VirnetX Prevails Over Apple

| About: VirnetX Holding (VHC)

As all VirnetX (NYSEMKT:VHC) fans know, the company is suing seven of the big names in tech: Apple (NASDAQ:AAPL), Cisco (NASDAQ:CSCO), Siemens (SI), Mitel (NASDAQ:MITL), NEC, Aastra and Avaya. The big event investors were waiting for happened on April 25, when Judge Davis issued his preliminary Markman Order. On April 26 VirnetX released a statement explaining how it was "extremely pleased with the Court's Markman Order." VirnetX should be pleased. It was hoping for a home run, but it got a grand slam.

After reading the Markman, it also looks like Google (NASDAQ:GOOG) and many other companies could now become licensees or be sued by VirnetX for patent infringement. Did the value of VirnetX patents just double? Quite possibly.

After consulting with technical experts, I've come to the conclusion that Apple is either going to have to buy VirnetX or else pay huge settlement and royalty fees. It appears that most of Apple's products are infringing on VirnetX patents, and Apple has very little defense.

But wait, there are six other defendants, including Cisco, who are probably going to have to fork over billions of dollars to VirnetX. Wouldn't it be smarter for Apple to buy VirnetX now before the settlement and royalty dollars start coming in from the other defendants? If Apple were to buy VirnetX, it could probably recoup all its investment.

Apple would also benefit because it would: completely settle its current litigation liabilities with VirnetX, eliminate the risk of its products being banned from importation into the United States by the ITC, and enjoy royalty-free IP. And, of course, Apple could continue to receive settlement and royalty payments from the current defendants, as well as any new defendants, including Google.

VirnetX could become an extremely profitable acquisition for Apple. I would be shocked if Apple isn't seriously considering this option right now.

Google, Cisco and the other defendants may also be considering buying VirnetX. The VirnetX patent portfolio is so broad, that non-infringing companies, such as Intel (NASDAQ:INTC), Samsung (OTC:SSNLF), HTC, and Verizon (NYSE:VZ), could definitely be doing some bidding. In my estimation, there are at least 15 companies that could benefit tremendously by owning the VirnetX patent portfolio. A bidding war is a definite possibility.

So if the Markman Order was so great for VirnetX, why isn't the share price shooting through the moon? The main reason is that investors just don't understand the Markman. Unless you're a patent attorney, a specialized software engineer, or a VirnetX employee, you will find it difficult to understand the true meaning of the Markman.

I worked for years as a hardware engineer and have done some programming, and still I had to consult technical experts in order to understand what the Markman Order really meant for VirnetX. Even the savvy institutional investors can't figure it out, and because VirnetX is forced to be so tightlipped, most investors are left in the dark.

There is another reason the share price didn't skyrocket. When VirnetX issued its press release, the company statements were extremely conservative and limited. VirnetX could not express management enthusiasm or go into details without jeopardizing the relationship with Judge Davis or the company's position with the defendants in the current litigation. VirnetX learned this lesson during the Microsoft (NASDAQ:MSFT) trial.

The need for company restraint explains the statement at the end of the press release, which said: "the outcome of this and any legal matter is unpredictable." Investors interpreted that last statement as a loss of confidence by VirnetX. Investors were spooked. The moment this press release hit the wires, the share price started falling.

I believe investors misinterpreted that last statement. VirnetX was simply using a language that would maintain the company's good standing with Judge Davis and not jeopardize its position of strength in the current lawsuits. In reality, VirnetX has never been in a stronger position than it is now. Management confidence has never been higher.

Okay, let's talk about what the Markman really means for VirnetX. VirnetX had some huge wins, and I would like to try to explain them in simple terms.

First, you need to understand that VirnetX went into the Markman asking for much more than it needed or expected to get. That's standard practice in these cases. You expect many of your claim requests to be denied, so you basically aim high.

Of the 20 claims, VirnetX prevailed in about 10, but more importantly, a couple of its wins were huge. At this point, it appears that the claims VirnetX did not win should have little impact on the current cases.

The big win for VirnetX was Judge Davis's allowance of "secure communication link," instead of the much more limiting "virtual private network." This gives VirnetX the Holy Grail. Here is exactly what Judge Davis said in the Markman Order:

The claims and specification of the '504 and '211 Patents reveal that the patentee made a conscious decision to remove the virtual private network limitation originally present in the '759 Patent claims. Thus, secure communication link shall be interpreted without this limitation in the '504 and '211 Patents.

Secure communications links are not limited by protocol the way virtual private networks are. They encompass the service providers and go to the heart of the defendant's products.

Here's an analogy: imagine you owned a highway between New York and San Francisco. Every time anyone traveled that road, they would pay you a fee. If they traveled any other roads, or took a train, or flew an airplane, you receive nothing. If they drove from Chicago to Miami you would receive no fee. That's the equivalent of a virtual private network: very selective and narrow in scope with limited income potential.

Now imagine, you owned all the highways in the world: all rail networks, all waterways, and all airspace. Any time anyone traveled anywhere, by any means, they would pay you a fee. That's the equivalent of a secure communications link, as defined by the Markman: wide in scope and nonexclusive, with almost infinite income potential.

A virtual private network is only one way of communicating, whereas secure communication links include many ways of communicating. For example Apple uses some kind of a secure communication link with Facetime, maybe it's a virtual private network, maybe it's something different. There's no way for us to know. Now, with Judge Davis's new ruling, it doesn't matter how Apple is doing it. Apple is infringing on VirnetX patents regardless of which type of secure communication link it is using. Of course this wide scope also applies to the other six defendants as well.

Something else investors need to understand is that under the definition of secure communication link, many new companies that were not liable to VirnetX, now may be required to pay LTE advanced licensing fees. VirnetX's hand is significantly stronger now, and I believe the company will be able to secure licensing fees from this new group of infringing companies, without relying completely on litigation.

The other big win for VirnetX was Judge Davis's interpretation of domain name. The defendants wanted an extremely complicated definition of a domain name, but Judge Davis sided with VirnetX's definition, which defines a domain name simply as a name corresponding to an IP address. The VirnetX definition makes Apple particularly vulnerable because it encompasses any name, including an e-mail address.

Google's level of infringement could rival Apple's. Google's entire android platform is based on a Google ID, which again, is an e-mail address. With this new definition of domain name, Google and many other high-tech companies could become licensees or be sued for infringement, because now it will be much easier for VirnetX to prove infringement.

VirnetX enjoyed another huge victory with Judge Davis's demolition of the Aventail prior art defense. This was Apple's and Cisco's main defense, but now Judge Davis has weakened that defense considerably.

Another factor investors need to keep in mind is that Apple is particularly vulnerable because VirnetX recently filed a complaint with the International Trade Commission and requested that Apple be prohibited from importing into the U.S. some of its iPhones, iPads, iPods and Macintosh computers. For Apple the pressure is on because the ITC action begins this summer. This provides yet another incentive for Apple to buy VirnetX.

All of the defendants will now be forced to negotiate settlements, as per Judge Davis's order on January 5, 2012. If you recall, Judge Davis ordered all parties to begin settlement talks within 30 to 45 days following the preliminary ruling. Well, the ruling has taken place, and settlement talks must begin by no later than June 6, 2012. Keep in mind: 90% of all cases settle after the Markman. Only 10% go to trial. Even without Judge Davis's order, settlement would be likely.

At this point the defendants will be negotiating in earnest because they realize they will have to pay, and the least expensive option will probably be to settle before going to trial. Voluntary settlements will be significantly cheaper than forced settlements.

After the recent Markman, I believe no defendant will want to go to trial. The defendants are keenly aware that in the Microsoft trial, VirnetX convinced a jury to rule against Microsoft.

The best options for any of the defendants will be to settle quickly, or to just buy VirnetX. If the defendants weren't so antagonistic towards one another, I would suggest they form a consortium and buy VirnetX. Even though that could be an extremely effective strategy, I don't expect defendants to be that cooperative, but you never know.

Right now investors are focused on the recent Markman, near-term settlement talks, the upcoming July Markman, and the November trial. Investors need to remember, that the real future for VirnetX involves next year's 4G LTE Advanced - Release 10 rollout. For a better understanding of how VirnetX will benefit, I recommend reading this article.

Yes, it's good VirnetX is suing past infringers, that's only right. But, once the entire world is using true 4G (instead of the amped up 3G that is currently being called 4G), many of the billions of secure connections taking place every minute, will be dependent on VirnetX licensing. The revenue potential here is beyond comprehension, and completely dwarfs the settlement fees that investors are currently focused on. This future potential explains why VirnetX CEO, Kendall Larsen has not sold any of his 7.8 million shares, even when they were trading at $40.

I predict a buyout within 12 months. To Apple, Google, Cisco, Verizon, Intel, and all other potential buyers: VirnetX is cheap right now. Make an offer. $100 a share would be a good starting point.

For complete disclosure and disclaimer information, click here.

Disclosure: I am long VHC.

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