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No Security In VirnetX Holding Corp’s (VHC) Stock

Tuesday, April 12th, 2011

Very few times in the last 15 years have I found a stock as expensive as VHC.  The only comparable situation that comes to mind is Google (GOOG) at its IPO. Our models showed that to justify its IPO price Google would have to grow at over 100% for at least 2-4 years. I thought that was awfully high for any company, but I was wrong as Google turned into one of the greatest companies and stocks of the past decade.

Is VHC the next Google? The market’s current valuation seems to suggest it is that and much more.

At $25.50, the current stock price implies the company will grow its revenues at over 100% compounded annually for 15 years while, simultaneously, improving its return on invested capital (ROIC) from -80% to over +120%. Shoot, those expectations make GOOG’s early valuation look quite small.

VHC bulls would say the VHC story has less to do with organic revenue growth than it does with settlement income.

Nearly all of the company’s 2010 reported Net Income profit comes from a $200mm one-time gain from the settlement of a patent infringement suit against Microsoft. VHC has similar suits pending against the likes of Aastra, Apple, Cisco, NEC, Siemens and Mitel.

So let’s check the bull case for VHC from the settlement income angle. We do that by quantifying current market expectations for the amount of settlements the company would have to win from the companies it is currently suing.

Our discounted cash flow analysis shows that VHC would have to win a $200mm settlement every year for each of the next six years to justify the current stock price. And expectations do not stop there. In addition to the 6 consecutive, annual $200mm settlements, the company’s organic revenues would have to rise to and maintain a high enough level to generate about $90mm in after-tax cash flow (NOPAT) after the settlements end. The company’s 2010 NOPAT, without settlement income, was -$44mm. Beyond the aforementioned achievements, no further growth expectations are in the stock.

As one of April’s most dangerous stocks, we find that VHC’s 2010 reported earnings are misleading if you do not believe that future settlement income will be recurring at the $200mm level. Owing to the $200mm gain from the settlement of a patent lawsuit against Microsoft, the company reported a $54mm rise in accounting earnings to $41mm or $0.84 per share. Removing the patent infringement settlement gain and looking at the economic earnings, we find that VHC’s profits declined by $35mm to -$47mm.

Making matters worse, VirnetX Holding Corp’s auditors issued an “Adverse Opinion” on the company’s internal accounting controls. Below is the direct quote from page 58 of the 2010 10-K.

“Specifically, the Company’s controls were not designed or operating effectively to ensure that Series I Warrants were completely and accurately recorded as a derivative liability, measured at fair value, with changes in fair value recognized as gain or loss for each reporting period thereafter.”

While not necessarily an “Enron-like” indictment on the company’s accounting practices, investors should be aware that “Adverse Opinions” on internal controls are quite rare. We have found only 70 in about 7,000 filings.

VHC gets our Very Dangerous rating because we believe the downside risk dwarfs the upside potential of the stock. Click here for a free copy of our report on VHC.

Given that the stock’s current valuation already implies the company will win at least 6 more $200mm settlements, we think there is little incremental upside potential. If the company falls short of those expectations, the stock could be in for a big drop.

In a business where investors make money by buying stocks with low expectations and selling stocks with high expectations, VHC fits the pro­file of a great stock to short or sell.

Note: I may initiate a short position in VHC within the next 72 hours.

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3 Comments

  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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