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Cyber security has become very profitable for traders on Wall Street. FireEye (NASDAQ:FEYE) shares have risen from the $12 IPO price to $75 within the last few months. Many of my readers have followed another cyber security trade, VirnetX (NYSEMKT:VHC), where my initial position at $5 rose beyond $40 a share.
Finjan could provide a short-term 100% gain
I just initiated a long position in an impressive yet undervalued cyber security company; Finjan Holdings (NASDAQ:FNJN). The company's patents cover core and foundational technology in a sector that will continue to grow as cyber threats become more sophisticated and widespread.
Based on the extreme level of undervaluation, the quality of the patent portfolio, and the near-term catalyst of a Nasdaq up listing, I believe this company offers investors the potential for a short-term 100% gain. Longer term, the return potential is considerably greater. If you missed my recent 22nd Century (NYSEMKT:XXII) article, and the subsequent 104% gain, Finjan offers similar potential.
Finjan currently has a valuation of $130 million as compared to VirnetX's $900 million valuation, or FireEye's $8 billion valuation. In my opinion, Finjan should be valued above $260 million within the next 30 days, whereas with VirnetX or FireEye, I do not expect the share price to double anytime soon.
Why do I expect Finjan's share price to rise?
As attractive as Finjan is, many institutional investors cannot invest in the company because it does not have a major exchange listing. This is one of the primary reasons the share price and volume are so low. The other factor is that most Wall Street traders do not even know Finjan exists.
But that's about to change. Once Finjan's S1 goes effective, which should happen within the next 2 to 4 weeks, Finjan should be able to get up listed to Nasdaq almost immediately. At that point, it appears all Nasdaq requirements will have been met.
Once an up listing occurs, there could be a high level of pent-up demand, creating a larger number of buyers than sellers, thus driving up the share price. As many of my readers remember, Organovo (NASDAQ:ONVO) went from $3.90 to $13.65 following the company's up listing.
Why I believe a Nasdaq up listing will happen soon
In the December S-1/A, Finjan indicated its intention to be listed on a national securities exchange as soon as possible. Since Finjan is a technology company, this will probably be a Nasdaq listing. From what I can determine, Finjan meets all the requirements for a Nasdaq listing, and only needs the S-1 to go effective in order to complete the process.
The original S-1 was filed on 7/16/13, and can be viewed here. The subsequent S-1/As were then filed:
- S-1/A filed on 9/20/2013
- S-1/A filed on 10/30/2013
- S-1/A filed on 12/13/2013
- S-1/A filed on 1/21/2014
Each S-1/A represents a round of comments from the SEC. In general, it doesn't take more than 2 or 3 rounds of comments before an S-1 goes effective. Since Finjan is now on its 4th round, I would be surprised if another S-1/A was required. Also, the changes in the S-1/As were minor and non-material which leads me to believe that there will probably be no more changes required.
The question then becomes, when will the S-1 go effective? The SEC has 30 days to respond to the S-1/A filed yesterday, but could respond in one week. A Nasdaq up listing should follow shortly thereafter. The only other option would be for S-1/A number 5 to be filed, which would delay the process for up to 4 more weeks, however in my opinion that's highly unlikely.
Since the company appears to meet all Nasdaq requirements, I believe Finjan has already initiated the up listing process, so that once the S-1 goes effective up listing could occur more or less immediately. Common sense tells us there would be no reason for Finjan to have delayed initiating the up listing process.
With a Nasdaq listing institutions could establish large positions
If you look at the heavily traded IP companies such as VirnetX, Acacia (NASDAQ:ACTG), or Vringo (VRNG), the roster of institutional investors is impressive; Renaissance, BlackRock, Vanguard, Oppenheimer, Bank of America, Soros Group, etc. Most of these institutions have large positions in IP companies even though many of these IP firms face challenges that Finjan is not exposed to.
In other words, Finjan appears to be one of the best companies in this sector, and once it becomes listed on a major exchange, I believe many of these institutions will want to establish significant positions. In fact, it's possible that some of these institutions will sell some of their current IP holdings, and switch to Finjan, because Finjan's patents were developed in-house, which greatly reduces the legislative risk that other IP firms are facing. Also, Finjan's $27 million in cash and debt-free balance sheet is particularly attractive to institutional investors.
Low float could amplify share price appreciation
But Finjan offers another element that could boost share price appreciation beyond what anyone expects; an extremely low float of just over 2 million shares. If investors start buying, with so few shares available, we could see Finjan share price rise well above the $10-$15 range in the next 30 days.
Such was the case with another IP firm, Spherix (NASDAQ:SPEX), when the share price went from $6-$27 within a few days, primarily based on the low float. Investors wanted shares, but not enough were available. As investors become aware of Finjan, the same phenomenon could occur.
But keep in mind that Finjan is extremely undervalued at today's $6 level, and in my opinion should be priced well above $10 regardless of a Nasdaq up listing or the company's low float.
Finjan's patented technology works like this: let's say that someone sends you a PowerPoint file that has a virus that downloads malware. Finjan's technology runs the attached file in the background, identifies the malicious code, strips it out, and replaces the clean attachment without you even knowing it. Finjan's inventions allow you and I to connect to the Internet safely, and seamlessly.
Finjan's patents have been proven
Finjan owns a valuable IP portfolio with over 40 patents around the world. The company has successfully licensed its intellectual property to five major software and technology companies resulting in more than $145 million in licensing and enforcement revenues. The patents have been proven. I recommend all investors take a look at the patents, which can be viewed here, because their importance and economic value will soon become obvious.
Harbourvest, Benchmark, and Cisco have already established positions in Finjan
The first thing that caught my attention when I began looking into Finjan were the institutional investors that have already invested in Finjan. For example, Benchmark Capital and Harbourvest Capital own over 43%. Cisco also has a significant position, and Microsoft has been an investor as well.
These large institutions would not have invested in Finjan without first confirming the strength and monetization potential of Finjan's portfolio.
Seeking Alpha's Michael Eisenberg is on Finjan's board
The Benchmark investment in Finjan is especially interesting, because Michael Eisenberg, a general partner at Benchmark, was one of the early investors in Seeking Alpha, and currently is on Seeking Alpha's board. He is also on Finjan's board. He is known for numerous wins in the IT space, including his investment in shopping.com which sold to eBay (NASDAQ:EBAY), for $620 million in cash.
Finjan's infringement target exceeds $100 billion
The next thing that caught my attention was the size of the infringement universe that these patents are addressing; $100 billion over the next 5 years. Even if Finjan were only able to capture 1.5% of that market, that would still be $1.5 billion in revenue.
But given that Finjan obtained 8% and 16% royalties from Secure Computing, I believe 1.5% is an unrealistically low estimate. I do not expect a large number of 16% royalty deals, but I think aggregate numbers well above 1.5% can be expected.
IPNav's Phil Hartstein is running Finjan
What really sealed the deal for me, was when I discovered that Finjan's president, Phil Hartstein left one of my favorite IP companies, IPNav, to join Finjan. IPNav is the world's leading full-service patent monetization firm. In an effort to understand more about the company and its patent portfolio, I initiated a conference call with Phil Hartstein. Here are some excerpts from that interview.
Q: Why did you leave such a lucrative and promising position at IPNav to join Finjan?
Phil Hartstein: Finjan represents the best of all potential opportunities for someone with my expertise. It has a patent portfolio that was developed by a company that built and sold products around the world. That patent portfolio has continued to be developed. It has a history of licensing and enforcement, and has generated $145 million through only 5 deals. And this was done with absentee management. In other words the old management team didn't really understand how to identify the value of the patents in order to maximize the financial returns by being a plaintiff on the assertion side. Also, I have a Board of Directors of top-tier venture capitalists that already understand intellectual property and its complexities.
Q: With an absentee management team, how was Finjan even able to generate any revenue from the patents?
Phil Hartstein: The value comes from the patents themselves. Finjan's patents actually made their way into products. Finjan's patent portfolio contains fundamental components of how security architecture is supported today. Behavior-based threat protection technologies have become an industry standard that must be included in end point products, web gateway products and networking and equipment products. The previous management team was able to generate revenue through licensing and enforcement, because of the strength of the patents themselves.
Q: Rarely do you see such a high level of institutional involvement, such as Harbourvest, Benchmark, and Cisco. Why do you think these guys came on board?
Phil Hartstein: Their equity position today presumably represents their belief in the technology. We are at a point now in this market where behavior-based threat protection technology at the endpoint, web, and network levels is a primary component of security architecture.
Q: Could you please elaborate on your technology, in layman's terms.
Phil Hartstein: At the time Finjan was founded, the best protection from malicious code or content was referred to as "Anti-Virus" protection. The technology to protect against viruses required you to first know a file had malicious intent and from there you could establish a signature for that virus taking note of simple characteristics like its size, its origination source, or specific segments of code embedded within. In the simplest terms, this approach is nothing more than a database solution leaving users susceptible in two areas. First, what happens in between the time that a virus becomes known and when the signatures (i.e. databases) are updated on your device - this is commonly referred to as "Zero-Day" threats? Second, as soon as you connect your device to a network or the internet, there is an entirely new avenue for malicious code to infect your device. Finjan's inventions solved these problems by fundamentally changing the approach to protection by observing the behavior of files and content as they enter the network or endpoint, in real time, either through software or in hardware components for protection at multiple points. Thus alleviating the need for database patching and also solving the interim Zero-Day gap. Additionally, our behavior-based technologies also protect against the polymorphic behavior profiles of modern malware which makes the inventions increasingly important in today's threat landscape.
Q: Why is it important that all your patents were developed in-house, as opposed to being purchased from outside inventors?
Phil Hartstein: Aside from the fact that Finjan's patented inventions have the potential to stand alone, the company was founded to solve a real-world problem, not solely to develop intellectual property. For more than a decade Finjan built and sold products embodying its inventions, actively competed in its marketplace, employed 150 people, operating facilities around the world, while receiving recognition and acclaim from the security industry. Having spent time with the original founder of the company, early company executives, our Board, and shareholders, there is one consistent message which is that Finjan should be receiving fair value licenses for its contributions to the space. Also important to our board and shareholders is that we continue to invest capital back into the security space. You may have seen our recent investment in a cyber security focused venture fund as a strategic limited partner.
Q: It looks like there are only about 2 million shares that are actually tradable. Based on what appears to be severe undervaluation, with any level of buying activity, the share price could double overnight. Am I correct in my perception?
Phil Hartstein: You're correct to observe that the float has been restricted. As the shares issued in the merger have started to become tradable, the float is gone up, but it remains at about 2 million shares. I can't comment on the value but we have done a lot of work since becoming public to increase shareholder value in both building an infrastructure for success and expanding our licensing and enforcement program. That story is just starting to be realized in the marketplace.
Q: How many potential defendants are there?
Phil Hartstein: I can't talk about all the potential infringers but I can tell you that it's a larger number of companies than most people perceive. In other words, it's not just a handful of companies.
Q: Don't you also have a history as an inventor?
Phil Hartstein: My name is on a couple of dozen patents. I understand the process as an inventor, and as a prosecutor having managed many large volume licensing campaigns.
Q: Finjan's business model is built around 80% licensing, and 20% litigation. Given that Finjan is currently litigating 4 defendants, that implies that a much larger number of licensing negotiations are going on right now. Can you comment on that?
Phil Hartstein: In the aggregate, your thinking is correct; however, at any given time the numbers associated on each side of the 80/20 relationship may fluctuate. Finjan's belief is that we invented and hold core patents covering technologies in the area of software and network security for which we should benefit from a fair value license. While we expect to engage in licensing discussions with a large number of companies there will of course be some who require a different approach - assertion. Our goal is to achieve fair value and while our preference is licensing we will commit to enforcement where necessary.
Q: What is your next significant catalyst?
Phil Hartstein: We have an S-1 on file with the SEC and we have also publicly stated the company's intent to up list to a national exchange.
At this point the interview was concluded.
Finjan's portfolio could generate billions
From my perspective, the institutional investors have validated Finjan's portfolio through their investments, and Phil Hartstein has reaffirmed that validation through his transition from IPNav to Finjan. Imagine the level of due diligence Phil Hartstein was able to conduct before making his decision. In other words, I have no doubt that this is a valuable and relevant patent portfolio that could generate billions of dollars in licensing and settlement fees.
Finjan's revenue potential
According to Finjan presentations, the initial patent infringement universe for the next 5 years is over $100 billion. But this only covers 3 areas of cyber security, and there are many other cyber security areas, such as mobile, which should ultimately be included. Keep in mind that global telecom spending alone is over $3 trillion annually.
Also, this $100 billion figure only includes US infringements, and Finjan owns international patents as well. These additional elements could bring Finjan's entire patent infringement universe well above $200 billion over the next 5 years.
But in order to keep things conservative, let's stick with Finjan's $100 billion projection. I believe Finjan could prevail in the majority of cases, but for the sake of argument, let's say that Finjan is only able to successfully license or litigate 50% of the cases. This would bring the potential infringement universe to $50 billion.
Finjan expects 80% of all infringement cases to settle through licensing deals, and 20% to be litigated. With a relatively low 1.5% royalty rate, this would bring Finjan $600 million in revenue over the next 5 years, or $120 million annually just for the licensing segment of the business.
But the licensing part of the pie is small compared to litigation, because cases that go to court should generate much larger royalty rates. Remember, the Secure Computing case generated 8% and 16% royalties. I estimate these cases to generate between 10% to 15%, particularly if willful infringement is proven.
If $10 billion of the infringement universe is subject to litigation sized royalty deals, (20% of $50 billion), and Finjan is able to obtain a 10% royalty, that would be an additional $1 billion in revenue over the next 5 years, or $200 million annually.
Between litigation and licensing, Finjan could earn $1.6 billion over the next 5 years, or 1.6% of the $100 billion infringement target. For a patent monetization company, $1.6 billion is not a particularly large number, but in Finjan's case, it's the low share count of just 22 million shares that provide investors with large upside opportunity. FireEye for example has over 120 million shares outstanding.
Since I am primarily a short-term trader, I needed to estimate what Finjan could earn in 2014 because that's what would have the biggest impact on short-term share price appreciation.
I believe Finjan should be able to generate at least 5% of the $1.6 billion within the next 12 months, or $80 million in revenue. Some of you may argue that 5% is too conservative, but I'd rather look at a worst-case scenario when generating this valuation estimate.
Gross margins should be at least 75%, so we can estimate earnings to be about 50% of revenue, or $40 million.
What is Finjan worth?
With 22 million shares outstanding, and $40 million in 2014 earnings, that translates to an EPS of $1.81. With a PE of 12, low for this sector, Finjan's share price would be $21.72.
Another way to calculate Finjan's valuation is to use a buyout based revenue multiplier model. Even though Mandiant received a 10X revenue multiple in the FireEye buyout, (see below), I believe a 5X multiple is reasonable to apply to Finjan. That would give Finjan a valuation of $400 million ($80 million in annual revenue times 5). With 22 million shares outstanding, this would give us a share price of $18.18.
Additional metrics that indicate Finjan's undervaluation
Other metrics which demonstrate Finjan's undervaluation, are the company's price to sales ratio and P/E ratio. Finjan currently has a price to sales ratio of 1.6, as compared to FireEye's price to sales ratio of 63, or VirnetX's price to sales ratio of 462. Finjan also has a very low P/E ratio, of 3.3. FireEye has no earnings yet, so we can't compare that metric. VirnetX's forward PE is 17.5.
I realize that P/E and P/S ratios only provide clues to Finjan's valuation, given the choppy nature of patent monetization. But these numbers do contain some level of relevance, and should be included in an overall valuation estimate. My point is this; when we combine all possible methods of estimating Finjan's current valuation, the company appears to be extremely undervalued.
Finjan's patent life extends to 2035
Finjan is continuously adding new patents to its portfolio, so a 5-year time frame is only being used for the sake of revenue estimates and valuation projections. Ultimately, Finjan should be profiting from its patent portfolio for decades. This is just one more example of why in-house patent development can be superior to patent portfolios that are purchased outside the company.
FireEye, one of the companies Finjan is suing for patent infringement, has been in the news of late, because this unprofitable cyber security company is currently being given a valuation of $8 billion, much higher than anyone ever expected. With a $12 IPO, shares have traded up to $75.
Just to give you an idea of the valuations in the cyber security space, FireEye, just paid over $1 billion for Mandiant, a private cyber security company. FireEye will acquire the privately held provider of advanced endpoint security products and security incident response management solutions to boost its cyber security offerings.
Mandiant has more than 2 million endpoints being installed on a global basis. The company serves over 30% of the Fortune 100 companies and this number is expected to grow.
Mandiant is expected to report sales above $100 million in 2013, and yet was given a valuation over $1 billion in the FireEye deal. A 10X revenue multiple is high, and just shows the value of companies in this sector right now.
If Finjan is able to obtain a licensing deal or settlement with FireEye, the numbers could be large, especially when you consider FireEye's $8 billion valuation and the company's $300 million cash position.
Summary: Why I like this trade
Here is a summary of why I believe Finjan's share price will rise substantially above the current $6 level.
Number 1: There are only 2 million shares that are freely tradable on the open market, the rest of the shares are locked up or restricted. With such a low float, any reasonable level of buying activity could double the share price within a very short time frame.
Number 2: Finjan has been very thinly traded. Some investors consider this a negative, but in my experience when a high quality company like Finjan begins to break out, a thinly traded stock can rapidly turn into a high-volume rapidly appreciating stock. In situations like this, investors who established positions before volume transitions from low to high, do very well as long as the company and its technology is solid.
When I initiated my position in MusclePharm (OTCQB:MSLP), at $4, the stock was trading less than 10,000 shares per day (pre-split). On some days no shares were traded. Shortly thereafter the trading volume increased by 1000% and the share price more than tripled. Finjan's trading volume has been increasing lately, and I expect that to continue as investors become aware of this under the radar IP jewel.
Number 3: With a $130 million valuation, Finjan's undervaluation appears obvious, when you consider that the patents have already been proven, and the infringement target is well over $100 billion.
Number 4: Because the patents were developed in-house, Finjan doesn't face the legislative challenges that IP companies that are forced to buy patents face. Also, in my opinion judges and juries could be more sympathetic with companies that developed their own patents, as opposed to purchasing portfolios from outside inventors.
Number 5: With $27 million in cash, and no debt, Finjan is in a strong bargaining position when negotiating with defendants for settlement rates. In other words, time is not an issue, and Finjan can hold out for the highest possible royalty rates. This also gives Finjan the opportunity to apply additional legal pressures that could not be initiated if time was an issue. This is a very important strategy that I believe Phil Hartstein will take advantage of, given his IPNav experience.
Number 6: It's my understanding that the patents that generated the $145 million were not Finjan's strongest patents, and we should see considerably better results as the entire portfolio is monetized by the new management team.
Number 7: The share structure is clean, with no options except those related to the ESOP agreement (which vest over 4 years) and are owned by 6 employees all currently working at company. There are no warrants of material value.
Number 8: Finjan is currently suing 4 companies including FireEye for patent infringement, but remember that only represents 20% of the infringement target. That leads me to believe Finjan is or will soon be in licensing negotiations with a larger number of other companies, since licensing represent 80% of the infringement target. My point is that with so many licensing and litigation elements in play, we could have numerous settlement announcements in 2014 and Finjan could exceed my $80 million revenue estimate. Remember, Finjan has already generated one $85 million settlement, so 2 or 3 large settlements would have a huge impact on revenue and share price.
Number 9: A Nasdaq up listing will be a game changer for Finjan because a whole new wave of investors will be able to establish positions.
Finjan's financial position
Finjan has $27 million in cash, and no debt. The company will not be buying other patent portfolios, so the cash burn will be minimal, about $3 million annually, plus legal fees, which could be up to $4 million annually. The sizable legal fees will be handled on a contingency basis. Also, I see no dilution risk because financings will not be necessary. In other words, Finjan has more than enough cash to thoroughly monetize the entire portfolio.
What's the risk?
The primary risk for investors is that even with a low float, if the share price rapidly appreciates, legacy shareholders could begin selling shares. This could limit some of the dramatic upside potential, but given that there are only 2 million shares in the float, this may not happen, nor may the effect be dramatic. One large institution could pick up those 2 million shares in one day. We have no way of predicting what the shareholders will do, if they will sell, or at what point, so this does present a level of risk in terms of potentially capping the upside.
Given that the patents have already generated significant revenue, I see little risk regarding the quality and strength of the patent portfolio. In my opinion, it's a given that this portfolio will generate large revenue streams. This is not something that can be said about IP companies with unproven portfolios.
There is some risk, regarding court delays. That goes with the territory with IP investments, but given Finjan's strong cash position, this risk factor is somewhat mitigated.
Finjan represents the ideal asymmetrical trade, a high probability of significant share price appreciation, with little downside risk. The recent drop in share price is unwarranted, and increases downside protection.
With 40 patents, over 50 potential defendants, and an infringement universe exceeding $100 billion, Finjan represents one of the best IP investments I've seen. The patents have already been proven which greatly reduces downside risk and amplifies upside potential. In my opinion, Finjan should be trading between $10 and $15, today. Longer term, return potential is considerably greater.
For complete disclosure and disclaimer information please click here.
Disclosure: I am long FNJN. 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.