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Introduction
There is currently a fairytale going around individual investor-focused websites like InvestorVillage.com, the Yahoo Finance message boards and Seeking Alpha that a tiny company with a handful of patents and little or no ongoing R&D is worth billions of dollars. The original company behind these patents cut off R&D funding, tried to sell the patents, failed to find a buyer or investor for even $10M and let the technology lie dormant for a decade. Fortunately for investors, or so the fairytale goes, these patents were purchased for a pittance, and the buyer decided to reverse merge into a publicly traded shell company, offering us all a chance to share its good fortune instead of keeping this value to itself as a private company. This company has an extremely active message board community, where various members discuss how this tiny company is going to make them all rich by extracting huge sums from the global technology leaders. Everyone agrees it is just a matter of time.

As you might have guessed, VirnetX (VHC) is the subject of this fable. VHC claims that its IP is essential for the automated establishment of VPN connections between trusted peers. VHC's stock already discounts it becoming by far the most successful publicly traded intellectual property NPE (non-practicing entity, aka "patent troll") in history, while there are enormous risks glossed over by the stock's promoters. The bull story on VHC suggests that their patent trial verdict and $200M settlement against Microsoft was just the beginning, as they will successfully sue other technology giants, and follow this by extracting a 1% royalty on all worldwide 4G LTE-Advanced sales. All of this is much easier said than done, and at its current $2B market cap VHC more than prices in success on all fronts. Since there is a lot to discuss, in today's Part 1 I will go over the potential outcomes in their upcoming Apple and Cisco cases, looking at the largest patent cases in history to put some context around how successful VirnetX could be. In Part 2 I will look at the company's prospects for collecting royalties on 4G handsets and equipment as declared standards-essential intellectual property licensed on fair, reasonable and non-discriminatory ("FRAND") terms.

Heading for East Texas
It's no secret that much of the current excitement around VirnetX centers around the patent infringement lawsuits it filed against Apple and Cisco (along with other smaller defendants) in the Eastern District of Texas. This district is popular with patent trolls for its rapid filing-to-trial time and plaintiff-friendly judges and juries. VirnetX successfully sued Microsoft there in 2010. Two of the smaller current lawsuit defendants recently settled with VHC for undisclosed sums which I believe to be trivial. In fact, the first defendant to settle (Aastra) appears from its Q2 2012 financials to have paid VHC an immaterial amount- I can find no mention of a legal settlement in their financial statements and on their cash flow statement they list a mere $268K spent on acquiring intangible assets. We will know the payment amount for sure when VHC's 10-Q comes out, but for now the stock seems to have added over $800M in market cap in the past couple of months based on settlements that may have only been in the hundreds of thousands of dollars. The constant buzz on Seeking Alpha the message boards is that Apple and Cisco are close to settling- first rumored around the time of the first Markman hearing, then around the most recent court-mandated mediation and most recently after a hearing on some pre-trial motions Apple that I believe were misinterpreted by bulls.

Based on my analysis of the case and the respective histories of both Apple and Cisco, I believe the two major defendants will not settle and will take this case to trial and appeal if necessary. Aastra and Mitel may have simply settled for small amounts to avoid ongoing legal fees, also giving VHC a chance for positive but ultimately meaningless press releases. At VHC's market cap they cannot afford to settle with the large defendants for less than several hundred million dollars without crashing the stock price, and believe given the likely range of outcomes Apple and Cisco may actually owe comparatively little or nothing at all after a trial and the appeals process. I am not going to debate the technical infringement details, but suffice it to say that VHC's claims are software patents based on an implementation of background technology and not the core functionality of the allegedly infringing products. VHC cannot plausibly make a case that it has an operating business harmed by the defendants. Neither Apple nor Cisco has made a practice of paying large sums to patent trolls, and both have aggressively countered VHC's assertions with claims of non-infringement and patent invalidity based on prior art. Investors seem to be treating VHC's victory in court as a foregone conclusion, but in my opinion they are ignoring several serious risks:

  1. VirnetX may lose. While VHC prevailed against Microsoft, jury notes reviewed by a source at the trial indicate that the jury was deadlocked for a portion of the deliberations. Additionally, the 2012 Markman hearing claims constructions added directness and anonymity to the definition of a VPN, a change from the claims construction in the Microsoft trial. Defendants had requested these changes, and while it enabled VHC to exclude the much debated Aventail prior art, it has resulted in additional claim limitations around VHC's technology and potentially made it easier for Apple and Cisco to make their cases for non-infringement. In other words, if the accused product does not connect directly and/or anonymously, it would not be considered a VPN and hence would not infringe. At any rate, the result of any jury trial is unpredictable, Apple and Cisco can afford to hire the best IP counsel in the business and I believe investors are foolish to treat a courtroom win as inevitable based on a single trial outcome and a couple of small fry settlements- especially given in the last trial the jury apparently struggled with its verdict and this time around the defendants have an easier bar for non-infringement.
  2. VirnetX may win, but be awarded a comparatively small amount of damages. At the Microsoft trial the defendant presented evidence that SAIC (the former owner of the IP) had tried but failed to sell the technology and could not generate investment interest at a valuation of $10M. In fact, my reveiw of court transcripts revealed that SAIC had internally described trying generate investment interest in VHC's technology as "like casting your lure into the weeds for hours and waiting for a bite". Partially on that evidence, Microsoft's expert witness testified that the damages were around $10M and that no one would have paid more than $10M for the whole company in 2003, when the hypothetical negotiations the jury was supposed to consider would have occurred. Naturally, VHC's expert witness made claims that they were owed a much more substantial $242M. The jurors seemingly decided to "split the baby" and awarded VHC just over $100M (the eventual $200M settlement came after VHC filed another lawsuit). This indicates they were at least partially swayed by Microsoft's expert. It is entirely plausible that the next jury will find for infringement but award an amount immaterial to VHC's current $2B+ market cap, which would likely cause the stock to collapse.
  3. VirnetX may win, but Apple says they have a workaround. While recently VHC message board posters seemed to believe that VirnetX had scored a major coup in getting Apple to release source code, this had already been determined by the court and was a completely expected and normal part of the discovery process. Apple has already released source code and agreed not to bring up source code at trial that has not already been provided. More interesting to me was VirnetX's motion to compel Apple to release details around cost and implementation of a "workaround" to VirnetX's patents. Software patents are notoriously subject to methodological workarounds and such workarounds are frequently easy and inexpensive to implement. A successful workaround strategy would negate the need to pay VirnetX any ongoing royalties, and provide a future roadmap for anyone VHC sues in the future.
  4. VirnetX may win a substantial award, but it will be subject to appeal. Plaintiffs love filing lawsuits in plaintiff-friendly jurisdictions, but large jury awards in patent trials have a nasty habit of being reversed or reduced at the federal appeals court level. More on this below. The appeals process can take years, and the appeals courts are generally more defendant-friendly than the Eastern District of Texas. Both Apple and Cisco should have no problem making the argument that their businesses and consumers would be irreparably harmed if there is an injunction on their products during the appeals process so any potential injunction would almost certainly be stayed pending appeal. In my career I have frequently seen companies who won victories at the district court level trade at a discount to the monetary awards to account for the timing and uncertainty of an appeal.

Big Results, Big Reversals
As I mentioned, some NPEs and even industrial companies have won big headline patent infringement awards in East Texas and other dockets. However, I examined many of these large awards, and from what I can see nearly every award of the size that VHC investors seem to be expecting has been overturned on appeal or otherwise reduced. Consider the cases of:

  1. MirrorWorlds, which won a $625M judgment in 2010 against Apple in the Eastern district of Texas, but had the verdict was completely tossed on appeal. Interestingly enough, this case involved Judge Leonard Davis, who also oversaw VHC's trial against Microsoft and is overseeing the current trials.
  2. Uniloc, which originally won a $388M verdict against Microsoft in 2009, went through a lengthy appeals process with reversals in both directions that resulted in them getting an undisclosed settlement apparently far smaller than the original award.
  3. Lucent, which won $1.52B in a patent infringement suit against Microsoft, and
  4. Johnson & Johnson, which won a $1.67B verdict against Abbott Labs. Both of these potentially record setting decisions were later reversed.

From what I have been able to determine, the largest upheld patent verdict was the $873M verdict in Polaroid v. Eastman Kodak Co. in 1991. I think this has limited applicability to VHC's situation since it was a dispute around ownership of a fundamental product invention between warring industrial companies. I believe the most successful (in terms of monetary collections) litigation-driven patent troll of all time is NTP, which won over $600M from Research in Motion due to its patents that purported to cover the basic concept of wireless email. However, it is important to note the jury awarded a mere $23M in damages to NTP, the rest was a gun-to-the-head license that RIMM was forced to sign to prevent an import ban on its products. Changes in law as a result of the eBay vs. MercExchange case since this NTP won its case against RIM mean courts no longer enforce mandatory injunctions, so VHC would depend on being successful at the ITC to actually force Apple to license, a strategy that has worked poorly for InterDigital (IDCC) as I will discuss later. In short, I simply can't find a precedent for any patent owner, much less one with a handful of patents, to extract the kind of money from patent lawsuits that a $2B market cap implies.

Note: On Thursday, July 19th VHC was dealt a potentially significant setback at the ITC when its Motion to Amend the Complaint was denied and the ITC terminated the investigation due to lack of standing. While VHC can appeal this initial determination, if upheld the termination means they will have to start again at the ITC, delaying the case for months and preventing VHC from using the threat of an ITC import ban to pressure Apple into a settlement if they were to win a jury trial in the patent case this fall.

What If They Win?
For a moment, let's ignore the major risks I highlighted above and assume VirnetX scores major victories in its current patent litigation, and they hold up on appeal years later. How much could this be, and what would it be worth to VHC shareholders? Microsoft is one of the largest tech companies in the world, and VirnetX successfully sued them for $200M, a stunning victory for a patent troll with a few patents in a narrow area. Microsoft is a much larger company than Cisco, but let's assume that VirnetX successfully wins the same amount, or $200M from Cisco. Apple is now a larger company than Microsoft, so let's assume that VirnetX wins twice as much from Apple as they did from Microsoft, or $400M. This $600M total, assuming it holds up on appeal and is collected, (when added to the judgment against Microsoft) might literally make VirnetX the most successful patent troll in history. Unfortunately for VHC shareholders, after taxes, legal contingency fees and potential future payments owed SAIC, I believe that the company would only keep about half of the cash from a headline award. Thus even if VHC is amazingly successful and wins an additional $600M, to the company and its shareholders it will be worth only about $300M or around 15% of VHC's current market cap. The company only has about $60M of the original Microsoft verdict after paying out a paltry $24M to shareholders, the rest going to lawyers, SAIC and taxes. How will the other 85% of VHC's market cap be justified once the three fattest targets in tech have settled out? Remember, to justify VHC's market cap on settlements alone after taxes and other payments, they would need to repeat the largest upheld IP litigation award in history four and a half times.

VirnetX bulls seem to believe that the rest of the value lies in licensing their IP as part of the 4G wireless standards. I will address this idea in Part 2.

Source: VirnetX: Do You Believe In Fairytales? Part 1