Recent developments in Overland's (OVRL) patent infringement trial point toward a clear victory in our opinion, and a massive blow to the business and the balance sheet of BDT.
In 2010, Overland Storage launched litigation against IBM (IBM), Dell Inc. (DELL), BDT AG, BDT-Solutions GmbH based in Germany and BDT Products. The complaint broadly claims infringement of BDT's products. IBM and Dell were named because they purchased the products that infringed on Overland's patents.
BDT is the largest tape provider in the world (60-80% of the market). Overland claims that BDT infringed on its patents and started selling equipment to Hewlett Packard (HPQ), taking away the lion's share of Overland's business. Defense of the litigation for BDT could eclipse $100mm, which is two times the entire market capitalization of Overland. BDT won the contract with Hewlett Packard approximately 6 years ago by giving a discount with an identical product. The HP business represented 70% of Overland's revenue at the time (approximately $150mm per year).
Overland is represented by DLA Piper (the largest law firm in the world), with the case taken 100% on contingency. John Allcock (lead counsel) has never lost a case in his career; he's taken 71 infringement cases to trial and won. The win number does not include settlements. The suit was filed with the ITC (International Trade Commission) where DLA also has a perfect record - winning all nine of the cases they have filed there.
On the November quarterly conference call, Eric Kelly (Overland's CEO) surprised investors by informing them that IBM and Dell settled the case:
As of today we are pleased to report that the ITC action and district court action against IBM and Dell have been resolved by settlement. Overland plans to continue the infringement case against BDT and we remain optimistic about the outcome.
Now available on the Sec.gov site is the redacted copy of the settlement agreement.
Recently, some investors have grown impatient because they want to know the details of the settlement with IBM and Dell. But parts of the agreement have been redacted to eliminate the ability of BDT and other future defendants to establish settlement criteria. However, the agreement clearly states that there is a payment due to Overland from IBM and that the payment will be received at a later date.
4.2Payment Instructions. IBM agrees to make this payment within ** of the latest of (i) the Execution Date of this Settlement Agreement; (ii) the Execution Date of the License Agreement; (III) the Execution Date of the **; or (iv) delivery of [wire transfer information]" (OVRL/IBM Settlement agreement)
Thus, three criteria need to be met before the payment is made to Overland. All three of these criteria have been met with the exception of one: "the Execution Date of the **." In our opinion, this redacted part of the settlement agreement refers to the judge's ruling in the ITC court. Overland added this criterion so that BDT couldn't determine the cash portion of the settlement by looking at Overland's balance sheet. Once the ruling is decided, we should see the cash portion on Overland's balance sheet grow exponentially.
Investors have faced several time hurdles in the ITC case against BDT. The latest six-month delay has been very disappointing. Impatient investors have sold the stock, pushing the price down. However, the cause of the long delay has now been resolved, so the decision by the court can now be made at any time - the judge need not wait until May.
In order to fully appreciate this, you need to have an understanding of the relationship between the various parties in the case, and how events unfolded. The original lawsuit filed by Overland came as a big surprise to IBM and Dell. After all, it was BDT who infringed on Overland's patents, and then sold the patent infringing products to IBM and Dell. When it came time to defend the case, IBM and Dell spent significant resources to litigate the case, while BDT did little. If you read the trial transcript (all 3500 pages) as we have, you will see that IBM and Dell attorneys led the case, while BDT's attorneys sat by idly watching. Needless to say, IBM and Dell were not very happy with the whole situation - they felt BDT got them into this patent mess and now BDT was expecting IBM and Dell to bail them out. So, after the trial, when IBM and Dell decided they should settle, they did not include BDT in the settlement negotiations (let's just say IBM and Dell were more than a little bit angry with BDT). When BDT found this out, they panicked. Now they were left standing alone, and in our opinion, unprepared. Subsequently, BDT failed to meet the court's deadlines and then filed a motion claiming that they should have been included in the settlement with IBM and Dell.
Earlier this month, the court issued Order #40 in the ITC case. Here are a few excerpts from the order:
BDT claims that its failure to comply with Order #33 was unintentional and was the result of mere attorney oversight. BDT argues that its counsel originally misread Order No. 33 to the extent it required submission of a revised brief. BDT claims that it expected any necessary corrective action to be handled by IBM and DELL.
This claim directly reinforces our belief that BDT was relying on IBM's attorneys to get them out of this legal quagmire. Throughout the trial, BDT has been relying on IBM; now, with IBM having settled, they are on their own.
The Brief makes it very clear:
Having reviewed the pleadings and arguments contained therein, the undersigned finds that BDT fails to meet the standard for reconsideration because there is no manifest injustice to BDT based on Order No. 37. While BDT only admits failure to comply with one order, that is simply not the case. Twice, BDT was instructed to remove the stricken portions of its post-hearing reply brief and twice, BDT failed to do so. Additionally, BDT's contention that it failed to comply with the court orders because it expected any corrective action to be handled in cooperation with IBM and Dell is not persuasive. Regardless of whether multiple respondents are acting jointly, it is the responsibility of all counsel to fully adhere to deadlines, rules, and orders of the undersigned. Disregard for such orders is not acceptable. … Casual disregard of a procedural date, as BDT has done in this instance, is not only completely inconsistent with resolving investigations in the most expeditious manner possible, but also severely hampers the Judge's ability to do so.
The undersigned also finds that BDT fails to meet the standard for interlocutory review because BDT failed to explain how Order No. 37 involves "a controlling question of law or policy as to which there is substantial ground for difference of opinion" and "either an immediate appeal from the ruling may materially advance the ultimate completion of the investigation or subsequent review will be an inadequate remedy." Accordingly, BDT's motion (746-057) is hereby denied.
A clear picture is being painted as to why the ruling has been delayed. Now that BDT is solo, it has missed deadlines and is throwing up obstacles to buy time (in our opinion). From the court's perspective, if the Chief Justice was going to rule in favor of BDT, there is no reason delay the ruling for several months, and the need to allow BDT a possible chance to see the settlement agreement between Overland and IBM would be unnecessary. He could just rule in favor of BDT and take one more case off his desk. However, if he were planning to rule in favor of Overland, he would want to give BDT every opportunity to plead its case, and/or to agree to a settlement. A key component to a judge's responsibility is to ensure due process is fully realized. In the spirit of ensuring due process, BDT has been given every opportunity to plead its case, thus eliminating grounds for appeal. As it stands now, all of BDT's motions have been exhausted with Order No. 40.
After reviewing the relationships between the parties, their actions, the court motions, and the motives of all of the players, it is our opinion that OVERLAND has already won its case and the judge is delaying so that BDT has no grounds for appeal. If this is true, we should see a large move up in the stock price in or prior to May 24th.
On the last conference call, management stated that the company will be profitable by the 4th quarter of calendar 2012. There are several new business lines coming on line in the next 12 months. The gross margin on these "cloud" business lines should be similar to the firm's service revenues of 50%-60%. With a quarterly top line number of $20 million, an average margin of 38%, and some minor cost savings our model yields profits of about 3 cents in the calendar fourth quarter. That profitability excludes the settlement revenues, which should bulk up the balance sheet and improve the income statement.
Some investors are concerned that management has recently sold stock. But all of the sales were pre-determined as part of their compensation package. Management compensation is heavily weighted away from cash and toward stock. Each member of the senior management team has agreed to take stock as part of Overland's 10b-5 plan. When the stock vests it creates an income tax liability, and a pre-determined percentage of the stock is automatically sold under the 10b-5 plan to cover the tax liability. This practice has now been changed so that the company will, in the future, do a 70/100 net settle - the executive will get vested at 70%, and the company will keep 30% to cover the taxes. We expect no new stock sales at all from insiders now or at any time soon. Further, we expect no further "insider selling" of any kind at any time ahead of the court decision on BDT. Keep in mind that Eric Kelly the CEO personally invested a significant portion of his liquid net worth in an early financing round, and has over one million options, so the recent automated selling of some 10b-5 incentive comp shares to cover tax liability is moot.
Going forward, Overland's strategy is to provide a complete suite of products to meet the needs of their channel partners and ultimately, the needs of their target market, the hyper-growth SMB market, and eventually compete upstream for additional market share. Since Eric Kelly has taken over the company, the focus has shifted from an OEM strategy to a branded products-focused strategy to leverage the company's valuable channel as well as its operating system. Their product suite has grown from just tape products to a robust product line that encompasses near line storage to archival (the cloud). Overland is the only company that now has Scale-out NAS, Scale-out SAN (Block), VTL, and Tape.
Overland's latest Dynamic Raid technology completely eliminates the need to provision storage capacity. This is a breakthrough product for the industry. Until now, storage required provisioning - allocating specific amounts to different groups, units or divisions of a company. When one unit ran out of capacity, more storage would need to be purchased, or existing storage re-provisioned.
Furthermore, Overland's SnapServer technology enables storage environments to effortlessly scale without downtime while ensuring maximum data protection. It's 100% compliant with Windows Active Directory and complete integration with Windows, UNIX/Linux and Macintosh environments. It offers the ability to expand and upsize with minimal effort, and can be managed remotely. The combined DynamicRaid and SnapServer technology lets any size business run its storage like an enterprise, at significantly lower cost.
Terri McClure, senior analyst at Enterprise Strategy Group states:
Many businesses are finding it difficult to acquire and manage the storage capacity and functionality needed to keep up with accelerating data growth over time. The speed of provisioning in virtual server environments has stressed the storage infrastructure and it's essential that storage solutions match that speed and ease to keep up with rapidly changing dynamics. DynamicRaid makes provisioning capacity and the management and protection of data extremely simple, plus it automates the growing of shared storage capacity while improving the predictability of future storage needs and capital expenditures. SnapServer DX enables businesses to count on improved storage utilization with less management and a highly efficient storage environment at a fraction of the typical cost.
Even Overland's bread-and-butter tape products look good. As stated above, Overland is the largest provider of tape storage in the market, by far. Now, there's nothing sexy or glamorous about tape, but its here for the foreseeable future, and the demand is growing dramatically. Research from analysts at Enterprise Strategy Group indicates:
Tape is the predominant storage media used for data protection due to its portability and, from an acquisition cost perspective, its price." As tape capacities continue to out-ship disk capacities and "the use of tape now dominates archiving over internal disk, external disk or cloud ... tape's lead is expected to grow during the next five years, demonstrating 45 percent annual growth by 2015.
Overland's storage lineup puts it squarely into the exploding small and medium-sized business storage market. With server virtualization and database applications demanding ever more capacity and performance, many smaller IT operations are looking to add networked storage. But even the entry-level products of storage titans like EMC (EMC) and NetApp (NTAP) are out of reach for these small shops, leaving the market segment to Overland and a few other companies
At $2 per share, Overland is currently selling at less than fire-sale prices. With a $50 million market capitalization, at 70% of sales, there is little downside, in our opinion. We believe the company could easily be sold for double the market cap, and we would not be surprised if private equity offers have recently been made at these levels. The current technology, patents and client lists alone are worth double the current valuation, with no consideration for the new products, IBM and Dell settlements, and potential BDT and other awards.
Here's a rough, but conservative approach to valuing the company. For the next two years, we expect $80-$120M in top line revenue per year. Conservatively estimating $20 million already settled from the Dell/IBM settlements, a $60 million settlement in the BDT litigation, and other litigations from future defendants (everyone BDT has sold product to - about 20 other possible defendants) for another $50 Million. Finally, assuming the company is trading at peer multiples of 1x revenues for its tape business and 2x revenues for its cloud business, we get a stock price of over $8 per share.
Keep in mind that Overland will be a nice acquisition target long before all of their plans come to fruition, and that Eric Kelly knows how to buy and sell a company. In 2002, he and a group of investors purchased Snap Appliance for $10 million. Two years later he sold the company to Adaptec for $100 million. Then more recently, he bought it back for $3.9 million and is merging it into Overland to create the new products.
Investors have a unique opportunity to invest in Overland now, as there is little in the way of Wall Street coverage. But Overland will be presenting at the America's Growth Conference on February 28 in San Francisco and then at the Roth Conference in March. We would expect Needham and Sterne Agee to be the next two analysts to pick up coverage.