I sense a need for some clarification on the capital structure of Document Security Systems (NYSEMKT:DSS). The company announced a merger and associated lawsuit when its shares were trading around $4.15 per share. Shares briefly rallied to $4.60 per share but have subsequently pulled back to $2.60 per share amid no news besides a conference call. What is going on with DSS?
My theory is that shareholders are having difficulty interpreting the value of DSS during its merger process with Lexington Technology Group. Lexington, after all, is the private company that is suing Facebook (NASDAQ:FB) and LinkedIn (NYSE:LNKD) in one of the most exciting lawsuits announced this year. DSS, on the other hand, is a public company with slowing growth and modest revenue potential. When investors are unsure about something, they usually sell first and ask questions later. Is the merger accretive? Is it dilutive? What is the expected timeline for Lexington's lawsuit, and will DSS benefit directly from its outcome? These are important questions; fortunately, they have answers in SEC filings.
By way of background, DSS' business is printing, tracking and security solutions. Lexington's business is monetizing patents and other intellectual property. DSS and Lexington signed a merger agreement on October 2 that is still pending regulatory and shareholder approval. On that same day, Lexington announced that its wholly-owned subsidiary was suing Facebook, LinkedIn and three other companies for patent infringement. Details on the lawsuit can be found here, and estimates for the potential payout have gone north of $1 billion. (Basically, Lexington's subsidiary believes that Facebook and LinkedIn used its patented methods for managing, storing, tagging, and sharing digital documents.) What I would like to address in this article are the upcoming catalysts for DSS shareholders, its merger-adjusted capital structure, and what shareholders should expect regarding both the merger and the lawsuit.
Was the Merger Dilutive?
When the merger was announced on October 2, the first question on every DSS shareholder's mind was whether or not the merger was dilutive. The answer is simple: The merger was roughly a merger of equals, so it was not very accretive nor dilutive from a capital standpoint. Lexington Technology Group was valued around $54 million, and DSS was valued around $88 million pre-merger. Moreover, Lexington will counterbalance its increased liquidity (and associated liquidation fears) with a signed agreement to try to keep shares trading above $5 per share for at least 40 out of 90 days of a 90 continuous trading day period following the merger. It also brings several experienced executives to the DSS team and a very valuable patent portfolio (the one being asserted against Facebook and LinkedIn).
Page 170 of the S-4 filing states that on August 16, 2012, Lexington sold 3,617,983 common shares in a private placement at $1.50 per share for gross proceeds of $5,427,000. The Q&A section clarifies the number of common and preferred shares in Lexington: 31,776,552 as of November 19, 2012. Therefore, Lexington sold roughly 10% of its equity for $5.4 million in August, valuing 100% of the private company at approximately $54 million. As of the merger announcement on October 2, DSS' market capitalization was around $88 million, so the merger was roughly a merger of equals. (Recall that valuation constantly fluctuates, and DSS was valued below $54 million as recently as May 2012.)
What Is the Schedule for the Facebook/LinkedIn Lawsuit?
Here is a rough timeline for Lexington's lawsuit. Note that the trial date is scheduled months after the merger is expected to finalize.
December 7: Hearing of the defendants' motion to transfer jurisdictions
Christmas: Decision on the motion to transfer (i.e. stay in Virginia or transfer to California or New York)
Early January 2013: Scheduling hearing (to choose between a 10, 12 or 14 month track)
February 2013: Expected SEC merger approval
March 2013: Expected shareholder approval and completion of merger
January-March 2013: Discovery process
April-June 2013: Markman hearing
July-October 2013: Final trial
This schedule is subject to change, but these are the ballpark dates outlined on the last conference call.
As you can see, pending SEC and shareholder approval, DSS and Lexington Technology Group will merge in March 2013. Assuming shareholders are looking to hold through this date, we already know that they will collectively own 50% of the combined company. Therefore, because Lexington's subsidiary is wholly-owned, post-merger DSS shareholders will directly benefit from lawsuit payouts (as it relates to their equity ownership and less taxes, legal fees and the promised 10% to inventor Tom Bascom). What else can they expect?
Post-Merger DSS: A Bit of Math
Today, DSS has 21.71 million shares outstanding. When Lexington's shares are added, there are 37.5 million common shares (and approximately 5.2 million preferred shares convertible into common outstanding in the combined entity). After the expected merger in March 2013 and assuming DSS stays above $5 per share for 40 out of 90 days following the merger, an additional 7.1 million common shares will be released from escrow. So there will be approximately 44.6 million of common shares and approximately 5.2 million preferred shares convertible into common shares outstanding in the merged company.
DSS now: 21.71M shares outstanding
DSS post-merger (if above $5/share): 44.6M common + 5.2M convertible preferred
In addition to the common and preferred shares, there are up to 11.5 million warrants and options and debt convertible into DSS common stock at various strike prices (at a weighted average strike price of approximately $4.10), including 4.9 million warrants issued to Lexington shareholders upon the merger at a price of $4.80 per share.
It is important to note that Lexington believes that DSS is undervalued at the current market price of $2.60, as Lexington participated in a PIPE financing in DSS at $3.30 per share. Lexington was also willing to commit to very aggressive equity performance terms wherein it agreed to the $5 per share threshold in order to receive 7.1 million escrow shares. Specifically, Lexington will split ownership 50/50 with DSS unless DSS trades above $5 for 40 out of 90 days following the merger (at which point DSS will become a 55% Lexington/45% DSS-controlled company). Therefore, Lexington is highly motivated (to the tune of millions of dollars) to see the price of DSS trading over $5, rebutting concerns that Lexington is simply looking to use DSS as a liquidation vehicle.
Investors who read the S-4 filing also realize that a private round at $1.50 in August converts around $2.80 to as much as $3.30 on a fully-diluted basis. So with Lexington's PIPE at $3.30 and the August round at $2.80-$3.30, investing at the current market price of $2.60 places you alongside a lot of very smart, committed and institutional-grade money.
DSS: Two Complimentary Business Divisions
One side of DSS operates in a small New England city, providing digital and print-based security services. This business is stable, growing slowly, and nearly cash flow positive. The other side of DSS is patent litigation and has two main areas of operation: a lawsuit against Coupons.com for up to $300 million plus another five defendant lawsuit that could be worth billions.
Even though revenue numbers are small for the former legacy business of DSS, it is valuable for a number of reasons. Generally, it provides jobs, generates healthy cash flow, and improves the security of documents. Interestingly, it also substantiates the legal status of DSS as an Operating Entity, not a Non-Practicing Entity (NPE) that is simply suing for patents that it does not utilize. DSS truly uses its patent that it alleges Coupons.com is illegally using, therefore it alleges real, stolen profits from the infringement, not just a technical violation. (NPEs are commonly regarded as "patent trolls" and gain inferior treatment versus Operating Entities.)
The latter business division of DSS is patent litigation: Exciting, risky, high-profile, high-reward... everything you hope for in speculative investment. Lexington's expertise is in this area, and assuming the merger completes, Lexington will bring executives to DSS who have recovered hundreds of millions in real courtroom payments. This division has two announced lawsuits and could deliver windfall payouts within the next 24 months if it succeeds. Lexington and DSS are litigating against the following defendants:
These two business divisions complement one another: the security division provides cash flow and legitimacy to the litigation division's high-profile lawsuits. There is not enough time in this article to analyze the lawsuits, but many other authors have done a nice job analyzing the dollar amounts.
Hopefully this article helps DSS investors understand the timeline and merger-adjusted capital structure of this pre-merger company. As has been mentioned many times, investing in small companies is inherently risky and volatile. I hope that during my analysis the following highlights were not overlooked:
The merger between DSS and Lexington was not a buyout. Roughly a merger of equals, DSS was worth $88 million and Lexington was worth $54 million when the merger agreement was signed.
At $2.60 per share, both Lexington and other private investors are underwater and, therefore, believe DSS is undervalued.
Assuming the merger completes in March 2013, Lexington will be highly motivated to see DSS' share price above $5 per share for at least 40 out of 90 days following the merger so that it can earn its 7.1 million escrow shares and a controlling stake in the company.
DSS will likely qualify as an Operating Entity and has "multiple shots on goal" for winning a lawsuit reward from any of six defendants, including Facebook and LinkedIn.
I have tried to keep this article neutral, but my personal opinion is aligned with management here. Shares are cheap. Lexington invested in DSS through a PIPE at $3.30 per share- 27% higher than the current price of $2.60. Lexington also has $35.5 million (7.1M shares at $5) riding on DSS trading above $5 per share by April (a rally of 92% from current levels). Moreover, the private round in August converts near $3 per share, and there are lots of investors like Hudson Bay that took big stakes above the current price. As I wrote above, investing at the current market price of $2.60 places you alongside a lot of very smart, committed and institutional-grade money.
Finally, I believe that if anyone can succeed against Facebook and LinkedIn, it will be a team led by executives like Peter Hardigan and Jeff Ronaldi (who, by the way, has never lost money on a patent portfolio and has secured more than $160 million in real lawsuit payments). This is the calm before the storm. As you can see from the above schedule, DSS' big events are scheduled for next summer, so shares should slowly start to ramp higher over the next six months. If Ronaldi has pushed all-in with DSS (and he has), I would want to join his bet. Regardless of my opinion, though, hopefully this article helps you to understand what DSS will be six months from now from a capital perspective.