Document Security Systems, Inc. - A Dollar Stock With Significant Upside Potential

| About: Document Security (DSS)

(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)

Document Security Systems, Inc. (DSS) is a leader in anti-counterfeit, authentication, and mass-serialization technologies. The company's specialized security programs are designed to protect against product diversion, counterfeit, theft, and other costly and damaging occurrences. DSS provides turnkey security solutions to corporations, governments, and financial institutions around the world.

The company's core business made an impressive revenues jump from $13.4 in 2011 to $17.1 million in 2012. But the last few quarters have been relatively flat, and that's likely the main reason why the stock has been hovering around $1.

DSS announced its 3Q 2013 financial results on November 13, 2013 reflecting its new business structure after the July 1, 2013 closing of the merger with Lexington Technology Group. The company merged its revenue lines into Printed Products and Technology Sales, Services and Licensing. In August, 2013 the company changed the name of Lexington Technology Group to DSS Technology Management to reflect its position in the DSS Group of Companies.

Printed Products included the results from the company's Packaging, Plastics, and Printing business units, the Technology Sales, Services and Licensing results include the results from the DSS Digital Group and DSS Technology Management, for those familiar with the way the company reported revenues prior to the merger.

For the third quarter, revenue increased 2% year-over-year to approximately $4.25 million. Printed Product revenue was essentially flat while Technology-related revenues increased approximately 14%.

Net income for the third quarter was approximately $6.5 million or $0.15 per basic and diluted share, which compares to a net loss of $1.1 million or $0.05 per basic and diluted share in the third quarter of 2012. The company benefited from a one-time deferred income tax benefit of approximately $9.2 million which resulted from the closing of the merger and a reversal of deferred tax valuation allowances that have been carried by DSS.

The year-over-year increase in Technology revenue primarily reflects the addition of revenue generated by our DSS Technology Management subsidiary (again, early contributions of the merger with Lexington Technology Group). I believe that this is the division that will ultimately lead to significant revenue growth going forward.

I should note that DSS' core business is not the main reason why I invested in this company. I've invested primarily because of the significant upside that represents the merger with Lexington Technology Group. The reader is welcome to learn about the details of the progress the company and made in its core business in the 3Q 2013 earnings transcript.

Here comes the interesting part. Before the merger, the 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"). DSS asserts that the Bascom Patents form the underlying architecture for the explosion of social networks by enabling users to link, search and provide selective access to information. These features are basic and fundamental for the frameworks that operates Facebook (NASDAQ:FB), LinkedIn (NYSE:LNKD), etc., as well as enabling the implementation of large enterprise applications as reflected by the company's most recent lawsuit against

As of today Bascom Research (now a subsidiary of DSS) had filed patent infringement lawsuits against at least six defendants. Three of the defendants that have already agreed to settle, but the two largest cases against Facebook and LinkdeIn are still pending. The U.S. District Court for the Northern District of California has set the Markman hearing date for February 26, 2014 for Bascom Research, Inc. v. Facebook, Inc., and LinkedIn, Corp. The company must feel confident about their case since three of the defendants have already agreed to settle.

From the information that has been made public so far, we know that BroadVision (BVSN) and Jive Software (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. The company has not disclosed much information about its recent settlement with Novell (NOVL), but I would expect to be in a similar royalty range.

In its 3Q earnings CC, DSS CEO Jeff Ronaldi stated: "The royalty revenues will probably start in later fourth quarter and first quarter (of 2014) ..." I expect to see a larger and larger contribution from the Technology division (umbrella that includes the Lexington Technology Group patent-infringement activities).

Using the available information to date, I will walk you to some simple calculations to try to estimate the potential windfall resulting from potential Facebook and LinkedIn settlements.

In 2012 Facebook reported revenues of approximately $5.1 billion. But the most recent quarter resulted in revenues of $2 billion reflecting significant growth that it's expected to continue. But just to be conservative I will use 2012 revenues. This means that 4% and 5% royalty rates would amount to about $204 million and $254 million respectively. From available information to date, DSS gets to keep at least 60% of the total settlement, with the balance going to other parties including the inventor and Kramer Levin (the law firm representing it). This means that DSS would end up receiving between $122 million and $153 million using the assumptions stated above from a settlement with Facebook. Using the same logic, the company would end up receiving between $23 million and $29 million from a settlement with LinkedIn. These royalty calculations are only for one year! DSS is seeking royalties on future year revenues as well, at least until the Bascom Patents expire in 2022! Facebook and LinkedIn have experienced double-digit revenue growth in recent years, which is expected this to continue for the foreseeable future. This means that royalty revenues for DSS would also grow over time, and therefore the potential appreciation in DSS stock price can be significant.

It is obvious to me that the market is pricing DSS for little over $43 million based solely on the prospects of its legacy/core business and it has not factored yet "The Bascom Effect." If one considers the potentially significant revenues from settled lawsuits and those to come, the future appreciation of DSS market cap is significant. I believe that the anticipation over the Facebook and LinkedIn lawsuits as the court date approaches will make the stock go up. This might be the best time to take a position in the company and patiently wait for better times which are certain to come in just a few more months.

Robert Wasserman, a respected sector analyst of Dawson James assigned at $4 target placing a value of $1.65 on the core business, and adding a "conservative" $2.65 to account for the potential revenues form it's patent-infringement lawsuits against Facebook, LinkedIn (LNKD), and (CRM) as explained later in this article. The company has made significant recent announcements that I expect will improve the performance of its core business going forward.

A bullish factor that I always consider when investing on a risky stock with significant upside like DSS is insider buying. There has been an encouraging recent uptick in insider buying.

But as with any investment in the stock market, there are risks involved in buying DSS stock. 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. According to its most recent 10-Q, DSS estimates that its legal fees over the next 12 months will be around $2 million. And with the amount of cash at hand per the most recent quarterly report, DSS would likely be OK for at least a year without being forced to raise additional capital. Investors considering buying this, or any other stock, should always read carefully the risks and uncertainties as spelled out in the company's 10-K and 10-Q filings.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in DSS over the next 72 hours. 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.