Document Security Systems: Run From DMC

| About: Document Security (DSS)

Editor's note: Some positions presented in this article have been disputed. See Seeking Alpha Policy for Disputing an Article.

When analyzing micro-cap technology companies, it is not unusual to discover fairly aggressive accounting tactics, like capitalizing software or manipulating deferred revenue. Likewise, a management team may have a technology whose claims have been slightly exaggerated, in an attempt to pique investors’ interest. However, when compiling a full research report on the small print technology firm Document Security Systems (DMC), it was difficult to find any redeeming features to the stock amongst all the red flags.

As of today, DMC is priced at $4.45, which equates to a market capitalization of around $73 million. DMC has trailing twelve month sales of $6.1 million, is currently burning $800,000 cash a quarter (DMC has never been profitable) and has a little more than $1 million in cash on the books as of September 30th, meaning the company is essentially insolvent. What follows is merely a brief introduction to the troubles at DMC, and why the stock is likely worth much less than it currently trades for, if it is worth anything at all.

Over-Hyped Technology

Despite the claims of management and the few bullish analysts following the stock, Document Security Systems (DMC) proprietary technologies for counterfeit prevention are not unique and in fact, compete with several nearly identical products in the space. For a company with supposedly “leading edge” technology, it seems odd that DMC’s total R&D spending has amounted to little over $1 million for the last three fiscal years combined. In addition, when using the application dates on DMCs patents, its patented technology is almost 15 years old on average.

There are several different technologies from competing firms offering results similar if not superior to DMC’s products. The dilemma for the average investor following the company is most of these technologies are virtually unknown outside the anti-counterfeiting industry. DMC has abused this lack of general awareness outside the industry to deceptively present themselves as a company with unique solutions for the large anti-counterfeiting market.

Suspicious Deals

DMC has a long history of announcing suspicious and largely irrelevant deals (including a large number of international deals for a company of DMC’s size) in an attempt to prop up the company’s share price.

One of the more unusual transactions was the company’s announcement on June 22, 2006 that DMC technology had been licensed to Barcode Technology [BTI] for inclusion in worker identification cards to be distributed in The People’s Republic of China. Under the original agreement, DMC issued a warrant to BTI to purchase 500,000 shares of DMC stock at $10 a share in return for BTI receiving exclusive rights to market and produce DMC technology in China. DMC licensed its technology to BTI and paid BTI in stock for accepting the license. How many companies have to pay its’ customers to take its’ product?

Dilutive Stock Deals

DMC has funded its operations through dilutive private sales of stock at below market prices. This is the primary motive behind DMC’s promotional efforts to announce new deals and create a misleading image of their technology as cutting edge.

DMC raised approximately $5.8 million in December of 2003 and $5 million in December 2006 through private placements. One alarming aspect of the private placements involves the brokerages selling the shares of DMC. The primary placement agent in the 2006 deal was Perrin Holden & Davenport (AKA PHD Capital). This company is listed by the United Kingdom’s Financial Services Authority (body that regulates financial services industry in the UK) as an unauthorized overseas firm known to be or have been targeting UK investors. The brokerage used in the 2003 placement by DMC, Fordham Financial Services, is also on the FSA’s list.

European Central Bank Lawsuit

Perhaps the most unusual aspect of the DMC story is the 2005 announcement of a lawsuit against the European Central Bank [ECB] claiming all 30 billion Euros infringed upon DMC’s European patent EP 0455750, seeking hundreds of millions in damages. In response, the ECB counter-sued DMC in nine national European courts to invalidate the patent. DMC’s original infringement lawsuit was thrown out, as the judge ruled DMC had improperly filed the case in the wrong court, and DMC is working presently on filing a new infringement suit in Germany. The validity trials are currently underway in 9 different European national courts, with the British and French courts finding DMC’s patent to be invalid, while the German court has found the patent valid. Unfortunately for shareholders, there exists troubling precedence against the potential for a big pay-out from the ECB.

In 1995, the predecessors to DMC sued the US Bureau of Engraving claiming the new US $100 bill infringed two of their US patents, 5,018,767 and 5,193,853, two patents which are now owned by DMC. The judge in the case found the two patents to be invalid as obvious from prior art, meaning that DMC’s patents covered techniques that were already public knowledge at the time of the patent application. DMC’s European Patent, EP 0455750, which is the subject of the current ECB lawsuit, was originally identical to these invalidated US patents. The European Patent Office initially rejected the patent application for the exact same reasons the US Federal Court found the US patent to be invalid. After their initial rejection by the European Patent Office, DMC altered the claims of the patent application in order to get the patent application granted. In doing so, these alterations changed the claims covered by the patent in such a way that the Euro (and all other currencies using the technology DMC is suing the ECB over), would no longer be found to be infringing the patent.

In conclusion, Document Security Systems is a wildly overvalued company teetering on the brink of insolvency, and investors would be best advised to run DMC out of their portfolio.

Disclosure: Author holds a short position in DMC

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