Today is a big day for VirnetX shareholders. The jury is currently deliberating in the company's patent infringement suit against Apple. A positive decision could double the share price.
Following are my reasons for why VirnetX could prevail:
1. Patent validity has already been established. The appeals court has already decided the patents are not invalid. These 4 patents were also deemed valid and infringed upon in the previous jury trial. That gave VirnetX strength in court because they didn't need to prove patent validity. Most importantly, the jurors will not have to figure out whether or not the patents are valid, that has already been established. That simplifies their job, and puts VirnetX in a favorable light.
2. The US Court of Appeals established that Apples VPN on-demand product infringed upon VirnetX technology. The VPN on-demand is the backbone of Apple's enterprise business and the fact that infringement has already been established puts VirnetX in an even stronger position in the eyes of the jurors.
3. There has been a steady stream of insider buying with some increasing their positions by 25%. Insiders best understand VirnetX's position in the current trial and in my opinion these insiders would not have been buyers unless the outlook appeared favorable for VirnetX. In other words, if they were worried about the outcome they would not be buying stock right before the trial, they would be selling.
The focus of this trade is based on the following quote from the appeals court:
"We affirm the jury's findings that none of the asserted claims are invalid and that many of the asserted claims of the 135 and 151 patents are infringed by Apple VPN on-demand product."
It can't get any clearer than that. I especially appreciate the phrase; "many of the asserted claims." We're not talking about just 1 or 2 claims here.
With patent validity and infringement already established, I believe VirnetX could prevail in court, and the damages and future royalty numbers could be sizable. In other words, it appears Apple is going to pay, we just don't know how much.
Why VirnetX could go from $4 to $8 this week
In the current trial with Apple, VirnetX is asking for $1.20 per unit in damages, or $532 million based on 443 million units (iPhones, iPads etc). Thus far only 238 million units have been proven, so all calculations will be based on 238 million units. These will be conservative calculations because it could be determined that 443 million units have infringed.
VirnetX is asking for $1.20 per unit in damages, and Apple is claiming $.19 per unit is reasonable. Typical negotiation tactics. Let's take a worst-case scenario, and say that VirnetX only gets $.19 per unit. That would be a $45 million award to VirnetX for damages. If VirnetX has proven infringement for any of the other accused functions, the number of infringing units goes up to 443 million. That would bring the damages payment up to $82 million.
But what's really important to shareholders are the ongoing royalties. I will base calculations only on iPhones sold in the United States. Of course Apple sells iPhones worldwide, so ultimately VirnetX should receive worldwide royalties. If Apple and VirnetX negotiate a settlement, worldwide royalties could be included.
If 100 million iPhones are sold in the US each year, at $.19 per unit, that would bring VirnetX $19 million a year in annual revenue, of which about $13 million would go towards earnings. With 53 million shares outstanding, that would be $.24 per year in earnings. With a PE of 15, that would give VirnetX a shareprice of $3.67.
What I like about this calculation is that it sets fair valuation for a worst-case scenario at $3.67. In other words, if Apple gets what it's asking for, the stock should trade around yesterday's $3.69 closing price.
However, it would not be surprising to see the share price trade below $3.67, at least temporarily, based on what would be considered a non-ideal outcome for VirnetX. But one thing to consider is that if Apple gets what it wants, $.19 per unit, it may not appeal, and VirnetX should begin receiving payments relatively quickly.
In my opinion the jury will award more than $.19 per unit, I'm just using this number to present a worst-case outcome.
Let's take a more optimistic view and say that VirnetX gets what it's asking for; $1.20 per unit in damages. With 238 million infringing units, VirnetX would receive a damages award of $285 million. If 433 million units are found to have infringed, the damages number would go up to $532 million, exactly what VirnetX is asking for.
For ongoing royalties, VirnetX would receive $120 million annually, of which about $84 million would go to the bottom line. That would give VirnetX $1.58 in earnings, and a shareprice of $24, assuming a PE of 15. Given the dependability and predictability of the revenue, a PE of 15 appears conservative.
Let's say the jury gives VirnetX something in the middle; $.70 per unit. VirnetX would receive a damages payment of $166 million, $303 million if the infringing unit number is determined to be 443 million units.
$.70 per unit would equate to $70 million in revenue, about $49 million in earnings, and an EPS of $.92. With a PE of 15, VirnetX's share price would be $13.86.
It's important to remember that VirnetX suggested that $1.67 per unit would be in a more appropriate number, so the jury will have that number in mind when it makes its decision. If $1.67 is granted, that would equate to a $33 share price and $723 million in damages.
With the current damages calculations, VirnetX is only asking for a fraction of 1%, considerably less than the 1.5% it has received in other licensing deals. This could inspire the jury to go higher than $1.67 per unit.
As a point of reference, remember that Qualcomm's royalties for 3G and 4G LTE E iPhones range from 3.25% to 5%. Finjan has demonstrated rates of 8% and 16% for their security patents.
Keep in mind that these shareprice numbers are calculated only on royalties, and do not include interest, damages or treble damages if willful infringement is imposed. Also not included in this estimate is LTE - A licensing revenue that we could begin seeing after the trial. When all these factors are taken into consideration, one can easily foresee a shareprice well above yesterday's $3.69 closing price.
The appeals court didn't object to the $368 million number
It's important to note that the appeals court said nothing in their opinion about the $368 million award being too high, which they have done in other opinions. They just didn't like the damages model that VirnetX used.
Obviously, given the different damages number VirnetX is proposing, the company changed the damages model, but my point is that the courts and the jury shouldn't have any problem with a number higher than $368 million, given that more time has elapsed since the original $368 million award. More elapsed time equates to a longer infringement time frame.
Don't forget about interest payments
From the last Apple trial there was another important order issued by the court that provides another perspective regarding how much VirnetX could receive from Apple.
The Court granted VirnetX's motions for pre-judgment interest, post-judgment interest, and post-verdict damages to date. Specifically, the Court ordered that Apple pay $33,561 in daily interest up to final judgment and $330,201 in daily damages for infringement up to final judgment for certain Apple devices included in the Verdict.
About 1000 days have passed since that order, bringing the daily interest up to $33 million and the daily damages for infringement to $330 million, providing a total of $363 million.
What we don't know, is whether or not this order is what will be applied or a different interest rate will be applied.
The wildcard; LTE-A licenses
While most investors are focused on the upcoming trial, there's another area that provides tremendous potential for VirnetX; LTE-A licenses. VirnetX's four affirmed patents appear to be necessary for the implementation of LTE-A which is being rolled out by all major phone manufacturers. It's my understanding that all phone manufactures who support LTE-A will need to obtain licenses for these patents. Any announcement of a significant licensing deal would be positive for shareholders, and could happen at any time, although I don't expect any announcement before the conclusion of the trial. This is another area of value that investors are currently ignoring, but once an announcement of a licensing deal is in the picture, VirnetX will be transformed to an entirely new level.
A short squeeze could push the share price into the stratosphere
With 28% short interest, any positive news will magnify share price appreciation. First, we would have buyers entering the market based on a court victory. That alone could more than double the share price.
But more importantly, the short-sellers will be forced to buy shares in order to cover their short positions. With almost 13 million shares short, that's a huge volume of shares that would need to be bought within a very short time frame. When the short-sellers panic as a result of a rocketing shareprice, any share price appreciation would be amplified.
With large demand coming from these 2 groups of buyers, and very little supply because many investors will not want to sell after a positive announcement, we could see short squeeze of monumental proportions. It's all about supply and demand, and when demand outstrips supply by a large margin, the upward trajectory becomes a runaway train.
An injunction would be a home run for investors
The other element investors seem to have forgotten about is that this time around, based on VirnetX's new Gabriel software, it appears there's a higher probability of VirnetX getting an injunction.
Two of the courts primary requirements for an injunction are patent validity and infringement, both of which have already been proven. An injunction delivers a crippling blow to any defendant because it prevents a defendant from manufacturing or selling any products that are deemed to be infringing.
If an injunction is granted in this case, the outcome for VirnetX could be better than anyone expects. Most importantly, an injunction would motivate Apple to settle as quickly as possible which should have a major effect on VirnetX's shareprice.
Willful infringement could deliver treble damages
Treble damages based on willful infringement are a possibility given that infringement has already been proven. Whether or not the jury or the court will judge infringement to be willful or not is anybody's guess. But, if the court believes Apple was willfully infringing, and treble damages are applied, we could be dealing with damages numbers that are mind-boggling.
Apple should just buy VirnetX
If VirnetX prevails in court, the most economical solution for Apple could be to buy VirnetX. I assume Apple is already considering this option, however I doubt that Apple would offer a price that would tempt VirnetX. Remember, Kendall Larsen did not sell one share when it was trading above $40, so he seems to believe the company is worth more than $2 billion. But, you never know, and with Apples $215 billion in cash, a buyout would not be surprising.
Insiders appear to be bullish about the trial outcome
Last May Michael Angelo, a VirnetX director received 8333 shares from the company at zero cost, which took his position to 39,000. Then on August 28, he purchased another 10,000 shares in the open market for $3.19 per share.
Robert short PhD, a director for VirnetX, but most importantly the company's chief technology officer and chief scientist received 13,333 shares in July at zero cost, bringing his position to 40,380 shares. He then purchased another 10,000 shares on the open market, increasing his position by 25%. Then in November he bought another 3000 shares, 1557 shares, and 5440 shares.
And then we have Kendall Larsen, VirnetX's CEO purchasing 27,700 shares in August.
Altogether that gives us 57,997 shares that were recently purchased by insiders. These insiders understand the potential outcome of the trial better than anyone on the outside, and in my opinion their purchases indicate that they believe the outcome will be favorable for VirnetX.
We couldn't ask for a better judge and jury
From what I can determine, we have an excellent judge handling this trial; Judge Schroeder. He appears to be fair, honest, intelligent, and reasonable. I believe Judge Schroeder sitting on the bench bodes well for VirnetX since all that is being asked for is justice.
Also, given the David and Goliath nature of this trial, $200 million VirnetX versus $500 billion Apple, we couldn't ask for a better venue than Tyler Texas. The last jury sided with VirnetX, and given that validity and infringement have already been proven, in my opinion there's an even higher probability of a positive outcome with a new jury.
What's the risk?
The risk is that I am wrong, insiders are wrong, and the jury or judge grants VirnetX a relatively small award. If this occurs VirnetX could trade below fair value. We cannot predict what the jury or the judge will award.
We also don't know when VirnetX will begin receiving payments because Apple will undoubtedly appeal the case even though that appeal could be denied.
There is also IPR risk, although that shouldn't affect this trade given that it's a longer-term event.
This is a unique opportunity because infringement and validity have already been determined. To some degree, it's like having the answers to the test before we take it.
With that in mind, it appears inevitable that VirnetX will receive awards for damages and future royalties. We just don't know how much. If willfulness is applied, the numbers could be huge. If justice is served, this could be the trade of the year!
Disclaimer and disclosure: It is probable that the author and his associates have a position in the subject securities consistent with the opinion expressed in this article and they reserve the right to buy and/or sell the securities mentioned in this article, at any time without further notice. For complete disclosure and disclaimer information please click here.
Disclosure: I am/we are long VHC.