In Part 1 of my series on VirnetX (VHC), I gave an overview of the current patent litigation and discussed why it is hard for me to believe that VirnetX's potential patent trial damages awards could justify its current market cap. Despite the just-announced deal with NEC and criticism I have received, nothing has changed my view on this front. Simply put, VHC would have to "break the mold" and set an all-time new record for an upheld and collected patent infringement jury verdict to justify the current market capitalization. In Part 2, I will discuss the second leg of the bull thesis, which simply stated is the idea that VHC will extract a 1% (or 1.5%, or 2%) royalty on all 4G LTE Advanced wireless sales. As we shall see, this is much easier said than done. I have continued to update my report in light of current developments.
ETSI and Wireless Standards
The standards for cellular wireless communications are set by ETSI, or the European Telecommunications Standards Institute. ETSI is the organization charged with coordinating between industry participants to decide on the technical standards for each generation of wireless technology. To make a long story short, through the 3GPP, the organization is setting the standards for 4G LTE wireless and has decided to include a security standard specification in Series 33. As part of the standards setting process, ETSI invites companies to submit any IP that the owners believe to be essential to a wireless standard, so that it may be licensed to industry participants on fair, reasonable and non-discriminatory ("FRAND") terms. VHC has submitted notice to ETSI that it believes its patents are essential to the Series 33 specification, and issued press releases to this effect.
While this seems to have given VHC owners confidence that they will be collecting 1% or more royalties on the eventually enormous worldwide 4G LTE-A revenue stream, it is important to note that anyone can declare their IP essential to an ETSI standard, but ETSI does not express an official opinion on whether the IP is actually essential. VirnetX is not part of any coordinated mechanism for forcing ETSI's constituents to license any particular technology or collecting royalties. So far, VirnetX is the only industry party to recognize VirnetX's IP as essential to 4G LTE Series 33 specification as far as I can tell. I actually emailed ETSI about VHC's declarations and here is the response I received (emphasis mine):
"It seems as if you have contacted also other colleagues at ETSI, trying to get more information about the standardization processes applied in ETSI and in particular information about a company called VirnetX, Inc.
Please note that documents of the General Assembly of ETSI but also documents of other bodies of ETSI aren't publicly available and that the access to such documents is restricted to ETSI members only.
Further, please be informed that ETSI is in general not checking the validity of the information contained in the IPR declarations made by declarants nor the relevance of the identified patents/ patent applications to the stated standards and therefore ETSI cannot confirm, or deny, that the identified patents/patent applications are, in fact, essential, or potentially essential to the stated Standards and Technical Specifications as defined in Clause 15 ETSI IPR Policy.
This applies also to the statements that VirnetX, Inc. has made to ETSI, so that ETSI hasn't checked neither the validity of the information contained in the statements made by VirnetX, Inc. nor the relevance of the identified patents/ patent applications to the stated standards and therefore cannot confirm, or deny, that the identified patents/patent applications are, in fact, essential, or potentially essential to the stated Standards and Technical Specifications as defined in Clause 15 ETSI IPR Policy."
Even assuming that through successful licensing efforts or the courts VHC does indeed establish its IP as essential to the LTE-A, standard, it is far from clear that it will command a significant royalty. Wall St. Analysts and message board posters love to throw out the idea that VHC will get 1%, because it sounds like a small, reasonable number. However, there are literally tens of thousands of patents (around 124K to be a little more exact) that have been declared essential to the various ETSI standards projects. I believe it will be difficult for VHC to convince industry participants that it deserves anywhere near a 1% royalty rate given its relatively small number of patents in a single family among the thousands of supposedly essential pieces of IP, not to mention the thousands of other non-FRAND smartphone-related patents. If every patent family incorporated in a modern smartphone design received a 1% royalty on the current sales price, an iPhone would cost as much as a new Mercedes sedan. In fact, in my research I ran across an estimate of the portion of LTE standards essential patents by patent owner. Major device makers such as LG, Nokia, Samsung and Ericsson appear on the list, alongside other patent owners such as Qualcomm, InterDigital and the Nortel IP purchased by the Rockstar Bidco consortium. VHC is nowhere to be found, which may make their argument for a substantial royalty difficult to make.
VHC currently has no mechanism for enforcing its claim to 1% royalties other than the courts system, which is a long and uncertain process that will be even more difficult overseas than it is in the U.S. Recently, and also relevant to VHC's current litigation, Court of Appeals Judge Richard Posner threw out a patent case between Apple and Motorola, ruling that a potential import ban would harm consumers and expressing skepticism about the general concept of issuing an injunction based on FRAND patents. In a recent court filing in the Apple/Samsung case, Apple claimed that the applicable royalty for the standards-essential wireless patents Samsung is asserting against it is $0.0049 per unit- this means that Apple might calculate it owes VHC a whopping $600,000 per licensed FRAND patent on the roughly 120M iPhones Wall St. expects Apple to sell in fiscal 2012. Samsung, in turn, asked for 2.5% royalties on its substantial chunk (as shown above) of wireless IP, but obviously Apple has not agreed to this rate and at any rate VHC does not have near the same amount of IP. According to analyst models I have seen InterDigital's (IDCC) top royalty rates are about 50 bps (.5%) on the wholesale price of a phone and go down substantially from there. Given the 250,000 estimated smartphone patents, the applicable royalty rate may be a tiny fraction of 1%- if they can collect anything at all. As my further discussion of IDCC will show, this is far from certain.
IDCC: The Elephant in the Room
I believe the perceived escalating value of smartphone patents has contributed to the investor excitement around VHC. In isolation, the story sounds good. However, VHC investors should pay close attention to the story of IDCC. After all, by any numeric measure, IDCC should have a much better claim to a royalty on 4G sales than VHC. IDCC has 18,700 (pro forma for its recently announced patent sale) patents and applications in multiple families against VirnetX's 46 patents from a single family. IDCC has approximately half of the 3G units shipped worldwide under license and has successfully negotiated licensing deals with Apple, HTC, RIM and Samsung. VHC does not have a single major wireless handset company under license. IDCC has recognized over $1B in IP licensing revenue over the last three years, while VirnetX has a grand total of just over $100K in royalties and a single $200M settlement. IDCC spent nearly $64M last year in ongoing technology development, while VHC spent less than $2M.
In IDCC's last earnings release, they spoke of getting to $800M in annual licensing revenue. Yet somehow despite the vastly higher number of patents, better previous history licensing technology and the fact that IDCC is spending a great deal more on both ongoing technology development and new patent applications, VHC's market cap is similar to IDCC's. The enterprise value comparison is even more incongruous, as IDCC has a sizable cash balance and is set to receive $375M ($250M after taxes) from selling 1,200 patents and 500 patent applications to Intel. Despite recognizing over $1B in revenue the past three years (far in excess of what VHC has ever collected) the enterprise value of IDCC is only around $800M, which does not make a lot of sense if they will really be collecting $800M in royalties per year sometime in the future. IDCC continues to devote substantial resources to technology development, while VHC spends a relatively paltry amount that raises the question of whether it will keep up with the wireless industry. This valuation discrepancy seems out of whack, and to me it suggests that at least one company is seriously mispriced.
Table 1: Comparison Between IDCC and VHC ($M)
3 Year Revenue
EV/3 Year Revenue
2011 R&D Expense
Source: 10-K Wizard, Yahoo finance and author's own estimates. IDCC patent count and cash adjusted for after-tax results of patent sale to Intel.
In my opinion VHC is the seriously mispriced one, and investors wishing to speculate on the value of smartphone patents are much better off owning IDCC. The difference is that IDCC investors are confronted with the messy reality of actually trying to collect royalties on wireless industry IP, while VHC investors are simply putting numbers on a spreadsheet. Some companies that should theoretically have to pay IDCC licenses (Motorola and Nokia in particular) have gotten away with paying nothing at all for years on end. The success Motorola and Nokia have had avoiding IDCC royalties, even in the face of ongoing ITC cases, has apparently made IDCC's major licensees such as Samsung, LG and RIM reluctant to re-sign licenses. IDCC's contracts with Samsung and RIM expire at the end of 2012, and I believe the current sub $800M enterprise value for IDCC reflects investor uncertainty that IDCC will actually get paid for its IP, despite its recent reversal at the ITC in the Nokia case. VHC's valuation seems to imply much less of this uncertainty, but in my opinion it should. VHC's ability to collect substantial wireless royalties is less proven and it seems extraordinarily difficult to believe that their small number of security-only patents are worth more than IDCC's thousands of patents in multiple families directly related to 3G and 4G wireless.
What is a 4G LTE Wireless Patent Family Worth?
There have been two major publicly announced wireless patent deals in the last 18 months, including the Rockstar Bidco's purchase of 6,000 Nortel patents for $4.3B ($750K per patent) and IDCC's sale of 1,700 patents to Intel for $375M ($220K per patent). Obviously, all patents are not created equal, and some are much more valuable than others. But these benchmarks suggest that VirnetX's mere 46 patents could also be worth only $10M to $22M in the open market, a distant cry from VirnetX's current $1.3B market capitalization. Even if the VirnetX IP proves to be essential to the 4G LTE Advanced standard, given the limited number of patents in VHC's single patent family, I actually think a better comparable for VirnetX's value is Acacia Technology Group's (ACTG) purchase of the Adaptix 4G wireless technology patent family for an enterprise value of $150M. But even this may overstate the value of VirnetX's IP, as Adaptix has 230 issued and pending wireless patents going back to 2000. ACTG management also specifically mentioned it was "excited" that Adaptix's IP was not subject to FRAND licensing terms, indicating that VHC may have impaired the value of its IP in its FRAND declaration. In its most recent conference call IDCC management indicated that the most relevant metric for valuing wireless patents is $2.3M per issued U.S. patent, which would imply a value of about $46M for VHC's 20 issued U.S. patents. Simply put, much like researching upheld patent trial awards, I could find no precedent wireless IP single patent family transaction value that comes close to justifying VHC's market cap. While VHC's patents may prove to be more valuable than the IP of Adaptix, IDCC or even the Nortel patents, this remains far from certain, and VHC's patents may also be worth far less.
As I have discussed, it is difficult for me to believe that VHC's market cap can be justified either by its current patent infringement lawsuits or the prospects it will collect a royalty on 4G LTE-A wireless. Recent patent sales cast further doubt that VHC is worth anything close to its current market cap, at least in a patent sale. The over-exuberance for VirnetX's prospects on the InvestorVillage.com message boards reminds me of the run-up to Rambus' (RMBS) much-hyped antitrust trial against Hynix and Micron. As the InvestorVillage.com veterans know, this was merely the prelude to a 70%+ stock price collapse. Long-term investors in publicly-traded intellectual property owners Tessera (TSRA), IDCC and TiVo (TIVO) have been similarly disappointed, despite the fact that these companies along with RMBS have a much more robust history actually developing and licensing technology than VirnetX. Amazingly, despite every company on this list having collected hundreds of millions more than VHC in lawsuit settlements, IP licenses and royalties, each has a smaller enterprise value.
VHC's stock could certainly perform leading up to this fall's Apple trial- or be up in the face of an initial trial win- but I also think the stock could repeat last summer's move from near $40 to below $15 in a difficult market. If it is reasonably successful, I think VHC could be worth around $510M or $10/share, very roughly calculated as $300M for post-fees court case victories + $150M in value for a 4G LTE wireless patent family + $60M in cash. In my opinion this would be a hell of an accomplishment given VHC's history. Of course, this is a stab in the dark, and it is theoretically possible VHC could be worth much more than this rough estimate, depending on how its various trials and licensing initiatives turn out. However, given the difficulty other publicly-traded IP companies have had and VHC's seemingly weak claim on 4G wireless royalties, I will take the under.
Disclosure: I am short VHC.