With all of Apple's (NASDAQ:AAPL) executive management's time and energy being spent developing new and interesting iProducts, some of the company's affairs are not disclosed in enough detail. It is not my opinion that Tim Cook should hold a conference call everyday to inform everyone if he decided on a small or large coffee, but some information is pertinent to the investor and the customer to help them make their respective decisions of buying shares or iProducts.
Dear Apple Investors
Other than the $368 million jury awarded headline last November, are Apple shareholders aware of the company's ongoing litigation with VirnetX (NYSEMKT:VHC)? More interestingly, are they aware of the alternatives that could save money and provide a more secure product? I think they should be informed, each shareholder does own a piece of the Apple.
On August 15, Apple and VirnetX met in court to discuss the much anticipated ongoing royalty rate for Apple's infringement of VirnetX's technology. The tune was slightly different from last October where Apple's engineer Patrick Gates testified that a FaceTime workaround would cost $3.6 million and take a few weeks. Those in attendance at the latest hearing stated that using Akamai servers as a workaround for FaceTime's infringement is a growing and exponential cost, and currently costs Apple $2.4 million per month. There is no way of knowing whether Apple was truthful in their statement that 100% of FaceTime calls are handled over Akamai servers, regardless the cost is growing at a fast rate. I am skeptical of the $2.4 million estimate by Apple since we have no way of knowing if 100% of the FaceTime calls are handled by servers. With Apple's record of their first estimate of a workaround time and price, I would be even more skeptical. On another note, these prices do not include the need for more servers to obtain 100% coverage or for the growing number of FaceTime calls, the maintenance to the servers and the extra servers needed to cover service interruptions. Even more interestingly is iMessage's infringement, slated to be argued at the second trial against Apple, uses much of the same technology as FaceTime. Handling an ever-growing 2 billion iMessages per day versus the 864,000 FaceTime calls per day (10,000 FaceTime calls per second argued at trial) would also require a server-related workaround if infringement is proven. Moreover, the $368 million number has grown to over $440 million and is growing with interest.
Many share in the opinion that Apple is just fronting a workaround to lower the royalty rate, then after a lower rate is decided, Apple can go back to their original way of infringing VirnetX's technology at a lower rate. This is a complete and obvious attempt of a workaround of the justice system and of Judge Davis. The Judge may set the 1.52% rate and tell Apple that if it is so much better, they can keep using the Akamai servers but if they backtrack then they will pay this rate.
In response to Apple's attempt to deceive the court, VirnetX responded that their damages expert did not "stack" damages for infringement when calculating VPN on Demand and FaceTime infringement. Meaning that the royalty rate should be the same whether it is FaceTime and or VPN on Demand infringing. Moreover, when he was asked how much damage should be at the first trial solely for VPN on Demand, the number he came up with was $703 million dollars. Let's keep in mind that Apple has made changes to VPN on Demand and changed it back after uproar from their user base. So they are still infringing.
Avaya settled without hearing about the Cisco (NASDAQ:CSCO) re-trial decision and prior to the Apple royalty rate decision, so why has Apple not settled? The only answer I can come up with is arrogance. Apple could have settled in good faith for a complete licensing agreement to cover all of Apple's infringement and even cover VirnetX's 4g LTE-A related technology they have for the future at a lower rate than going through trial. Furthermore, they would no longer be subject to paying huge legal fees in court and would not have to worry about any new applications that may infringe VirnetX's technology in the future. One can assume that Apple will not get a lower rate for going through the legal system instead of settling in good faith. If I was Apple's executive management I would have settled for a rate between .075% and 1% instead of the possibility of a 1.52% rate VirnetX has intelligently argued. The difference may seem small to an investor, but apply that to the profit margins of all the products that are infringing and you come up with a very big number. In the realm of Apple's margins that every company envies, wouldn't a smaller decrease in them be better than a larger decrease? I think we can all agree that it is a smarter decision by management to protect margins as much they can, by settling for a more secure technology and less of a decrease to their margins. This is no small number, this royalty rate will provide VirnetX with hundreds of millions of dollars per year.
Dear Apple Customers
All of this workaround conversation has brought us to an important and obvious point - recognizing the customers who are using Apple's FaceTime service. Paying for Apple's premium products assures a secure, always-working mindset that we have with their pre-loaded applications, such as FaceTime. Although if the utilization of relay servers brought service disruptions, a lower quality of service, and opening up all data to Apple whether through FaceTime or iMessage, then Apple may lose some serious brand power.
In the situation of telecommunication-related technology, let's take a look at a quote from the father of the telephone. Alexander Graham Bell provides Apple with some words to heed:
"When one door closes, another opens; but we often look so long and so regretfully upon the closed door that we do not see the one which has opened for us."
The door that will be closing is Apple's brand power and the degradation of its customer base through the loss of its superior service to the gain of others who employ VirnetX's technology. There is a very high chance that Samsung (OTC:SSNLF) could come along and employ VirnetX's technology in their phones to create a FaceTime like service with the quality that Apple used to provide. Samsung would gain market share and profit more through the sales of a product containing a more secure FaceTime like application with a higher quality of service. Moreover is the fact that Microsoft (NASDAQ:MSFT) has 299 million Skype users, and is in steep competition with Apple as we can see even from the latest Surface vs. iPad commercials. After licensing, I could easily see Microsoft releasing a commercial surrounding all the problems with FaceTime's server related approach and their newly enhanced, secure Skype experience. Apple has obtained its loyal customer base through the creation of cutting edge products, a base that will erode if Apple starts cutting corners.
Oh there won't be any problems, Apple will work them out, right? Wrong.
At the latest hearing, 500,000 user complaints were reported with regard to FaceTime, now that it is employing workaround servers. One complaint included a customer service representative who stated that it was a temporary problem due to the ongoing litigation. A relevant point that goes back to Apple trying to deceive the justice system. There are no estimates at the decrease in margins due to the loss of customers for having problems with two of the main selling points of Apple's products; FaceTime and soon to include iMessage. All to the gain of a competitor - something Apple is not in short supply of.
On Apple's website, under the privacy section, we can get a glimpse into the differences between VirnetX's technology and that of using a relay server approach. Currently, Apple's security statement reads:
"For example, conversations which take place over iMessage and FaceTime are protected by end-to-end encryption so no one but the sender and receiver can see or read them. Apple cannot decrypt that data."
Now heading to the undisputed Court testimony,
"Dr. Jones distinguished a relay server, which VirnetX conceded did not infringe, from a NAT router, which VirnetX argued does infringe. Dr. Jones explained that the relay server creates two separate communications, while a NAT router still allows for "end-to-end communication between the two devices" because it merely translates addresses."
The relay server approach does not provide end-to-end encryption, leading to privacy concerns. Although this article is not meant to be a technical one, a brief overview of the differences can provide some background as to the items discussed in this article.
With a new lawsuit filed against Apple recently, VirnetX is not backing down. Apple's investor and customer base overlap, but they share a common problem in management's inability to settle with VirnetX to decrease their margins by a factor less than going through the justice system for a superior product for their customers. Arrogance should not be a calculation in a company's bottom line. Apple's management should settle with VirnetX to blanket all current and future infringement all while offering their customer a better user experience.
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.
Additional disclosure: Always do your own research and contact a financial professional before executing any trades. This article is of my opinion only, and is not a recommendation to buy or sell any securities. Thank you to LCP for providing Apple's statement and the quote from the court.