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In derby parlance, a "dark horse" is an obscure racehorse that unexpectedly defeats its competitors. Bookies offer cheap bets on dark horses because very few clients expect them to win. The risk of betting on dark horses is high, but payout ratios are very generous relative to the small wager. In this article, I will explain why MGT Capital Investments (MGT) is a metaphoric dark horse: uncelebrated yet worth consideration for a small wager.

MGT's business is to monetize intellectual property. As many investors have already noticed, MGT's recent entrance into patent litigation has caused a flurry of interest in its stock, prompting a rally from $2.93 to $7.46 prior to its subsequent mid-range consolidation in the $4s. The company's market capitalization has stayed below $20 million, even at its height, due to its small float of just 3.037 million shares.

MGT's initial rally was fueled by the retention of a top-tier law firm, Nixon & Vanderhye, and a subsequent lawsuit filing naming high-profile defendants like MGM Resorts (MGM), Caesar's Entertainment (CZR), Penn National Gaming (PENN) and WMS Industries (WMS). With the help of Nixon & Vanderhye, MGT is pursuing damages and royalties on behalf of patent inventor Steven Brandstetter and James Devlin of J&S Gaming. If MGT prevails in the lawsuit, it will receive 30-40% of the total amount awarded, depending on when payments are made and after deducting incentive payments for J&S Gaming and Nixon & Vanderhye.

Optimistic estimates for the value of MGT's lawsuit range upwards of $1 billion. Nevertheless, despite no debt and having approximately $7 million in cash, there is some overhang on MGT's stock due to MGT's delisting notice from NYSE-AMEX and 3 million new warrants priced at $3.85 per share during the last financing. On October 5, 2012, MGT received a notice of non-compliance with listing standards, specifically due to low equity and continuing operational and net losses. MGT has responded by paying off its debts and cleaning up its capital structure. A reinstatement hearing date is scheduled for December 12, and MGT hopes to receive a notice of good standing after this date. Regardless, MGT now has no debt, very low operating costs and $7 million in cash- a good starting point for a company embarking on a legal battle.

With a tiny market capitalization around $12 million and a tiny float of 3.037 million shares -- of which 1.1 million is held by insiders -- MGT investors could receive a significant windfall in the event of a favorable legal outcome. This is the essence of any dark horse bet: a cheap wager for windfall payouts. The only difference between a dark horse bet and MGT is that a race always has a binary outcome (win or lose), but MGT's lawsuit is more a question of how much MGT will win in its various legal battles. So long as MGT succeeds in capturing at least a few percent of its contested billions, the reward will equal multiples of its current market capitalization. Investors who are able to accept the possibility of failure might want to evaluate this interesting dark horse wager.

MGT's Slot Machine Patent

Patent litigation is a relatively new field for stock market investors, but it has provided lucrative outcomes for recent patent victors like Apple (AAPL) (winning $1 billion from Samsung), VirnetX (VHC) (winning $368 million from Apple), and Vringo (VRNG) (winning $30 million plus royalties from Google). Although it might fail entirely, MGT hopes to enjoy the same success as its peers.

MGT alleges that MGM Resorts, Caesars Entertainment, Penn National Gaming, WMS Industries, and Aruze Gaming America have infringed on the patent in either the manufacture, distribution, or sale of slot machines under the trade names "Pirate Battle," "Paradise Fishing," "Reel 'em In Compete to Win," "Clue," "Battleship" and "Great and Powerful Oz." MGT Gaming seeks injunction from any continuing acts of infringement, including recovery of litigation costs and treble damages with interest.

This move marks MGT's foray into a recession-proof market. With gaming revenues of $36 billion in 2010, the American Gaming Association counts an average of 60 million casino visitors annually with a stable average spend, regardless of economic downturns. There are over 800,000 electronic slot machines in operation in the U.S., accounting for nearly 70% of casino revenues with an average life span of seven years per machine. Thousands of new machines with interactive video displays and super jackpots from linked devices are manufactured every year, supplanting the once ubiquitous single-payline machines which now account for only 30% of machines. Forbes reports that allegedly infringing machines account for 1.25% of the U.S. market (or about 3,000-10,000 slot machines in total) with average wagered revenues around $3,000 per machine per day.

Background and Risks

In May 2012, MGT acquired 55% of MGT Gaming, with the remaining 45% owned by J&S Gaming. MGT Gaming holds the rights, interests, and the rights to recover past damages from any infringement of U.S. Patent 7,892,088 (the '088 Patent') entitled "Gaming Device Having a Second Separate Bonusing Event." This patent relates to a casino gaming system wherein at least two slot machines are networked together and linked to an interactive LCD sign. This setup allows two players to participate in a special bonusing event by playing in video game style on the LCD interactive sign after specific events in regular gaming have occurred.

No prior art is assumed at this time given patent approval and absence of a counter claim. Brandstetter originally filed for the '088 patent in 2001, and it took the U.S. Patent and Trademark Office a decade to clarify and award the patent. After J&S Gaming evaluated its "David and Goliath" position against companies like MGM and Caesars, it realized it did not have sufficient strength for the lawsuit. So, it surrendered 55% rights in order to incentivize a properly capitalized company to see the lawsuit through to its completion. Now that the lawsuit is backed by Nixon & Vanderhye and a public company with $7 million in cash, J&S Gaming's chances of success are markedly improved.

Nonetheless, small-cap investing is risky and not suitable for all investors. Small companies tend to fluctuate in price by significant amounts in very short periods of time. MGT is particularly prone to volatility because of its small float of just 3.037 million shares. Investing in MGT is also risky because of the company's heavy reliance on a single revenue source: patent litigation. Finally, any major setbacks in the progression of the lawsuit would require MGT to use its cash reserves to pursue alternative business opportunities, thereby weakening the company's balance sheet. Investors should consult with a certified professional for personalized investment advice.

Betting on the Dark Horse

MGT's downside in the lawsuits is restricted to expenses in pursuing the case (likely far less than its cash reserves of $7 million). On the upside, if MGT prevails in the courts, shareholders could be looking at a reward that may run into the hundreds of millions.

MGT has positioned itself as a debt-free, publicly-traded opportunity for investors looking for gains from a high-profile lawsuit. MGT has teamed up with a top-tier law firm with a record of success in the pursuit of intellectual property, treble damages and by filing a case in the same court that has provided the successful precedent. The outcome of the case is uncertain, and MGT may lose entirely, but costs are negligible relative to the prospect of bumping its current market cap by a significant multiple. All told, MGT may be a volatile ride, but it does provide a unique "dark horse" option: a low-cost wager (the entire company is worth $12 million) for a generous victory payout (hundreds of millions in damages and royalties).

Source: MGT Capital Holdings Is A 'Dark Horse' Bet Worth Considering