Alpha Exposure

About the Author Alpha Exposure

Alpha Exposure writes about long term fundamental investment ideas, and invests in them as well. This author has substantial investment research experience.

VirnetX Obfuscates The Truth: Stock Worth Under $1

In his book, “Fooling Some of the People All of the Time,” David Einhorn recounts his encounters with employees at Allied Capital and Wall Street analysts who covered the stock that disputed his work while readily admitting that they had not read or seen his presentation. While it seems that VirnetX (AMEX: VHC) is aware that we have written about them, it appears to us that they are purposefully obfuscating the truth. The CEO during his “fireside” chat as well as VirnetX’s press release on September 19th, did nothing to refute what we argued in our most recent article. In this article, we will compare what VirnetX said in their press releases and conference call to what we have written.

During the “fireside” chat, the CEO made a point to say that VirnetX’s patents had been validated by the courts. We fully agree that the district court and Court of Appeals for the Federal Circuit (CAFC) have upheld the patents asserted against Apple (NASDAQ: AAPL) and we even pointed this out in our article. However, we also pointed out that the courts and PTAB have different standards for examining patents and that patents that are upheld at the district court level can be overturned by the PTAB. The CAFC can then agree with the PTAB that the patents are invalid and throw out all non-final judgments. This sequence of events was what played out in Fresenius, USA Inc. v. Baxter International, Inc. which is described in this article. Therefore, while the courts have upheld VirnetX’s patents, we believe that there is a lurking danger from the reexamination proceedings at the PTAB that shareholders may be unaware of and that VirnetX seems unwilling to acknowledge.

In its press release, VirnetX also noted that “The USPTO has terminated the reexamination proceedings with respect to certain claims of VirnetX’s U.S. Patent Nos. 6,502,135; 6,839,759; 7,418,504; and 7,921,211.” It is important to note the term “certain claims” in this sentence. The claims that were dismissed are of no relevance to the lawsuit against Apple because the dismissed claims were not being litigated. The claims being litigated are still under reexamination. The PTAB noted that the “petition to terminate reexamination of the remaining claims of the ‘135 patent under reexamination, i.e., claims 1-9 and 13-18, in the ‘1679 reexamination proceeding is dismissed.” Put simply, this means that the reexaminations are continuing with regards to claims 1-9 and 13-18. Since Apple’s VPN On Demand product was accused of infringing claims 1, 3, 7 and 8 of the ‘135 patent, it remains likely that the PTAB will uphold its initial findings of invalidity for these patent claims and that all of the patent claims which Apple was found to have infringed will be invalidated. Upon an invalidation, Apple would owe nothing for VPN On Demand’s alleged infringement of this patent.

We also do not want to let the concerns we raised around the problems that a time bar pose for VirnetX be ignored. As we pointed out in our last article, we believe that the reason VirnetX has yet to launch lawsuits against other parties is because VirnetX knows that if it sues someone else, the new defendant will not be time barred from filing new IPRs. Since past IPRs have only been rejected due to technicalities around the time of their filing relative to the date of a lawsuit being filed, there is a very high probability that IPRs from an entirely new entity would be accepted. If the PTAB subsequently invalidates the patents before the Apple case finishes, then Apple would no longer be liable for any damages. We believe that VirnetX is well aware of this risk and does not want to do anything that could put its patents in further jeopardy. VirnetX even admits in its press releases that the dismissals of certain Apple and Microsoft (NASDAQ: MSFT) claims were due to the parties being time barred from filing IPRs. Indeed, for the claims where the time bar did not exist, Microsoft had its claims accepted. VirnetX has been lucky that it has not had to actually argue the merits of the patents in front of the PTAB. Because VirnetX faces the risk of additional IPRs, we are very skeptical of VirnetX’s claims to be close to additional licenses. After all, why would a company make a licensing deal with VirnetX when it can file an IPR and see what happens over the course of a couple of years?

During the “fireside” chat, we were struck by several other claims made by the CEO. First, he told investors that the company’s cash burn was, “less than $1 million per month in burn rate…” That claim certainly does not square with what the financials actually show. As we pointed out in our earlier article, the company ended last year with $38.9 million in cash (defined as cash plus investments held for sale) and now 6 months later, it is down to $25.7 million – or about $2 million per month of cash burn. We have trouble seeing why the cash burn will decline given the ongoing legal expenses. The CEO also told investors that the CAFC had determined what the royalty rate would be going forward and that the only thing left would be what the base that you apply that royalty rate to would be. During the “fireside” chat, CEO Kendall Larson stated, “I also want to point out that the guidance for the royalty has already been given. The guidance is use the licenses, you asked me the question earlier about the patents that have been licensed. We have comprehensive patent portfolio licenses with several strategic vendors such as Avaya, Siemens, NEC, all those licenses that were done are all over 1%, and so the guidance that the Federal Circuit gave us is to use the VirnetX licensing model as our guide. All of those are over 1%.” However, this is simply not true. Nowhere in the CAFC opinion does the court say that only the royalty base and not the rate is still up for dispute. In fact, the CAFC opinion even noted, “Finally, Apple notes that the sixth license covered sixty-eight VirnetX patents, and was therefore much broader than the license to four patents Apple would be seeking in the hypothetical negotiation. It also equated to a 0.24% royalty rate, which is significantly lower than the 1-2% rate Weinstein testified VirnetX would accept.” Even if VirnetX were to ultimately achieve this 1% rate, we showed in an earlier article that at this rate and using the $29 royalty base that was undisputed by the CAFC, there is not much value to VirnetX’s stock. The company also left unaddressed the open question of whether VPN On Demand deserves a much lower royalty base than FaceTime does. The higher royalties that might be due for FaceTime may never be realized because based on Apple’s description of how FaceTime works, the new definition of “secure communications link” appears to rule out infringement by FaceTime since the anonymity limitation is not met.

Of the three damages theories VirnetX originally presented, only one attempted to apportion between FaceTime and VPN On Demand. Even though we know that the damages VirnetX sought were too high, we know that the apportionment was approximately 75% to FaceTime and 25% to VPN on Demand. As was noted in the CAFC ruling, “This theory yielded a $708 million demand, consisting of $566 million for products including both FaceTime and VPN On Demand, and $142 million for those including only VPN On Demand.” (Link) This section of the CAFC ruling clearly talks about VPN On Demand having significantly less value than FaceTime. If only 25% of damages should have been attributed to VPN On Demand, then the jury award would have been $92.3 million. However, this $92.3 million number gets further reduced after accounting for legal contingency fees as well as SAIC’s portion of the award. As we see it, VirnetX simply collecting an ongoing royalty for VPN On Demand is unlikely to bring VirnetX to profitability. Below we lay out our math on why we believe this:

Screen Shot 2014-10-22 at 15.00.44

Keep in mind that the starting point for this calculation of $142 million does not represent 1 year of damages, but rather multiple years of damages on a variety of products including iPhones, iPods, and iPads. VirnetX claimed that there was infringement going all the way back to the original iPhone and the iPod Touch, both of which were launched in 2007 while the iPad was launched in 2010. There is no good way to know how many devices or how long a period of alleged infringement this verdict covered, but we do know it would be incorrect to think that VHC would collect $63.7 million a year. If we assume the damages in this case cover a blended period of 3 years, that would bring the average royalty per year down to $21.2 million. This figure would be lower than VirnetX’s current cash burn which is over $25 million a year. Therefore, over the next 4 years before the patents expire in October 2018, VirnetX would collect almost $85 million in royalties. Unfortunately, they would also burn over $100 million in cash over that time period leaving nothing but dilutive equity raises for shareholders.

Even if VHC were to be awarded the full $142 million, this would yield a value of only $98 million to VirnetX:

Screen Shot 2014-10-22 at 15.00.55

Once again, keep in mind this $98 million does not represent 1 year of damages, but rather multiple years of damages. If again we assume the damages in this case cover a period of 3 years, that would bring the average royalty per year down to $32.7 million. This figure would be greater than VirnetX’s current cash burn of over $25 million a year, but would only leave around $7.7 million for shareholders or approximately $0.15 a share each year. However, since the patents would expire in October 2018, there would only be about another four years of collections or approximately $0.60 per share incremental. Thus, a best case scenario (which we believe is unlikely) would result in a total value of $2.50 per share for VirnetX.

Finally, we would like to address the meaning of the CAFC upholding the jury verdict of no invalidity. Many shareholders seem to believe that this is binding on everyone. It is not. It is only binding on Apple and only then when the case is final in all respects. This case is unlikely to be final in all respects until 2018 and that means that Apple’s ongoing Inter Partes Reexamination proceedings can proceed. If Apple is successful in the ongoing reexaminations, then VirnetX’s entire case would be dismissed. Also, in the meantime, anyone else who gets sued will get their own crack at showing invalidity, and if VirnetX ever loses (either by a jury or the PTAB), the finding of invalidity becomes binding on VirnetX and it can’t sue anyone over the invalidated patents. Some shareholders don’t understand that fights over validity will go on until the patents expire, especially if VirnetX threatens others with the same patents. As for the patent expiration, as was pointed out by one commenter there seems to be some contention over when the patents expire. All four of these patents claim priority to application 60/106,261. This application was filed in October 1998 and since the patents have a 20 year life to them, they expire in 2018.

In conclusion we heard nothing in the CEO’s “fireside” chat or in VirnetX’s press release which refuted our opinion that the patents remain highly susceptible to being invalidated and that the stock is worth well less than $1.00 per share.

According to, which measures analysts’ and bloggers’ success rate based on how their calls perform, analyst Alpha Exposure has a total average return of 40.7% and a 76.2% success rate. Alpha Exposure is ranked #153 out of 3907 bloggers.

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