Payment technology is a viable business, even during a worldwide slowdown. Enterprises that make their money through it are not exposed to the same default risks as lending institutions, and results have been terrific. A microcap company known as SmartMetric (OTCQB:SMME) has intellectual property ("IP") for charge cards, a type of product identified with industry titans Visa (NYSE:V) and MasterCard (NYSE:MA). It is seeking a share of their revenues at court. Though the concerns for anyone who would consider putting money behind SMME.OB are exceptionally high, there could be an astonishing reward. Perhaps more prudently, the company may also be used as a hedge for those enjoying returns on their tech investments.
An invention is being asserted: U. S. Patent 6,792,464 ("'464"), issued to Chaya Hendrick, CEO of SmartMetric. Sixteen other patents currently cite it, including Hendrick's '860. Application in the USA is listed as occurring in February of 2000, with a filing date in 2001 and issuance in 2004. It is only valid here. According to the USPTO, it would expire 20 years after the earliest filing, apparently in February of 2020.
Generally speaking, the '464 is for chip and pin cards that connect to a computer system and network. Its listed background art is captivating. The patent defines "Contact" cards that are inserted into a reader and have a microchip that makes contact with it to exchange data, and "Contactless" cards that do not have an exposed chip and communicate with a reader using an internal antenna.
Contemporary Commercial Development
Today, nearly 13 years after issuance of the '464, the wider industry is implementing EMV, an acronym for "Europay, MasterCard and Visa, the companies that in 1994 initiated the development of [its] specifications." The technology increases security and "Global interoperability." There is contention that merchants are likely to prefer legacy swipe readers. However, for several reasons, measures are being employed to speed upgrading. Hendrick elucidates: "Banks put transaction limits on the use of wireless cards...it's easy to pick up card data that is sent wirelessly."
Visa is a top company, and has rewarded stockholders with a 60% rise over the past 52 weeks. It is now using incentives, and also liability policies, to encourage chip issuance and adoption in the USA. Effective October, 2015, a party not using EMV would be liable for fraud. Visa is also waving compliance validation requirements. SmartMetric provides another perspective,
Visa [has] mandated that all ATM and retail reading machines have to be able to accept contact cards...most, if not all, of the retail reading machines sold over the last five years are chip ready...all they need is a software update that can be done remotely.
Visa specifically instructs its clients not to use "Contactless-only" chip cards. Further, as of July 11, 2012, magnetic stripe technology must be supported on a dual-interface card, which works with contact chips, magnetic stripes, and contactlessly (Visa PayWave). Dual-interface is heavily used in the marketplace.
MasterCard, Visa's rival, has performed nearly as well: its stock shows a 54% gain over the past year. Its shift is described here. Like PayWave, MasterCard's contactless PayPass probably should continue to be non-infringing with regard to the '464. According to SMME, "If it doesn't have a chip that is read on insertion into a reader then it doesn't fall within the patent..."
MasterCard is also offering a new M/Chip so that its customers can meet "The EMV standard." Its marketing materials say "The consumer inserts his or her card into the terminal or ATM, or taps their phone or clicks and pays online. That's it. Safer, simpler and smarter." The company also describes how payments work,
1) Card authentication takes place either online by using dynamic encryption or offline by protecting against counterfeit cards...
3) Transaction authorization is completed either online with encryption technology or offline by using issuer-determined risk parameters.
The North American Card market continues to develop, though some project a slowing overall rate. According to the International Card Manufacturer's Association's Card Manufacturing Magazine,
Chip cards will continue to displace lower priced traditional magnetic cards, thereby fortifying the dollar mix...North America will experience some modest declines, however financial cards will remain strong in anticipation of EMV and debit and prepaid growth.
Industry professionals interviewed by the Magazine provide additional pertinent information about business. To quote Barry Mosteller, Director of R&D, CPI Card Group,
A Visa representative has said that 20 to 60% of cards will need to be EMV by 2015...While many EMV issuers continue to...issue dual interface for...high value members do not be surprised if contact only volumes dwarf dual interface until the contactless infrastructure grows in the US.
Keith Yeates, President, Bristol IT Technologies, believes that
The advancement of EMV in North America will limit the number of card manufacturers participating in the secure financial card market and those select few will enjoy the growth it will bring. The larger card manufacturers will get larger at the expense of some smaller players in the area.
The Patent Infringement Lawsuit
A case has been ongoing for years. I have only become aware of this matter recently, several months after an April 11, 2012 Court of Appeals for the Federal Circuit decision. According to SmartMetric, the appellant court has sent its findings back to the lower district for continuation of a hearing. Thus, for the ongoing suit, the '464 patent is only valid for swiping a card into a data card reader; and for use on public and private networks, such as the internet and intranet. Seeking Alpha's Dan Ravicher offers insight in his April, 2012 article, saying there is a case on credit card readers; however, he may not have purveyed a fully-inclusive description. Also, there have reportedly been two Markman rulings favorable to the plaintiff, one after July, 2012.
SmartMetric is likely fortunate to be represented by the preeminent Patrick Bright, of Wagner, Anderson & Bright. He has had a lengthy career in IP law. He is also known for working on contingency. Pertaining to fees, Hendrick says, "We do not need to raise funds for the legal costs...[they] are being covered from outside the company so we can take this to the Supreme Court."
There is a new judge on the case (No. CV 11-7126 MWF (FMOx)), Hon. Fernando M. Olguin, recently promoted from magistrate. After rescheduling on December 2, 2012, trial is now set for September 3, 2013 against MasterCard and Visa. (Discovery cutoff is March 13, the Pretrial Conference and Motions in Limine deadline is August 12, and the last day for Settlement Conference is June 14, 2013.)
The venue is the United States District Court, Central District of California. A 2011 PwC Patent Litigaton Study finds that it is a favorable place for patent claims, ranked fifth for overall success at 35.3%, just ahead of the Eastern District of Virginia. There is a 71.4% positive outcome rate at trial. The defendants must be trying to conclude the matter before it falls into a jury's hands.
For some background on SmartMetric, its business is security from, and protection against, identity theft. The company's technologies include a fingerprint scanner device that accesses health records. It expects one million to five million unit sales of a medical key ring. It also offers various other products and "[Has] even been approached by a government that is looking at using their cards as national ID."
A 2006 decision makes it more challenging for an entity that does not practice use of its technology to prevent the sale of another company's item that is found in violation of a patent. Relevantly, SmartMetric informs that "Visa argued to the court in their last filling that yes they viewed [us] as a competitor." Yet, an injunction is probably of little concern, and might be stayed pending years of appeals. Also, the defendant(s) can contersue. More broadly, regarding settlement leverage, Hendrick explains:
Yes big leverage...What would it be worth to say American Express or Diners to advertise that it is the only card that can be used around the world...that is if we give them an exclusive license and lock out Visa and MasterCard...Also, if a transaction is taking place in London but it connects to say the Visa network in anyway in the USA, it infringes in our opinion.
Perhaps the London part is what Ravicher was getting at?
A June 6, 2012 news release says there are already 1.5 mln relevant cards. The company states that all of the chip and pin EMV products Visa and MasterCard are issuing to replace existing cards unlawfully use its technology. Another question for SmartMetric is whether or not a dual-interface offering may also infringe. The answer is "Yes a dual-interface card does infringe...Contactless cards default to contact if in the first attempt to read the contactless...[it] fails."
It is easy to be incredulous toward a claim that the industry behemoths lack proper licensing, particularly when EMV is named for them. A concern for me involves any patent that Visa or MasterCard somehow has not disclosed. The defendants have supplied 25,000 pages of documents, 1,000 pages of them being germane (and some of the most damning evidence is said to be in the respondents' own records). Still, they are trying to withhold other requested materials; and certainly possess valuable trade secrets. If new patents are introduced that can be used to initiate reexamination of the '464 at the United States Patent and Trademark Office (USPTO), then a standard tactic for the defense is to stay the trial. Further, it would probably be easier to show invalidity at the USPTO because a lower standard of proof is required.
Also, only one patent is being asserted and there are many potentially successful defenses against it. A demonstrated ability to work around any finding(s) could free MasterCard and Visa from their responsibility to pay a royalty. Let me add that there is a catch to a workaround as revised methods can easily violate other intellectual property rights--belonging to a new and different party.
There are many risks to investing in micro cap companies and SmartMetric is one. Shares can be less liquid, having wide spreads and low volumes. Also, their pricing can be volatile, changing substantially without any news or event that otherwise materially affects the stock. When such a corporation's equity trades over-the-counter, added concern is indicated because financial standards are typically lacking and the business tends to be unproven.
The company's most recent 10Q describes dilution risk (If they can raise money at all). Also, 200,000 shares of Class B Preferred Stock have been given to Applied Cryptography, Inc. ("ACI") in exchange for patents. The paperwork says ACI can purchase the property back and has not chosen to do so as of September 30, 2012. On a January 4, 2013 phone call, investor relations advisor Nuwa Group has said SmartMetric owns the patent in total for its lifetime. Further clarification, preferably written, would be helpful.
Popular investor tactics for IP assertion stocks involve using options for events such as a hearing. Consider VirnetX (NYSEMKT:VHC), which has gained over 11,000% since 2005. Television personality, and former manager of a successful hedge fund, Jim Cramer, currently recommends deep in the money calls for its trial with Apple (NASDAQ:AAPL), and alternatively suggested a calendar spread trade in the past. While there are no options available for SMME.OB, shareholders could be rewarded with terrific gains this year.
For those interested in hedging against patent risk, Mark Cuban's results after obtaining over 1,000,000 shares of Vringo (NASDAQ:VRNG), the winner of a recent patent infringement trial with Google (NASDAQ:GOOG), have been amazing. VRNG is up 235% in the past 52 weeks, which is off of the following chart, while GOOG is showing a 15.15% gain. The wider Technology Select Sector Index (NYSEARCA:XLK) is up 12.16%. V and MA are respectively the XLK's 11th and 13th largest holdings; AAPL is first and GOOG is fourth (AAPL has underperformed VHC).
Anyone who took a stake in VRNG because they like the story, after its March 14, 2012 merger and prior to Cuban, may be enjoying a 103% return. Contrastingly, just ahead of the October trial, the Citadel Investment Group hedge fund appears to have essentially used an options straddle and bought stock.
Quantifying a monetary value for any award resulting from the ongoing case is beyond the scope of this article. Though SmartMetric has not publicly stated any amount, Hendrick says $100 mlns+ is "Where our head is." The '464 should be valid for over seven years in the future, and a royalty for its duration, in exchange for licensure, might provide annual revenues many times the company's current market cap. Actual earnings acceleration, or the ability to assert other claims that could be at least as lucrative, involves separate questions.
SMME.OB stock has been trading at around $0.20. I am considering using a $0.17 or $0.18 limit order in an attempt to purchase hundreds of shares, and to buy again below $0.15. While there are plenty of things that could go wrong before trial, the situation seems to be such that a favorably ruled motion or buy-in by an important party could easily send the stock's price higher. If nothing else, a $0.02 gain would amount to at least 11.11% appreciation using a sell order at $0.20.
Technology, specifically when used for payment, is a healthy line of business that can be profitable for stakeholders. Companies in the sector, and virtually all other corporations, remain exposed to IP lawsuits that investors can actually hedge against by owning businesses focused upon licensing activities. In fact, some of the big winners in the stock market are IP companies.
For those who reasonably prefer to entrust their money to Visa or MasterCard, ease of use and security of payment cards are highly important. Thus, the functions that are believed to be most effective for safely and globally carrying out transactions deserve attention. Though growth may slow in the United States and North America, steps are being made toward assuring lawful and seamless worldwide use for consumers.
"Stock Talk Live," SmartMetric online presentation and interactive question and answer session. 1pm, Tuesday, January 8, 2013. Some grammar in SmartMetric quotations has been changed.
Card Manufacturing Magazine, "A Year In Cards." December 2012. Volume 22, No. 8. CMA Publications Group: Princeton Junction, New Jersey.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in OTCQB:SMME over the next 72 hours. 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.
Additional disclosure: I have initially been contacted by a representative of SMME.