speculative investment, but the question itself remains unturned. What are the components of risk that make Vringo a speculative play? And just how speculative is it?

The negative surprise investors stomached when Judge Raymond Jackson limited the damages Vringo stood to collect under the laches doctrine illuminates just how valuable risk analysis is to Vringo investors. To that end, this article will delve into these risks and ascertain the downsides of a position in Vringo.

Legal Risks

Many breathed a heavy sigh of relief when the jury verdict in favor of Vringo was announced - the binary event had passed, and Vringo ended up on the right side. But the jury's verdict is only one point on the Vringo Vs. Google timeline - it is far short of an immutable close. The market now awaits the judge's final ruling and consideration of both parties' motions.

This process holds a significant amount of risk. And this risk suffers from a degree of incalculability - it falls under the opaque nature of a decision that rests in the hands of one individual. As a first step, Jackson reiterated that the court will rule on the legal question of obviousness regarding the Lang patents. Courts have issued a plethora of opposing rulings regarding the obviousness test, which makes this risk both tangible and unpredictable. For decades, the Federal Circuit employed the teaching-suggestion-motivation test: "a patent claim is only proved obvious if some motivation or suggestion to combine the prior art teachings can be found in the prior art, the nature of the problem, or the knowledge of a person having ordinary skill in the art."

In the Vringo Vs. Google case, a person of ordinary skill was defined as "an individual with a bachelor's degree in computer science with at least 2 years of experience in the field." However, the goal posts of obviousness have been in constant motion. The newest prominent interpretation comes from the Supreme Court's decision in KSR International Co. Vs. Teleflex Inc. (NYSE:TFX), where it adopted "a standard for obviousness that required a person having ordinary skill in the art both to have good reason to create the invention in light of the prior art and to have had a reasonable expectation of success in doing so." The Supreme Court's decision raised the hurdle patent holders must jump. It also shed light on the flux within which the concept of obviousness exists.

The jury provided responses to certain factual considerations under subpoint C of the verdict form that will inform Jackson's ruling regarding obviousness. I view their findings that prior art does not apply, that a "long felt need for the solution" existed, that there had been "unsuccessful attempts by others to find the solution," and that "unexpected and superior results from the claimed invention" have been demonstrated bode favorably for a ruling that the Lang patents were not obvious.

A point of concern is that unlike the '420 patent, the jury found that the '664 patent came to be in an environment of "independent invention of the claimed invention before or at about the same time as the named inventor thought of it." A bifurcated ruling could result in which one patent meets the criterion and one fails.

Apart from the obviousness test, Jackson could modify past damages calculations downwards, or, more significantly, could choose not to heed the jury's suggestion of a 3.5% ongoing royalty, reducing the percent or nixing it entirely. He could also apply the royalty to a smaller piece of Google's revenue than the market anticipates.

In my view, the probability of these occurrences is slim, but it is also incalculable. If none of these occurrences come to bear, Google could file an appeal and the decision could be overturned. This risk is once again small, but unascertainable. However, any of these occurrences would equate to a game over for the short-term value of Vringo equity.

Patent Risk

During trial, the jury found that the Lang patents were valid. However, the question of their continued validity represents embedded risk. Most significant is Google's move to request a re-examination of the '420 patent by the United States Patent Office. Vringo will respond by November 25th and maintains that Google's request is a "standard and typical tactic used by defendants in patent litigation cases." This is true; however, empirical data spanning 1981 to the present from the results of such filings by a third party point to considerable risk: all claims in a patent have been confirmed 23% of the time, a subset of claims in a patent have been modified 65% of the time, and all claims have been canceled 12% of the time.

Rulings on what happens if a patent is invalidated after a court hands down a final decision have been a mixed bag and point to the idiosyncratic risk that Vringo faces. A salient scenario has already begun to unfold in the Apple Vs. Samsung case regarding Apple's (NASDAQ:AAPL) "rubber-banding" patent. The USPTO found the patent to be invalid upon re-examination due in part to (wait for it) obviousness, and Samsung (OTC:SSNLF) immediately filed a motion with the trial judge informing her of the decision. The tumultuous volatility in patent law led the Patent Law Practice Center to exclaim, "this is the world of patents where fiction, fantasy, and irrational decision frolic in the autumn mist!"

That exasperation should be enough to send shivers down the back of any investor. In the case of Vringo, the situation is not as grim as it may seem, because significant mitigators exist to counter this risk. First, the re-examination only covers patent '420, whereas the jury found that Google infringed both the '420 and '664 patents. Second, the re-examination process lasts, on average, more than two years, by which time Jackson will have handed down a final ruling on past damages and an ongoing royalty. The security of ongoing royalties will bear the brunt of this risk.

Business Risk

On a broad level, it is pivotal to understand that the underpinnings of Vringo's business model are vastly different than that of most other companies. The company does not enjoy the relative certainty of generating revenue from an established product. It makes and plans to continue making its living from the monetization of a growing patent portfolio through litigation and settlement. This business is highly volatile in today's patent world, hinging on the decisions of random citizens and judges with vastly different legal opinions.

Yet the future of patent litigation is also fraught with risk. A major shift away from the prevailing legal framework could occur and adversely impact Vringo's core business. Criticism of the current patent system is gaining traction and often centers on rancor over so-called patent trolls like Vringo. The only buffer to this risk is Vringo's potential to successfully license its patents and settle lawsuits on the back of its victory against Google.

A second significant form of business risk Vringo is exposed to is the certainty of its cash flows. When Sara Lee sells a cheesecake, the company receives its hard earned cake money with near certainty. If the bulk of Vringo's windfall comes from ongoing royalties, as many believe, it is subject to a myriad of risks. Google's future revenue generated from the Lang patents is uncertain, new technology may be invented, Google could create a work-around. There is risk in the uncertain time horizon of cash flows and in the counterparty's ability to pay in the long run (i.e. the chance that Google files for bankruptcy).

Each of these risks has a small to infinitesimally small probability, but no one can accurately determine it, and as a result, the discount rate that the market will utilize to convert Vringo's future revenues into a price per share is undoubtedly higher than for almost any other company. For instance, after VirnetX Holding (NYSEMKT:VHC) won a $368 million verdict from Apple two weeks ago, its market capitalization has risen by roughly 20%, or about $250 million, considerably less than the nominal sum of the verdict.

Finally, the risks Vringo faces as an enterprise are uniquely passed on to its equity investors. Without debt on the company balance sheet, downside risk falls entirely on the shoulders of current shareholders. However, upside potential does not entirely belong to current shareholders, given the dilution (due to the considerable volume of outstanding options and warrants) that will occur if the stock appreciates. That sort of asymmetric risk-return profile is never a good thing for equity investors.

Looking at the House of Cards

Vringo faces a bevy of risks, stemming from idiosyncratic variables in its lawsuit against Google to the broader trajectory of its business given the constant volatility inherent to the patent world. For all of this, the necessity of a broad assessment of these risks has been largely glossed over. At the same time, the risk Vringo faces has declined considerably because the jury ruled in the company's favor. Having surveyed the potential hazards, I maintain my conviction that Vringo is a speculative investment with positive expected value.

Each contingency Vringo faces adds to the uncertainty its current and would-be investors are exposed to - this undoubtedly has caused its equity to trade at a considerable hair cut from its true economic value. For many, Vringo will be a lasting case study in the pivotal nature of downside risk and the incredible difficulties associated with ascertaining the probability of such contingencies. As Nassim Taleb recently said, "In a world that constantly throws big, unexpected events our way, we must learn to benefit from disorder."

Disclosure: I am long VRNG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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