For those of you new to this story, Vringo is suing Google (GOOG), AOL (AOL), Gannett (GCI), Target (TGT), and IAC (IACI) for patent infringement. There's a good chance Microsoft (MSFT), Yahoo (YHOO), and many other tech giants will be facing Vringo lawsuits also. To keep things simple, this article focuses on the Google lawsuit. Based on the outcome of the recent Markman hearing as well as other factors that I will elaborate on below, I believe that Google will either settle pretrial, or Vringo will prevail in court on October 16th, 2012.
I began my Vringo journey earlier this year when I received a call from an investment banker who recommended I buy shares in the company. Since this was the same banker who suggested I buy VirnetX (VHC) when it was trading at $2 a share, I took his call seriously. (VirnetX is now trading between $35 to $40 a share.) Before I could finish my due diligence, however, the now famous Tech Crunch article came out and Vringo's stock price tripled. I was frustrated that I couldn't get in at $1, so I kept waiting for the share price to fall back. It never did.
I continued my due diligence, examining the claim charts, patents, management background, and court filings. I spent hours on the phone with numerous technical experts, my goal being to discover whether or not it would be worth establishing a position in Vringo. After more than 100 hours of thorough investigation, I became convinced that Vringo had a very good chance of prevailing over Google.
I want to own shares now because 90% of all cases settle pre-trial. If there is not a pretrial settlement, as we get closer to the trial date the share price should appreciate significantly. If Vringo wins this case, I would not be surprised to see Vringo shares trading above $30.
Here are the relevant facts along with my interpretations.
97% of Google's revenue in the United States comes from the company's search engines. During the last six years, Google has generated $67 billion while using Vringo patents. If Google is convicted of infringement, Vringo is entitled to damages, and possibly treble damages because the infringement appears to be willful. If we take an extremely conservative royalty rate of .5%, Vringo could receive $335 million, just for past infringement.
Okay, that's a big number, but we are only halfway there. If Vringo prevails, Google will have to pay ongoing future royalties for the next four years. Google is a much larger company now, and I estimate that over the next four years, Google will be generating US revenue in excess of $75 billion while using Vringo patents. Again, using the .5% royalty rate, Vringo stands to reap $375 million in future royalties.
That gives us two potential settlement figures: $335 million for past damages, and $375 million in future royalties, or a total of $710 million. Now let's translate these numbers into potential share price appreciation.
If we use VirnetX as an example, it received a $200 million judgment from Microsoft, of which it was able to net about $125 million. That one victory, combined with the recent Astra and Mitel (MITL) victories, as well as potential future victories, has created a recent market cap for VirnetX of around $1.875 billion. Once patents begin generating cash, their value increases dramatically, hence the increase in market cap for VirnetX.
If we take the VirnetX market cap, of $1.875 billion and divide by the $125 million that it received from Microsoft, we end up with a value multiplier of 15. (Cash received times value multiplier equals market cap.) In other words, the market is saying that VirnetX is now worth 15 times the net cash it received. This value multiplier is the premium the market assigns to VirnetX once the company has proven its patents could generate cash.
We can also look at this another way: VirnetX was trading at $2 a share before the Microsoft settlement, and is now trading between $30-$40 per share after the Microsoft, Astra, and Mitel settlements. The share price has appreciated by a factor of 15 to 20, in line with our value multiplier of 15.
The big question is how much of a value multiplier can we apply to Vringo in terms of estimating a new market cap? It's clear that once Vringo proves that its patents can generate licensing fees, the company's current market cap will be multiplied by some factor. Will it increase by a factor of 15, as was the case with VirnetX? Yes, it could, but to keep things extremely conservative, I am going to give Vringo a value multiplier of 5.
If Vringo prevails over Google, and receives $710 million, Vringo should net about $568 million (Vringo stated it would keep 80% of any settlement fees as pure profit.) With a value multiplier of 5, that would give Vringo a market cap of $2.84 billion (multiply $568 million times 5). With a market cap of $2.84 billion, using a total diluted share count of 81.5 million, the Vringo share price would be $34.8.
Okay, let's see what would happen if Vringo received a 1% royalty rate. For past infringement, Vringo would receive $670 million. For future infringement, the figure comes out to $750 million. The total infringement would be $1.42 billion of which Vringo should net 80%, or $1.13 billion.
Using a value multiplier of 5, the post settlement market cap would be $5.68 billion. That gives us a share price of about $70.
If you want to look at share price potential based on EPS, the numbers look even better. Using a .5% royalty rate, with earnings of $568 million, we have an EPS of $6.96. (divide $568 million by 81.5 million shares). With a PE of 10, that gives us a share price of $69.60. With a 1% royalty rate, we get a share price just under $140. Given the extremely variable nature of Vringo's future revenue stream, I realize the EPS model is not ideal, but it does give us a rough approximation.
In terms of figuring out what kind of a royalty rate Vringo could actually receive, I think it's good to focus on what VirnetX received. VirnetX offers a similar model to Vringo.
If you take a look at the VirnetX licensing rates, (scroll to page 28 of the link) you see that they range from between 1% and 5%. With regards to the recent VirnetX settlement with Mitel, VirnetX CEO Kendall Larsen had this to say: "We are pleased to have come to an agreement with Mitel on terms consistent with our VirnetX IP Licensing program." In other words, VirnetX is receiving somewhere between 1% and 5% from Mitel because the Mitel settlement is consistent with the VirnetX IP licensing program. I expect VirnetX to receive similar licensing fees from Apple (AAPL), Cisco (CSCO), Siemens (SI) and all the other defendants.
I am assigning Vringo a substantially lower royalty rate than VirnetX, as a worst-case scenario. If Vringo ends up receiving 1.5% or higher, we can all be pleasantly surprised.
Here's another thing to keep in mind; I am not the only one analyzing these numbers. Other analysts will be coming up with their own figures, and no matter how you look at it, the settlement potential is huge. I expect more analyst coverage within the next few weeks. This story is just too compelling to ignore. If other analysts come out with more aggressive royalty rates, imagine what will happen to the share price.
Everything depends on whether or not Vringo can win this case. Keep reading, and I will explain why I think Vringo will prevail. First off, I see five possible outcomes as a result of this lawsuit:
Number one: Vringo wins in court and receives damages and future royalties.
Number two: Google wins, and Vringo shares immediately lose most of their value.
Number three: Google buys Vringo before the trial.
Number four: Google settles with Vringo before the trial.
Number five: Microsoft, Yahoo, or any number of big players buy Vringo.
Now let's take a look at what this patent case is all about. This is one of the most inspiring IP stories I have ever seen. It centers around the incredibly successful search engine technology that Google is using to generate most of its revenue.
When you or I want to do a search on Google, we put in a keyword, and Google then performs two searches. An organic search is run to generate the non-ad search results (this is what you and I pay the most attention to), and a search of the ad system is run to generate actual advertisements that appear next to the organic results. Google makes no money from the organic search, but 97% of its revenue comes from the ads. (Vringo is contending that Google is infringing on both the organic search and the ad system.) High-quality ad ranking attracts advertisers which keeps them coming back and pleases end-users by delivering relevant information.
Google's search advertising system filters advertisements by using "quality score," which is a combination of advertisements' content relevance to a search query and click-through rates from prior users relative to that advertisement. This filtering technology is at the core of Vringo's patents. For a better understanding of "quality score," I recommend watching a video in which Google's chief economist, Hal Varian, explains it.
Before the search engine industry, Andrew Lang and Donald Kosak, the inventors of Vringo's patented software and former Lycos CTOs, conceived of improved technologies needed to produce better search results for users such as advertising search results. They adapted their filtering technique to apply to search systems and invented filtering systems and methods that filter items for content relevance to a search query or a wire, provide feedback information from prior users and in the filtering items, combined the provided feedback information with the content relevancy to determine whether or where an item should be ranked in a search result response to the query or a wire. This is the essence of the 420 and 664 patents. From my perspective, this is exactly what Google's search engine does.
Google and the other search engines use the Lang/Kosak relevance filtering technology by filtering and presenting search and search advertising results based on the combination of an item's content relevance to a search query and click-through rate from prior users relative to that item. This filtering technology is what makes search engines work so well and why search engines are able to generate such large revenue streams through advertising.
Prior to using Vringo's technology, Google tried two other methods, neither of which proved viable. It looks like Google's tremendous revenue stream is largely a result of switching to Vringo technology in 2005/2006. I can only speculate, but it seems that if Google had not begun using Vringo's patented technology, it may not have become the predominant search engine.
For a more in-depth understanding of this case, I definitely recommend that you read the complaint. It's fairly easy to understand, and is essential reading for anyone who is considering investing in Vringo.
I also recommend reading the 420 patent. This is not easy reading, but it's worth the effort.
Now let's look into the question of whether or not Google is willfully infringing. First off, the Vringo patents are among the most cited in this field of Internet search and are foundational to Internet search technology. Both AOL and Google have their own patents which cite the Vringo patents as art that existed prior to the time of filing. Both Google and AOL have been aware of the Vringo patents for quite some time.
The patent office has seen these patents many times. These are not patents that sat in the garage and collected dust for a decade. They are foundational patents that many people in a lot of these companies have seen for years.
Further to that point there is a particular portfolio of patents that received a lot of notoriety a few years ago. Those patents were originally filed by a company called Overture. Overture sued Google for patent infringement. Yahoo purchased Overture to continue the litigation against Google, and that also got Yahoo off the hook in terms of infringement. Those Overture patents in particular are interesting because the patent applications were initially rejected at the patent office because of Vringo's 420 patent. The Overture patents had to be trimmed back because of the 420 patent.
Many people have looked at these patents, and if there was a way to get them invalidated, we probably would've seen it or heard of it by now. For example in the Overture case, I'm sure Yahoo tried to get the 420 patent invalidated so they could proceed with the Overture patents. But they didn't.
For many years, Google and other tech heavyweights have filed their own patents which mentioned the Vringo patents. How could Google mention the Vringo patents without being aware of those patents? The more I look into this, the more it appears that Google's infringement was willful. No wonder Google has 50 attorneys working on this case.
To be conservative, my analysis does not include the assumption of willful infringement, however if willful infringement is proven, the settlement figures could be larger than what I've projected. More importantly, willful infringement makes a jury's decision to rule against Google, almost inevitable.
But this court case is not the end of the road for Vringo. In my opinion, most search engines, including Yahoo and Bing could be liable, and I believe we will see significant lawsuits in the future. I expect that both Yahoo and Microsoft are looking at Vringo as a takeover target. Not only could these companies remove their patent liabilities, but Vringo could provide phenomenal future revenue for both companies. A bidding war between Microsoft, Yahoo, and Google would not be surprising.
Here are some other facts that make this a phenomenal trade.
Number one: Google requested a re-exam for only one of the two patents in the lawsuit. This is very unusual because most of the time, defendants will automatically request re-exams for all patents involved. Why didn't Google request a re-exam for both patents? Apparently Google must have believed there was only one patent that had a chance of getting a re-exam. But Google was wrong there also. The patent office rejected Google's request because of various deficiencies. To me, this patent office rejection greatly affirms the strength of the Vringo patents.
Number two: The outcome of the recent Markman hearing couldn't have been better for Vringo. It was a clean sweep for Vringo, uncommon in Markman hearings. There was some misinformation circulating immediately following the hearing claiming that Vringo had won 4 claims and lost 2. Vringo did win 4 claims, but the other 2 were changed by the judge in ways that benefit Vringo.
Number three: About a week ago, Google's lawyers asked the judge to reconsider the Markman ruling. Google is basically telling the judge that he made a mistake. This is a desperate move on Google's part, and I anticipate the judge will deny Google's request. This could happen any day now and could provide a powerful catalyst for the share price.
Number four: The damages report from the expert witness is due in the next couple of weeks. This expert will be giving Vringo an estimate of the total dollar value for this case. No matter how you look at it, this will be a big number. The information may or may not be made public, but as is often the case, there could be leaks. What do you think will happen if the expert comes up with a $2 billion damages estimate? If a number like that hits the Street, Vringo shares could skyrocket.
Number five: Vringo made a very smart tactical decision when it decided to try the case in the Eastern District of Virginia. This particular court system is the fastest in the country. But more importantly, 67% of the rulings in IP cases favor the plaintiff.
Number six: In addition to Donald Lang and Andrew Kozak, Vringos' IP team has a couple of other heavyweights. First we have David Cohen, who left the Nokia Worldwide litigation team to join Vringo. He was uniquely responsible for the litigation strategy that extracted $1 billion from Apple.
We also have Vringo board member, Donald Stout, a cofounder of NTP and preeminent patent attorney. He conceived of and implemented the patent infringement case against Rimm (RIMM), which netted NTP over $600 million. One extremely important fact for shareholders is that Donald Stout was an examiner at the US patent office, and he knows patents like very few attorneys ever could.
But here's something that I think may be more important than anything else I've written in this article. Donald Stout was so impressed with Vringo's patent portfolio that he invested his own funds and currently owns over 1 million Vringo shares. He has the background and experience to make an informed decision about the quality of Vringo's patents, and his vote of confidence speaks volumes about the strength of Vringo's patents. His due diligence was greater than anything you or I could even come close to achieving. If a patent attorney and patent examiner such as Donald Stout buys Vringo shares, I am a buyer also.
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Disclosure: I am long VRNG.