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Hedge fund manager, research analyst, contrarian, long-term horizon
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Based on my own personal experience, in investing it is usually only a few variables that really matter. Everything else is noise. This is especially true when it comes to NPEs such as VirnetX (NYSEMKT:VHC) and Vringo (NASDAQ:VRNG), who acquire a small number of key patents and aggressively enforce them against the biggest companies in the industry. This strategy is extremely risky, but the payoff can be huge.

Another patent assertion company that has received much attention lately is Document Security Systems (NYSEMKT:DSS). Unlike most NPEs, however, DSS has a legitimate business which keeps it from being labeled a "patent troll". The company specializes in fraud and counterfeit protection for all forms of printed documents and digital information. Over the last 12 months, this core business accounted for 100 percent of the company's $18 million in revenues.

In this article I will not be focusing on the core business. Instead, I will talk only about the company's recent merger with Lexington Technology Group (now a subsidiary of DSS called "DSS Technology Management"). This merger is the key variable that will make or break this company. Although I usually hate mergers, since most of them never turn out well in the end, this time truly is different. Before we go any further, it is important to explain why this merger is so important to DSS.

The Bascom Portfolio

Before the merger was completed, Lexington Technology Group acquired a patent portfolio of six patents and four pending patent applications relating to technology invented by Thomas Bascom (the "Bascom Patents"). While most people have probably never even heard of this man, DSS believes that his patents are central to how we use the internet. In simple terms, the patented technology covers the ability to link, search and provide selective access to information. According to DSS, these patents form the underlying architecture for the explosion of social networks, such as Facebook (NASDAQ:FB), LinkedIn (NYSE:LNKD) and others.

As of this writing, Bascom Research (now a subsidiary of DSS) had filed patent infringement lawsuits against five defendants, has announced three settlements and currently has two cases pending against Facebook and LinkdeIn. The Markman hearing is currently scheduled for February 26, 2014. I believe this is a short-term catalyst that provides enormous upside potential for DSS. Again, three out of the five defendants have already settled. This tells me that the Bascom Patents are valid and worth paying for, which should have the last two defendants very worried right now.

The Stakes Are Huge!

There is a lot of money at stake here. From the information that has been made public so far, we know that BroadVision (NASDAQ:BVSN) and Jive Software (NASDAQ:JIVE) agreed to pay an effective royalty rate of 4% and 5%, respectively, for their use of the Bascom Patents at issue in the litigation. Furthermore, although the company has not disclosed much information about its recent settlement with Novell (NASDAQ:NOVL), I would not be surprised to see the same type of numbers here as well.

Using the information that we do have, we can do a back-of-the-envelope calculation to figure out the potential Facebook and LinkedIn settlements.

In 2012 Facebook reported revenues of approximately $5.1 billion. A royalty rate of 4% would amount to about $204 million. A royalty rate of 5% would amount to about $254 million. It is also important to mention that DSS gets to keep at least 60% of the total settlement, with the balance going to three other parties: Mr. Bascom (the inventor), IP Navigation (the monetization advisor) and Kramer Levin (the law firm representing it). This means that DSS would end up receiving between $122 million and $153 million after all is said and done.

While LinkedIn is somewhat smaller than Facebook, it is still considered a large company. In 2012 LinkedIn reported revenues of approximately $972 million. A royalty rate of 4% would amount to about $39 million. A royalty rate of 5% would amount to about $49 million. Again, at least 60% of this goes to DSS, which means the company would end up receiving between $23 million and $29 million from this settlement.

I am only taking into account fiscal year 2012 revenues here. Not only is DSS seeking damages for prior year revenues, but the company is seeking royalties on future year revenues as well (at least until the Bascom Patents expire in 2022). Moreover, both Facebook and LinkedIn have experience double-digit revenue growth in recent years, and I expect this to continue for the foreseeable future. This is great news for DSS because its royalties would also grow over time. It should be obvious by now that the income potential here is enormous.

Currently Mr. Market is willing to sell you DSS for less than $55 million. In fact, he is so pessimistic about this company's future that the stock has lost over 70% of its value during the last 12 months alone. Some of this probably has to do with the share dilution caused by the merger; however, this is only part of the problem. I believe investors are putting too much focus on the company's core business, and ignoring the new IP business which is where the real value is. As I already explained, the probability of DSS winning these lawsuits is high. And just one settlement from either of the two defendants mentioned above could potentially be greater than the company's current market capitalization. Taking these things into account, I believe this stock presents the ideal asymmetrical trade; huge upside potential, with limited downside risk.

Insiders Are Buying and So Should You

Insiders currently own more than 4% of the shares outstanding (not including options, warrants and shares held in escrow), which gives them "skin in the game." However, what I find more interesting is the pattern of recent insider purchases. Over the last 12 months, insiders have purchased 80,317 shares, and not a single share was sold during this time. While this might not seem very much, it is important to point out that all of this buying occurred between September 11th and September 13th of this year. As the saying goes, insiders might sell their shares for any number of reasons, but they buy them for only one - if they think the price will rise. The only reason DSS insiders would all of the sudden start purchasing shares is if they were expecting something big to occur in the near future. The actions of these insiders reinforce my belief that there is a short-term catalyst on the horizon that could favorably impact the stock price. In fact, I expect to see more insiders buying in the coming weeks and months.

Risks to Consider

A negative outcome of the litigation is the biggest risk with an investment like this. Even if DSS ends up winning, which as I mentioned is very likely, the litigation could be time consuming and costly. Although in the short-term the company should not have problems. Even if it paid off all of its debt, it would still have nearly $4 million in cash left on its balance sheet. According to its most recent 10-Q, DSS estimates that its legal fees over the next 12 months will be around $2 million. So the company should be fine for about two years without being forced to raise additional capital. These are just some of the risks that should be considered before buying this stock.

Summary and Conclusion

Investors are focusing too much on the company's core business and ignoring the enormous revenue generating potential of its patents. Three out of five defendants have already settled, which means the Bascom Patents have been validated. The likelihood of the last two defendants settling is high, and this will have a favorable impact on the share price. Even the unusual pattern of insider buying suggests that something big will happen in the near future. When taking everything, I believe this stock has enormous upside potential with little downside risk.

Source: Forget Facebook And LinkedIn, Invest In The Company Suing Them Instead