Apple's Dilemma With Virnetx Patents

| About: Apple Inc. (AAPL)

Many of Apple's (NASDAQ:AAPL) products are dependent on patents held by Virnetx (NYSEMKT:VHC). Virnetx won a suit against Apple in November of 2012 finding that Apple infringes several of Virnetx's patents relative to secure VPN. The particular features that were part of the litigation were FaceTime and VPN On Demand. Both of these features are key to Apple's market penetration. VPN on demand has enabled Apple to penetrate enterprise customers by offering the security that they demand. Competing smart phones do not offer secure VPN implemented with the simplicity that Apple offers. Unfortunately for Apple, their implementation infringes on patents held by Virnetx as found by the jury. On August 9th of this year, Virnetx and Apple are to report to Judge Davis whether there has been progress made in settling their patent dispute. If progress has not been made on a settlement agreement, on August 15th Judge Davis will have a hearing about the award of ongoing royalties that Apple must pay for the patents they infringe. This is only the beginning of their Virnetx patent problems.

Apple's next problem is Virnetx holds many patents dealing with secure data transmission with many more in the approval queue at the patent office. Several of VHC's patents are required for 4G LTE advanced which increases data speeds beyond the current 4GE LTE. Cell phone manufacturers, such as Apple, who will be offering 4G LTE advanced, will require a license from Virnetx for their patents. Some of these patents are patents Apple has already been found guilty of infringing. After having a royalty forced on them by Judge Davis, they will have to either negotiate a second license for patents necessary to implement 4G advanced or undergo another round of litigation. In the case of litigation, Apple would be responsible for willful infringement opening themselves for triple damages. ( See Dustin Moore's article "VirnetX Quietly Expands Its Multi-Billion Dollar Patent Arsenal")

What are Virnetx's patents worth under FRAND? The following table from a paper on the American Bar Association's web site "VALUING STANDARD ESSENTIAL PATENT'S" provides a list of published royalty rates for standard essential patents for LTE by several companies.

Company Royalty Rate
Qualcomm (NASDAQ:QCOM) 3.30%
Huawei 1.50%
Ericsson (ERIK) 1.50%
Nokia (NYSE:NOK) 1.50%
Nortel (OTCPK:ARTM) 1.00%
Siemens (SI) 0.80%
Motorola (NYSE:MSI) 2.30%
Alcatel (ALU) 2.00%
Click to enlarge

The rates in the table average 1.73%. Virnetx's patents are very valuable because of the security they provide. The value of any patent portfolio is really based on what customers are willing to pay. So far, the average rate for those who have licensed Virnetx's patents is 1.52%.

The bottom line is that Apple needs to reach agreement with Virnetx or it could cost them and their shareholders much more money than is necessary. How much more? Consider that Virnetx has probably offered a license in the range of 1% to 1.25% based on their volume. In the original litigation that Virnetx has already won, Judge Davis will set a royalty rate. This royalty rate will almost certainly be above 1% . It is likely that the royalty rate will be set in a range equivalent to the companies already licensing the patents, as if it is not, the wrong message is being sent. Virntex has requested a royalty rate of 1.52% . A company forced to comply legally should not get a better rate than licensees who voluntarily comply. Should Apple decide not to settle, further litigation will commence relative LTE advanced when Apple begins shipping products with that feature. As this would constitute willful infringement Apple could be found liable for triple damages. If VHC was awarded another 1.5% for royalties for LTE, a 3% hit to margins would be significant, especially if their competitors voluntarily license the patents at a significantly lower rate. Nothing like shooting yourself in the foot.

See my previous article "Upcoming Virnetx Royalty Rate Judgment Likely to Affect Apple's Stock Price"

Disclosure: I am long VHC. 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.