Patent Plays: How To Balance An Underlying Business With The Potential For A Large Verdict

Includes: DSS, SITO, XSPA
by: Alexander Maxwell

Correctly predicting the outcome of a court's decision can be incredibly hard. Add in hundreds of millions of dollars being on the line, and you can see why some investors love investing in the intellectual property litigation space. The potential for upside is enormous for these smaller companies. However, so is the potential for downside should they end up losing their case. If you cannot successfully defend a patent in court, it becomes hard to convince people that they need to respect the patent rights of the company. One way to minimize the downside is to have an actual business to fall back on. By this I mean an actual revenue generating business, which would help to offset some of the costs of attorneys and promote a certain valuation for the company. This provides for a proverbial safety net, should the decision ultimately be negative. I like three specific patent plays: Document Security Systems (NYSEMKT:DSS), Vringo (VRNG), Single Touch Systems (NASDAQ:SITO). All of these stocks have very interesting patent lawsuits; as well as the potential for a very high return on their investment should they ultimately prevail in their lawsuits.

Document Security Systems is an interesting Intellectual Property play, in the idea that DSS is also generating revenue. Document Security is a company which is engaged in the development of anti-fraud, anti-counterfeiting, and authentication technologies. Now, what adds a company like DSS to this list is the fact that it is currently wrapping up a proposed merger with Lexington Technology Group. The merger with Lexington is what helps to make Document Security Systems such an interesting buy. Document Security would essentially provide the underlying business, which would generate revenue and hopefully reach profitability soon. Document generated $5.4 million in revenues for the fourth quarter of 2012, with a gross profit of $1.6 million. You will notice that their net loss went up slightly, but considering that it is a non-recurring expense related to merger activities, I would not at all be concerned about the net loss increase. Now, what would Lexington Technologies bring to the table that Document would find so attractive? Currently, Lexington is in the middle of litigation versus Facebook (NASDAQ:FB), LinkedIn (LNKD), Jive Software (NASDAQ:JIVE) , Broadvision (NASDAQ:BVSN), and Novell . The lawsuit is over four patents which cover key aspects of online collaboration and relationship linking. The patents are entitled: 7,111,232: Method for making document objects available to users in a network, US Patent number 7,139,974: Framework for managing document objects stored on a network, US Patent number 7,389, 241: Method for users of a private network to provide other users with access to link relationships between documents, and US Patent Number 7,158,971: Method for Searching Documents on a Network. Essentially, the company is claiming that Facebook is infringing upon its patents when Facebook allows for people to make connections between photos, people, or events. Needless to say, if you have ever been on Facebook, the process of making these connections are rather important to the user. This lawsuit has a very important date coming up, the Markman hearing.

For those of you unfamiliar with the concept, let me quickly dive into what a Markman hearing is. Essentially, in a patent infringement case, both sides have different interpretations as to what the patent covers, and as to what the language of the patent means (of course the plaintiff wants a rather broad, more encompassing definition, while the defense wants a much more restricted definition). Before the Markman hearing, both sides submit their proposals of the language for each claim that is alleged to be infringing in the patent. The judge after reviewing the proposals will rule on which language will ultimately be presented to a jury. Remember, that the Markman date can be quite lucrative for stocks, some stocks which saw huge increases on their respective Markman dates were ParkerVision (NASDAQ:PRKR) and Vringo amongst others. The Markman hearing date for this lawsuit is set for October 2nd, 2013. This date will be the first proverbial test for the lawsuit, and a win for Lexington/DSS in terms of patent construction would be very good for shareholders. The merger with Lexington Technologies is expected to be closed in the spring of 2013, which would be well in time of the expected Markman hearing for the case. Whether or not Lexington/DSS will eventually be successful in their patent infringement lawsuit is very hard to say for certain, but as I have emphasized before, I like the underlying business for DSS. This should help to cushion at least some of the downside should Lexington end up losing its case.

The odds of DSS losing, however, seem to have lowered due to the fact that they recently announced a settlement with one of the Defendants in their litigation. This settlement would provide minimal revenues for Lexington, but provides a very important boost. Through the settlement the Defendant is essentially admitting that the patents are valid, enforceable, and more importantly that the Defendant infringed upon Lexington's patents. Document's hand is further strengthened when we consider the fact that this was even before the Markman hearing. If the Defendant at all believed that they might receive a not guilty verdict, they likely would have taken their chance at the Markman hearing. DSS and Lexington seem to have a very bright future together, and should be a stock to watch in the next few months as their patent lawsuit progresses.

Another interesting patent play which has been receiving a large amount of press recently is Vringo . Vringo is almost notorious amongst the patent community for its recent courtroom victory against Google (NASDAQ:GOOG). Vringo is different from DSS and SITO (the last stock featured in this article) in the idea that it does not have much of an underlying business (it has a few apps that are bringing in small amounts of revenue). However, in recent days Vringo has begun to fall in stock price due to a court filing in which Google has found a so called run around, in the idea of an ad system which does not infringe on Vringo's patents. If it is true, this would obviously be bad news for Vringo's shareholders as it would lower the amount of future royalties received from Google. Remember, with 30 million dollars in past damages, it seems as though Vringo will be relying on future royalties from Google in order to pay the bills. This is provided of course that Vringo is in no way successful with its appeal of the decision. Having a work-around to the point where Google would no longer infringe on Vringo's patents would lower the amount of future royalties received because Google would no longer be required to license the patent from Vringo from the day when Google updates its adwords system. Vringo will remain a volatile stock, largely following the tone of court filings. Should Vringo be successful in getting the laches ruling overturned, that could mean hundreds of millions of dollars more in past damages for Vringo (money that even if Google changed its ad system, they would still owe to Vringo). Vringo's lawyers have proven themselves to be quite capable, and have shown their ability to take out some of the titans in the internet industry.

Vringo, however, is not just suing Google. Vringo recently announced that it is in settlement talks with Microsoft (NASDAQ:MSFT), related to a patent infringement lawsuit. This settlement would provide Vringo with much needed revenue, and would help to validate Vringo's claims in the minds of investors. The settlement talks were significant, so at the mention again of a settlement I would look for the stock to move up. However, should no settlement come to fruition, Vringo could be in for another long ride versus Microsoft, similar to the one experienced against Google. Vringo also holds a multitude of other patents, through which it is actively pursuing litigation against competitors. These competitors are not just in the United States, as Vringo has started enforcement activities in Europe as well.

Vringo is exciting due to the fact that it is also playing on another front against a large telecom company in ZTE. Vringo is suing ZTE, because of patents that Vringo acquired from Nokia (NYSE:NOK). Vringo previously filed lawsuits versus ZTE in Germany and in the United Kingdom. Vringo recently expanded its European enforcement action against ZTE, through the filing of a lawsuit in France. What is very interesting about this lawsuit is that Vringo claims to have specific evidence of ZTE's infringement due to particular information uncovered during a seizure to obtain evidence (which is allowed under French law). Vringo is in my opinion the most interesting of the mentioned patent plays, simply because it has so many irons in the fire. With all of the various enforcement activities that Vringo has taken as of late, something is bound to break in Vringo's favor, the question is which will come first Google, Microsoft or ZTE?

However, Vringo is also lacking a true underlying business. Establishing an underlying business would help to cushion Vringo against any loss in court, and would provide some much needed revenue. While the scenario that Vringo is unsuccessful in its lawsuit against Google is unlikely, it cannot entirely be ruled out by the market. Vringo seems to be in a very nice position to strike, and will be for the future thanks to an agreement signed with Virginia Tech. This agreement should help to provide Vringo with the next generation of patents, specifically the companies are attempting to develop a technology that could "potentially enable first responders to quickly set up wireless networks in areas where telecommunications infrastructure has been destroyed or rendered inoperable." This technology could potentially represent a shift for Vringo, towards building an underlying business model. Obviously, this would be in the benefit of shareholders; as I mentioned above an underlying business would help to lower downside risk should the patent infringement lawsuits ultimately be unsuccessful. Vringo is an exciting patent play, and having already proved the validity of its patents in the recent infringement lawsuit versus Google, Vringo should remain on the radars of investors.

Now, for a relatively unknown company in Single Touch Systems. Single Touch is a company that purports to be a "technology based mobile media solutions provider." So what do the underlying numbers at Single Touch look like? For the first quarter of 2013, SITO increased its revenue to $2,000,000, which represented a 22% rise over the previous year. They also have improving gross margins (which would be important for any business). Something that is incredibly significant from their earnings announcement is a quote from the Single Touch CEO: "Based on these growth rates we anticipate becoming profitable on a cash basis during fiscal 2013." Single Touch recently provided even more exciting news, announcing that it just launched its #taxi service in the United States. This service allows for consumers to easily be able to contact a taxi. This could also be very lucrative for Single Touch. Single Touch mentioned that during its beta rollout, there were in excess of 100,000 calls connected and that they estimate that the number of calls in the US could surpass 20 million. Revenue from the call is split with the telecom carrier, as well as Single Touch's partner CellWand Communications. This product has the opportunity to help Single Touch reach profitability even faster than previously predicted. A company being profitable is a major accomplishment, however, we cannot simply value Single Touch by the possibility of it being profitable in the future.

Valuing Single Touch based solely upon the prospects of its underlying business being profitable would fail to realize the full potential of the company. Single Touch announced on August 24th, 2012 that it filed a lawsuit in the Federal District Court of the Central District of California versus Hulu. The patent infringement suit revolves around patents which are owned by Single Touch, involving streaming and route media technology. Hulu is essentially a web TV service, where a person pays for a subscription and then is able to watch their favorite television shows online. Hulu is a relatively big company, having revenue of $695 million in 2012. A win versus Hulu would help to validate SITO's patent portfolio. The formal complaint uses levels some interesting accusations against Hulu. Will Single Touch ultimately be successful? Only time will tell. An interesting element shaping up for this case is the fact that Single Touch well before the lawsuit sent a letter to Hulu telling Hulu about the patents. This takes away Hulu's possibility that they can make the claims that they were unaware of the patents. This also presents an interesting scenario: while it is rare that in the US court system it occurs, it is a possibility that Single Touch could be awarded treble damages, as now they have evidence that Hulu knew that the patents existed and were in effect. Single Touch also has another interesting catalyst coming in the wings.

They recently sent a similar letter to Facebook, letting Facebook know about the patents owned by Single Touch. Given that Single Touch took similar action against Hulu before suing Hulu, it is possible that Single Touch would be setting the stage for suing Facebook as well. A win or settlement with Hulu would be very important for Single Touch, as it would validate the patents, and the enforceability of the patents. Now, any company can file a lawsuit versus much larger companies. What is important when suing a large company is to have some of the best legal talent in the business, and that is where Single Touch's attorneys come into the picture.

Single Touch is also well represented in their lawsuit. The law firm representing Single Touch in the litigation is Polsenelli Shughart. This firm is a rather well-respected firm nationally, and according to rankings is a tier 1 patent litigation firm, however, only in Kansas City, MO. It is important for Single Touch to have very good attorneys if they want to have any chance of beating Hulu in court. You can put money on the fact that Hulu will have some of the best patent litigation attorneys in the business defending the claim. I am not entirely sure about whether or not Single Touch's attorneys will be able to get the job done. However, management chose that law firm for a reason, and I would defer to the idea that they made the best possible choice for their shareholders. Single Touch presents a very interesting opportunity. Should Single Touch prevail in their lawsuit versus Hulu, the door could be open to large damages. This would put Single Touch in a different category of patent players, as now they would have shown that their patents are valid and enforceable (think VirnetX (NYSEMKT:VHC) or it might be a tad bit early to do this but I would say Vringo as well).

Predicting the outcome of a jury decision is hard, but these companies at least have 'cushions' which should help to protect shareholders. The risk of losing is inherent in any patent litigation company, however, the financial benefits of winning would be large to any of these companies. All of these companies have large potential based upon their ambitious lawsuits. However, only time (and potentially a jury) will tell if these companies will be successful in their lawsuits.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in DSS over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.