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Though the recent trading of new patent focused stock MGT Capital Investments (NYSEMKT:MGT) has been anything but positive, the stock still offers tremendous upside potential. Considering the well-documented success of VirnetX Holding Corp (NYSEMKT:VHC) and recent success of Vringo Inc. (NASDAQ:VRNG), investors might be surprised by the lack of initial success of those patent firms.

MGT and its subsidiaries are engaged in the business of acquiring and monetizing intellectual property rights.

The stock originally popped to 52-week highs on the filing of a patent lawsuit against the major casino operators and game makers only to crash right back to new 52-week lows. Recent history has shown that these patent stocks don't actually rally until the cases progress past the initial stages.

Quick Transition To Patent Lawsuit

The company has quickly transitioned to focusing on intellectual property rights to acquiring a patent and attempting to enforce it. CEO Robert Ladd was only named as CEO on January 9, 2012 after being a board member for the previous two years.

He quickly changed the focus of the company towards the acquiring and monetizing of patents and moved to purchase Patent #7,892,088 from J&S Gaming on May 11, 2012. The patent only cost $200,000, but it gives MGT a 55% controlling interest of a potentially lucrative asset.

The patent was recently granted on February 22, 2011, highlighting that it was recently reviewed by the patent office. The patent addresses a gaming system in which multiple gaming machines are networked to one another and to an interactive sign. The technology allows the players to play a second bonusing game and compete against one another if the bonus is triggered.

Patent Lawsuit

On May 11th, the company filed a lawsuit claiming a patent infringement against multiple companies believed to be violating MGT's patent entitled "Gaming Device Having a Second Separate Bonusing Event." The patent is directed to a gaming system in which a second game played on an interactive sign is triggered once specific events occur in a first game.

The lawsuit was filed in the United States District Court for the Southern District of Mississippi (Jackson Division). The company alleges the defendants Caesars Entertainment (NASDAQ:CZR), MGM Resorts International (NYSE:MGM), WMS Gaming - a subsidiary of WMS Industries (NYSE:WMS), Penn National Gaming (NASDAQ:PENN), and Aruze Gaming America either manufacture, sell, lease, or operate gaming systems in violation of the patent owned by MGT.

The allegedly infringing games include Pirate Battle, Reel'em In Compete to Win, Great and Powerful Oz, Battleship, Clue, and Paradise Fishing.

The company expects to recover damages including a reasonable royalty, trebled, plus interest and costs.

The list of defendants includes a major list of gaming companies though notably some of the big names are not included. Whether some of the larger gaming companies aren't using the infringing machines is not clear. The possibility exists for inclusion of further games and defendants.

Patent Details

According to Patent Buddy, the patent was originally filed on October 18, 2001 and issued on February 22, 2011. The claim is as follows:

A gaming machine system comprising: at least two gaming machines linked together, said gaming machines linked to an interactive sign; said at least two gaming machines allowing at least two players playing a first regular game on said at least two gaming machines; a device connected to said gaming machines to direct said at least two players to play a second bonusing game after satisfying a certain operation of the linked gaming machines that triggers a bonusing event from said linked machines; said second bonusing game is a bonusing video game to be played on said interactive sign; said interactive sign comprising an LCD screen; said LCD screen displaying said bonusing video game that players enter in once said bonusing trigger event occurs on the said at least two linked gaming machines; wherein said LCD interactive sign allowing said at least two players playing said at least two linked gaming machines enter said bonusing game and compete against each other by playing said bonusing video game on said LCD interactive sign.

The visual presentation is presented below:

(click to enlarge)

The biggest issue for non-technology and non-patent experts is the ability to gauge the enforceability of a patent. In this case, the patent is very clear and the picture very clearly depicts the games now popular at many casinos. In fact, the LCD interactive signs are unmistakable and likely difficult for casino game makers to create a workaround. It appears better to accept the reasonable royalty rate instead of creating an alternative method that may not be as popular.

Group Play Slot Machines Popularity

The group play slot machines provide for a more exciting user experience with the ability to earn bonuses and the interaction with other gamers. The games are a lot more likely to attract a younger crowd than the old style machines. While these machines are relatively new and limited, the popularity provides for a substantial growing opportunity.

According to a Los Angeles Times study that MGT references in a presentation, approximately 1 million gaming machines exist in the U.S. with $36 billion in annual revenue. This study excludes the tribal casinos. Another study from 2010 had the global market for slot machines at over 4.2 million machines and revenue exceeding $76B. The company estimates that up to 10,000 group play games exist that are infringing on the patent with potential for growth over the next few years.

Though most analysts expect the market to continue growing, worth noting is that the typical infringing game includes seats for four to six players or the equivalent of up to six old-style slot machines. On top of that, the large LCD screen likely requires additional space to house the games making the space requirements significantly higher than traditional games.

WMS At The Forefront

WMS Gaming sells 5 of the games specifically listed in the lawsuit with only Paradise Fishing sold by Aruze Gaming. Considering WMS Gaming a primary target, investors should review videos and descriptions of those games on wms.com. As an example, Battleship has the following description along with a video highlighting the key features:

Jumping straight from the classic board game to the slot floor is BATTLESHIP slots, the second Team Compete to Win™ competitive slot adventure from WMS. Randomly triggered communal bonuses play out on 3 overhead screens, pitting Blue Team against Red Team in battles to sink the most ships for additional bonus rewards. When triggered, all eligible players on the bank enter communal bonus rounds with their eligible teammates.

The description appears to match the patent claim. Multiple players on connected slot machines with bonus rounds on interactive overhead screens. If this game isn't violating the patent, WMS will need to provide a case that isn't obvious.

Likewise, Pirate Battle appears to offer a similar description of multiple slot machines linked with bonus rounds playing out on a singular overhead screen.

On top of the heavy concentration of machines being sold and developed by WMS Gaming, the company has agreed to be acquired by Scientific Games (NASDAQ:SGMS) for $1.5B. This lawsuit could have a material impact on the merger especially considering Scientific Games lists WMS as a leader in interactive gaming content. The reasonable royalty rate requested by MGT probably wouldn't impact the valuation of the merger as those costs might even be passed onto the buyers, but Scientific Games would undoubtedly prefer to have such pending lawsuits resolved prior to a merger.

Patent Potential

Via the presentation in November, the company estimated the present value of royalties over the life of the patent of between $330M and $4.5B. This amount is incredible for a company with a fully diluted market value of only $24M.

The company provided the following details on the infringement opportunity:

  • Number of infringing machines between 3-10K.
  • Revenue per machine per day between $3-5K.
  • Annual infringing revenue - $3.3-18B.
  • Reasonable royalty rate between 1-2.5%.
  • Annual revenue potential to MGT Gaming between $33-450M.

What the forecast doesn't address is the potential growth of the infringing machines. Clearly the industry could shift towards non-infringing machines or develop a new concept that doesn't infringe this patent, but based on the excitement over existing games such as Paradise Fishing or Pirate Battle, it seems more likely that the companies accept the reasonable royalty rates.

If the machines in question double to 20,000, the revenue presumably doubles as well. Investors need to be careful in not extrapolating the revenue per machine and total machine potential too far as the machines take up considerably more space and the limited supply of existing machines surely juices the users per existing machine. The company already forecasts that revenue on the existing base of up to 10,000 machines could be as high as $18B, which amounts to a substantial portion of the revenue base for all slot machines.

For now, the analysis of the potential profits becomes insanely large based on only 8M shares outstanding and revenue potential in the hundreds of millions. Engaging in that analysis doesn't provide a lot of usefulness as any positive outcomes will generate a significant return to investors. The real key focus of any analysis is whether or not the company will win this case.

Cashing Out Medicsight

At the end of January, the company announced it had retained Munich Innovation Group to license or sell Medicsight. The subsidiary owns a portfolio of international medical imaging patents. While these patents were not viewed as valuable, the announcement was surprising as the general concept was that the company planned to focus on acquiring patents.

An outright sell would leave the company reliant on one patent, but Minyanville claims the patents to have a $4-5M value that would provide a nice cash cushion for the company.

Balance Sheet

As reported in the Company's Current Report Form 8-K dated December 10, 2012, MGT has a debt-free balance sheet with stockholders' equity of approximately $6.8 million. As it enters 2013, the Company has approximately $5.5 million of cash, 3.2 million common shares outstanding, plus 1.4 million preferred shares (convertible into common stock on a one-for-one basis). In addition, the company has 4.0 million warrants exercisable at $3.64 per share. If fully exercised, the company will collect $14.5 million and be left with a solid balance sheet with around $20.0 million in cash and only 8.6 million diluted shares outstanding.

As mentioned above, the Medicsight sale could further generate cash for the balance sheet to where the company could purchase more patents to build out a portfolio of intellectual properties.

Stock

The stock hit new 52-week lows in the last month, as the original hype on the patent lawsuit slowly wears off. In the year since the new CEO, the stock still trades higher than the sub $2 level from the beginning of 2012. Based on the patent purchase news and lawsuit news, the stock jumped to $7 both times providing a solid example that a purchase at the current level could yield a large gain on the next positive news item.

1-Year Chart - MGT Capital

(click to enlarge)

Conclusion

The stock provides one of the largest risk/reward situations in the stock market. A denial of the request to transfer the case out of the Southern District of Mississippi could kick off the case. With all of the defendants located in different areas, the company expects to move forward in Mississippi. In addition, the law firm of Nixon & Vanderhye provides a solid tier 1 patent litigation law firm.

The past histories of both VirnetX and Vringo suggest that this weakness is an ideal time to purchase patent stocks with strong cases. In both situations, the stocks had long periods of limited gains after the initial lawsuits were filed. The patient investor tended to make the most money.

With the limited float and market value, the stock will skyrocket on any positive news. Likewise, with only one patent, any dismissal of the lawsuit or a negative jury verdict would crash the stock though the cash position will help cushion any blow.

Source: MGT Capital: Small Patent Stock With Huge Potential

Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.