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The recent surge in public Intellectual Property companies has garnered much investor interest and heated discussion here on Seeking Alpha. Vocal vantage points on both sides of the spectrum regarding fair valuations for several of these companies have led me to spend a good deal of time wading through projections and outcomes to come up with my own conclusion. I see a bright future ahead for several of these IP companies, and one company in particular has a few differentiators that cause it to stand out against the backdrop when weighing upside potential versus downside risk. The company is Document Security Systems (NYSEMKT:DSS), which has announced a definitive agreement to merge with Lexington Technology Group pending shareholder approval on or about July 1st.

This graph from Lexington Technology Group's presentation highlights the explosive growth for the industry in general:


(Click to enlarge)

The upside potential is clearly what excites investors about investing in IP companies. Many of them are established as non-practicing entities [NPEs] to begin with, meaning they do not have any sustaining business and plan to earn the majority of their revenue from licensing or enforcement of patents. Derogatorily referred to as patent trolls, defenders say they are a necessary means of defense against larger companies' serial infringement with little regard to the patent owner's rights. Regardless of which side someone stands on in this battle, from an investment standpoint it is hard to argue with the share appreciation several such IP companies have enjoyed.

Two examples leading the way

Two in particular I have followed closely, that have been hard to miss reading about on Seeking Alpha, are VirnetX (NYSEMKT:VHC) and Vringo (NASDAQ:VRNG). Vringo has followed a similar business model as VirnetX in the NPE mold of a patent holding company attempting to enforce its patents against industry behemoths such as Google (NASDAQ:GOOG). Both have led early investors down a largely profitable, be it recently volatile, path. Without rehashing too much background information, for which much material can be found right here on Seeking Alpha, VirnetX went from as low as $1.05 in April 2009 to $41.93 in July 2012 and since drifted down to its current $23.89 price. Vringo went from $0.68 in January 2012 to $5.73 in October 2012 and currently trades at $3.27. VirnetX has secured several huge verdicts, including a $368 million one against Apple (NASDAQ:AAPL). Vringo was awarded a $30.5 million victory against Google and others for past damages, but the golden goose for them that is still in litigation will be to what percent of Google's future royalties they are entitled.

A main reason I think now is the time to buy DSS is because I believe there will be a big run-up preceding the Markman hearing scheduled for October 2nd, just like VirnetX and Vringo experienced leading up to their Markman hearings. I also believe some investors are waiting on the sidelines to jump into DSS following the completion of the merger in early July as a precaution. There is no reason to question the merger with Lexington going through in my mind, as the announcement of it has been well publicized, so any shareholders who are not in the stock for the merged company's business plan would have already sold their position.

Follow the smart money

Something that has also been discussed extensively here on Seeking Alpha for Vringo in particular has been the institutional "smart money" investors that backed Vringo from the beginning and enjoyed substantial gains along the way. Here is a snapshot from Vringo's S-4 of a few of those early investors:

Name and Address of Beneficial Owner

Amount of
Beneficial
Ownership(3)(4)(5)(6)

Percent of
Class

5% Stockholders (Preferred)

Hudson Bay Master Fund Ltd.
777 Third Avenue
New York, NY 10017

6,474

95.0

%

Iroquois Master Fund Ltd.
641 Lexington Ave, 26th Floor
New York, NY 10022

344

5.0

%

5% Stockholders (Common)
(Excluding Named Executive Officers and Directors)

Hudson Bay Master Fund Ltd.
777 Third Avenue
New York, NY 10017

3,500,223

9.99

%

Iroquois Master Fund Ltd.
641 Lexington Ave, 26th Floor
New York, NY 10022

1,952,530

6.0

%

Frost Gamma Investments Trust
4400 Biscayne Boulevard
Miami, FL 33137

1,606,872

5.0

%

Michael and Betsy Brauser TBE
3164 NE 31st Avenue
Lighthouse Point, FL 33064

1,660,435

5.2

%

Barry Honig
4400 Biscayne Boulevard, Suite 850
Miami, FL 33137

1,874,684

5.8

%

This group invested in the private company Innovate/Protect which held the intellectual property and later merged into Vringo.

Here is what stood out to me about one IP company in particular from their S-4 filed in May:

Name and Address of Beneficial Owner(1)

Amount of Beneficial Ownership

Percent of Class

Amount of Beneficial Ownership

Percent of Class

5% Stockholders

Hudson Bay Master Fund, Ltd.(2)
777 Third Avenue
New York, NY 10017

10,717,039

39

%

9,360,100

52

%

Four Kids Investment Funds LLC
(Alan Honig TR)(3)
17582 Bocaire Way
Boca Raton, FL 33487

2,813,193

15.5

%

-

-

Barry Honig(4)
4400 Biscayne Boulevard Suite 850
Miami, FL 33137

4,722,752

23.4

%

2,045,056

11

%

1960480 BT(5)
2515 McKinney Ave
Suite 1000
Dallas, TX 75201

5,704,650

24.7

%

4,992,000

28

%

Iroquois Master Fund, Ltd.(6)
641 Lexington Ave. 26th Floor
New York, NY 10022

2,004,188

11.0

%

-

-

Frost Gamma Investments Trust(7)
4400 Biscayne Boulevard
Suite 850
Miami, FL 33137

1,971,926

10.9

%

-

-

This table of investors looks almost identical to the table of investors from the Vringo S-4. This table of investors is from Document Security Systems S-4 filed on May 7, 2013. Both Hudson Bay and Dr. Phillip Frost are large early investors in both companies. Hudson Bay has become known as a smart-money IP fund here and immediately lends validation to any company's IP portfolio in which it has invested.

Frost's pedigree speaks for itself, a billionaire biotech investor that is current Chairman of Teva Pharmaceuticals (NYSE:TEVA) and Chairman/CEO of Opko Health (NYSE:OPK). He has garnered many headlines recently as the prominent example of insider buying with his almost-daily purchases in the open market. These purchases have proven prudent recently with Opko up almost 40% just since the start of the year. Frost, #190 on Forbes 400 list, originally made his fortune selling Ivax Corp for $7.4 billion in 2006 to Teva. He certainly has an eye for the small-cap space as well, where his recent successes have included the aforementioned Vringo and MusclePharm Corp. (OTCQB:MSLP). Frost made his investment in MusclePharm at $4/share when the stock was hovering in that range at the end of January. It has tripled since then to its current $12.05 share price. Suffice it to say, Frost is someone I am looking to invest alongside with early if I spot the opportunity.

Further similarities between Vringo and Document Security Systems

One other striking similarity I noticed when researching Vringo and Document Security Systems is how the companies are structured. Lexington Technology Group is a private company with investments in two IP portfolios that has entered into a definitive agreement to merge with Document Security Systems. This is exactly how Vringo was originally consummated with Innovate/Protect. Document Security Systems plans to continue to operate and grow its current business platform that generated $17.1 million in revenue last year. That is a differentiator I have found that helps Document Security Systems to stand out in the burgeoning IP space. While it becomes a very attractive investment based on the upside potential, it is nice to have the existing business generating cash flow and protecting the downside.

Focusing just on the IP in the soon-to-be consolidated company, this graph from the Lexington Technology presentation illustrates how Document Security Systems plans to differentiate itself in that arena as well:


(Click to enlarge)

Document Security Systems will not just enforce patents, but also will license and commercialize IP for monetization purposes. This should produce a steady stream of cash flow for the IP division company, in addition to the vast upside that comes from a potential settlement with a Facebook (NASDAQ:FB) or LinkedIn (NYSE:LNKD).

Recent News

On April 23, Lexington Technology, announced that its wholly owned subsidiary, Bascom Research, reached a settlement with a defendant in its ongoing litigation in the Northern District of California. As a result of the current settlement, Lexington will realize revenue beginning in 2Q 2013. Terms of the patent license are confidential as stipulated in the agreement, but include an effective royalty rate of approximately 4% for use of the four Bascom patents currently in litigation. It then announced a settlement with a second defendant on May 14. These are both great precedents going forward as the company eyes the bigger fish in Facebook and LinkedIn.

DSS Valuation post-merger

The company's two main assets at the present time are its Bascom Research patents and its legacy DSS business line. To value the Bascom Research patents, in particular, the claims against Facebook, LinkedIn, Novell (NASDAQ:NOVL), Jive (NASDAQ:JIVE), and BroadVision (NASDAQ:BVSN), I applied a DCF to projected royalties (both past claims and running royalties), from October 2012 (date of initial complaint) through 2022 (patent expiry dates). Open graph was introduced in 2010, and from FY10 to FY11, FB's revenue grew by 70% YoY (source: FB S-1 filed on 2/1/12). Given how integral relationships between objects has become to the growth of both FB and LNKD, I have estimated a formula based around future royalties in which we take half of FB's and LNKD's combined U.S. revenue, and then apply a 4.5% royalty rate to this total. According to technology agreements with the SEC, the median royalty rate for software re-bundling or re-marketing licenses is about 14% (source: Economists Incorporated), while Dell Computers (NASDAQ:DELL) pays royalties of 15% or more for highly marketable products (source: Francine Segars, negotiator of software licensing agreements for Dell Computers). I have chosen to apply a lower royalty rate, due to the multibillion dollar revenue bases of FB and LNKD. I settled on the 4.5% rate as it is the median royalty rate of the two settlements reached so far in the Bascom Patent case, with BroadVision Inc. (4% royalty rate) and Jive Software (5% royalty rate).

Revenues for both FB and LNKD are projected to grow initially at 19.2% per year for 4 years (BIA/Kelsey has projected a 19.2% annual growth rate for the next four years for social media ads), and then eventually declining to a lower growth rate of 10% per year. I apply a 75% operating margin (this is consistent with the long-term EBIT margin of 75-80% estimated by Gilford Securities analyst Robert V. Tango, Jr. for VirnetX) and 35% tax rate (based on U.S. corporate tax rates) to the future royalties.

Applying a 10% discount rate to these future cash flows yields an NPV of $505.22 million. Given that this case has not yet reached a Markman hearing (scheduled for October 2nd), but taking into consideration the strong historical results of the management team, I apply a 50% probability of success to the base case scenario. According to PriceWaterhouse Coopers's 2012 patent litigation survey, software companies that are practicing entities have had an approximately 30% success rate in patent litigation cases, according to data compiled from 1995-2011. I have increased this number to 50%, due to the much higher historical success rates of the management team (CEO Jeff Ronaldi has won verdicts totaling at least $120 million according to the company presentation), and also due to the fact that they have reached two settlements thus far in the case setting a precedent. This gives us an NPV of $252.61 million.

12-Oct

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

FB & LNKD Claim

50%

$267.91

$1,916.07

$2,283.95

$2,722.47

$3,245.18

$3,731.96

$4,291.75

$4,935.52

$5,429.07

$5,971.98

$6,569.17

Royalty Rate

4.50%

$12.06

$86.22

$102.78

$122.51

$146.03

$167.94

$193.13

$222.10

$244.31

$268.74

$295.61

Operating Income

75%

$9.04

$64.67

$77.08

$91.88

$109.52

$125.95

$144.85

$166.57

$183.23

$201.55

$221.71

Taxes

35%

$3.16

$22.63

$26.98

$32.16

$38.33

$44.08

$50.70

$58.30

$64.13

$70.54

$77.60

Cash Flow

$5.88

$42.03

$50.10

$59.72

$71.19

$81.87

$94.15

$108.27

$119.10

$131.01

$144.11

Discount Rate

10%

NPV

$505.22

Prob of Success

50%

NPV

$252.61

Given uncertainties around what the ultimate claim on revenue or royalty rates will be, here is a sensitivity analysis for the NPV, giving a range of claims around FB's and LNKD's revenues (between 10%-90%), and royalty rates (between 0.5%-6.5%).

Royalty Rate

#####

0.5%

1.5%

2.5%

3.5%

4.5%

5.5%

6.5%

Claim of Rev

10.0%

$5.61

$16.84

$28.07

$39.29

$50.52

$61.75

$72.98

30.0%

$16.84

$50.52

$84.20

$117.88

$151.57

$185.25

$218.93

50.0%

$28.07

$84.20

$140.34

$196.47

$252.61

$308.74

$364.88

70.0%

$39.29

$117.88

$196.47

$275.06

$353.65

$432.24

$510.83

90.0%

$50.52

$151.57

$252.61

$353.65

$454.70

$555.74

$656.78

In addition to the Bascom research patents, I also assign a value to the company's legacy packaging and printing businesses. Given the strong revenue and gross profit growth shown in this segment, the release of DSS's new AuthentiGuard technology, and the company's commitment to turn the product line near breakeven, I assign a 1.7x P/S multiple (peer group median) to DSS's ttm revenue of $17.1 million to obtain a value for this business of $29.1 million.

DSS PEER COMPARISON

Name

Ticker

Price

Market Cap (M)

P/E (TTM)

P/S

P/B (mrq)

Rev.

Rev. Per Share

EV/EBITDA

BVPS (mrq)

Nanotech Security

NNTCF.PK CN

0.87

25.59

N/A

11.2x

20.2x

2.2

0.08

N/A

0.04

Opsec Security Group

OTC:OSGFF LN

43

51.95

17.6x

0.6x

0.9x

69.1

1.11

8.0x

0.81

Nuance Communications

NUAN US

21.33

6,746.14

24.1x

3.8x

2.4x

1753.1

5.68

20.4x

8.79

Spectra Systems

SPSY LN

22.5

15.65

N/A

1.7x

0.6x

9.4

0.21

N/A

0.54

Datadot Technology

OTC:DADTF AU

0.03

12.56

N/A

1.7x

1.9x

7.1

0.02

N/A

0.01

Median

20.8x

1.7x

1.9x

14.2x

Document Security

DSS US

2.55

54.71

N/A

2.8x

5.7x

17.1

0.82

N/A

0.4

Finally, I add the company's net cash position of $1.1 million as of March 31, 2013 to the $7.25 million to be injected into the company upon completion of the merger with LTG to obtain a net cash position for DSS of $8.35 million. Adding together the valuations for the Bascom research litigation, the DSS legacy business line, and the company's net cash, I have come up with a value of $290.06 million, or $6.95 per share (based on projected post-merger shares outstanding of 41.7 million). This represents upside of over 150% as compared to the current share price.

Additional upside exists for DSS as well, as I have not assigned values to the Company's case against coupons.com, VirtualAgility's litigation against Salesforce.com and others, or the possibility of additional IP acquisitions.

Existing Business Competition

The security print market is comprised of a few very large companies and an increasing number of small companies with specific technology niches. The expansion of this market is primarily due to the fact that counterfeiting has expanded significantly as advancing technologies in digital duplication and scanning combined with increasingly sophisticated design software has enabled easier reproduction of original documents, vital records and IDs, packaging, and labels. Document Security Systems' competitors include Standard Register Company (NYSE:SR), which specializes in printing security technologies for the check and forms and medical industries; and De La Rue Plc (OTCPK:DELRF), that specializes in printing secure currency, tickets, labels, lottery tickets and vital records for governments and Fortune 500 companies. Large Office Equipment Manufacturers, called OEMs, such as Sharp (OTCPK:SHCAY), Xerox (NYSE:XRX) Canon (NYSE:CAJ), Ricoh (OTC:RICOF), Hewlett-Packard (NYSE:HPQ) and Eastman Kodak (EKDKQ.PK) are developing "smart copier" technology that recognizes particular graphical images and produces warning words or distorted copies. Some of the OEMs are also developing user assigned and variable pantograph "hidden word" technologies in which users can assign a particular hidden word in copy, such as "void" that is displayed when a copy of such document is made. In addition, other competing hidden word technologies are being marketed by competitors such as NoCopi Technologies (OTCPK:NNUP) which sells and markets secure paper products, and Graphic Security Systems Corporation, which markets scrambled indicia.

Conclusion

Document Security Systems currently has 21.7 million shares outstanding. After the merger, the company will have 41.7 million shares, which gives the company a post-merger market cap of $115.5 million. Based on my calculations above, the combined company has room to grow its market cap well above 150% in the near term running up to two significant milestones: the completion of the merger expected on July 1, and the October 2 Markman hearing. It has been shown that volume tends to precede big movements in price, and the heavy volume on upward price movement to close last week is a strong indicator that now is the time to buy DSS.

Risks

The largest near-term risk investors face is the merger not gaining shareholder approval and falling through. While I am unsure why any shareholders would vote against the merger since it only appears to add upside, this is the biggest risk and must be considered. Share prices of intellectual property companies tend to be volatile judging by recent price movements in several IP stocks. I think the proposed business plan should help limit this downside volatility somewhat, but it is certainly a risk to consider. An outline of risks as identified by the company can be found in its SEC filings here. As always, do your own due diligence before any investment.

Disclosure: I am long DSS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Document Security Systems: Near-Term Upside Of 150%