Sign Up For The Next New Constructs Webinar






Navigation

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

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.

10 Comments

  1. mike says:

    You are misinformed. Virnetx going to get their lions share of revenues from licensing not lawsuits

  2. Brent says:

    How does this uninformed author FAIL to even refute the contents of the following very public article relating to VHC’s REAL source of future revenues???

    http://seekingalpha.com/article/260612-virnetx-opens-door-to-licensing-its-multi-billion-dollar-4g-patents

  3. Alexander says:

    Wow, obviously the stock is coming down again, but you seem to have no idea what you are talking about, because purely hiding behind statistical data hardly gives you an accurate picture of what is going to happen to this company in the future. In my opinion the next generation of mobile network has no way around VHC security protocols and thus the company will earn billions in royalties. If you honestly believe that this company will try to continue suing others as their main tactic of profit creation, you’re way off.

  4. troy says:

    Are the patents in question truly essential? Are companies like Interdigital able to circumvent the patent with new technology?

    Do you think it is possible for VirnetX to build a royalty/license based business vs relying on fully paid-up deals similar to the MSFT deal? Are they able to entice companies to work on license deals rather than go through litigation? Are there enough margins for companies to be able to negotiate a mutually beneficial licensing deal?

  5. trojanhorse says:

    David, this is some of the WORST journalism [and potentially investment advice] I have ever witnessed.

    VirnetX is currently considered a “development stage” company that is right now bringing their patent portfolio forward for licensing. The degree of future revenues will be heavily weighted on their patents being recognized as essential to 4G security standards. Some of these patents are the same ones that were reaffirmed by the U.S. Patent and Trade Office following the Microsoft settlement. In addition, VirnetX has retained Wilson Sonsini to assist them in wide-scale licensing of their patents portfolio.

    VirnetX has sent the necessary paperwork to the standards committee for review/confirmation of essentiality. Those details are issued in PRs and available on the company website. Coincidentally, the general assembly of the 4G secutity committee will be deciding on many of these issues next week…(like you did not know that).

    David, this is some of the WORST journalism [and potentially investment advice] I have ever witnessed.

    VirnetX is currently considered a “development stage” company that is right now bringing their patent portfolio forward for licensing. The degree of future revenues will be heavily weighted on their patents being recognized as essential to 4G security standards. Some of these patents are the same ones that were reaffirmed by the U.S. Patent and Trade Office following the Microsoft settlement. In addition, VirnetX has retained Wilson Sonsini to assist them in wide-scale licensing of their patents portfolio.

    VirnetX has sent the necessary paperwork to the standards committee for review/confirmation of essentiality. Those details are issued in PRs and available on the company website. Coincidentally, the general assembly of the 4G secutity committee will be deciding on many of these issues next week…(like you did not know that).

    You failed to point out to your readers or you intentionally ignore key details, which I mentioned are plainly visible and accessible via the company’s website. Your avoidance to provide any useful and material information suggests you know nothing about the company. Maybe you are the laziest financial journalist of all time? Or you had a motive to publish a negatively slanted article?

    I am not claiming the details in your write-up are false. I am only pointing out that you delivered a gross disservice to your audience. It is extremely interest how you take the time to read through an SEC filing, CHERRY-PICKING a non-issue sound bite, and on the other hand you somehow overlook to report on the reason why the stock has generated such speculative interest? You only discuss lawsuits…because they too have a way to be perceived as negative and risky.

    Finally, what kind of idiot (who also claims to research companies) announces they MAY short a stock in the next 72 hours when knowingly the very article itself would create price pressure on the stock? Not only are you a crappy journalist, but you’re not very smart…but since I really believe you are aware of most of the things I have pointed out, you are likely just a sorry stock manipulator.

    tojanhorse

  6. David says:

    I’m curious, how much did you make researching (cough!) this stock.

    Hope your short position serves you well.

    I believe there’s laws against playing these games.

    Too bad the FTC don’t do their job either.

  7. VHC has some promising technology and the patents to help protect it. I do not contest that.

    The key point of my valuation analysis is to provide a framework for assessing exactly what kind of revenue and profits those patents must produce.

    There are two primary paths of growth for the company, which are addressed as per below:

    1) Revenue growth, in the form of licenses of other deals
    > “At $25.50, the current stock price implies the company will grow its revenues at over 100% com pounded annually for 15 years while, simultaneously, improving its return on invested capital (ROIC) from –80% to over +120%.”

    2) settlement income.
    > “…VHC would have to win a $200mm settlement every year for each of the next six years to justify the current stock price.”

    The question that a rational investor must ask is: will the company’s future growth be meaningfully better than either scenario above or some combination thereof.

    VHC may very well be a great company…as some strenuously assert. However, a good company is not always a good stock. My opinion is that the valuation of the stock gives it a Very Dangerous risk/reward profile.

    There are simply too many other attractive-or-better-rated stocks to choose from to warrant taking the risk of betting on a better financial future than what is already baked into VHC’s stock price.

  8. Steven Gansz says:

    Hate to break it to you guys, but before you go criticizing someone about their money management skills you might want to check their performance record. Chances are you aren’t anywhere near what NewConstructs does, especially over longer periods of time (where only true investors care to be measured). I don’t like to come on and defend someone (in this case I don’t have to), but it’s just amazing how few participants in the world of finance understand tried and true moneymaking practices (see below).

    I could care less about VHC, or any SINGLE stock. However, the arguments I’ve seen for the stock are the same for every “next great thing”. Separating the business from an operational standpoint and a legal standpoint is the only rational thing to do and at least from a quantitative standpoint, the people here are spot on.

    However, as David mentions Google was a truly expensive stock at its IPO, but it turned out to be a terrific company and the value of the stock reflects that. The best investors rarely load up on a budding Wal-Mart or Microsoft, because they rarely satisfy any criteria for successful investment. Investing isn’t about hitting grand slams every year it’s about always hitting singles.

    Most value investors will gravitate towards this site because of the solid research it does. AND, because they find a lot of the same companies under review that they themselves might hold. I would seriously consider taking a minute to realize what you are up against when you try and refute some of the claims that have been made here….

    In closing, let me break out one of my favorite quotes from The Intelligent Investor, “It would be rather strange if – with all the brains at work professionally in the stock market – there could be approaches which are both sound and relatively unpopular. Yet our own career and reputation have been based on this unlikely fact.”

    That’s something I’ll put my name behind!

    P.S. Great site David. I actually came across it one day because I was looking for a way to do exactly what it appears you have; automate the 10-k scouring process. I guess that’s what my Electrical Engineering degree says I should be doing. Ha!

  9. Some of the comments on this article (here, Forbes and Seeking Alpha) compel me to explain a key difference in my approach to investing and those who are so focused on VHC’s IP and patents.

    The issue here is that we have fundamentally different approaches to the market. You are a “speculator” and I am an “investor”. For detailed definitions on those terms, go to:
    http://ncblog.cloudapp.net/2010/06/07/investing-vs-speculating/

    As a speculator, you invest based on your expectations about the near-term direction of the price.

    As an investor, I must take a more disciplined approach. I focus on the risk vs reward of a stock. This approach, akin to Buffet’s, means that I may miss big gains in some story stocks. But, as an investor, I am willing to sacrifice betting on less certain outcomes in exchange for the confidence I have in the outcomes of the bets I do make.

    When I say “disciplined approach”, that primarily means that valuation matters. And the valuation of VHC is super high. So high, that no true “investor” could justify investing in it. For specifics on how high the valuation is, see details above. When the market price implies 100% revenue growth compounded annually for 15 years, an “investor” must take pause. If that “investor” has other cheaper investment alternatives, then he is compelled to favor them. In the case of US stocks, I know there are many, many stocks with far better chances of exceeding their market expectations than VHC. Do you realize that 15 years of 100% rev growth means VHC’s revenue will have to grow to $2.5bn just to make current stock price reasonable. The higher the stock price goes, the higher the expected cash flows and, therefore, the higher the hurdle for the company to exceed expectations, which are what I believe drive stock prices.

    Here is a picture of my DCF model, which shows all assumptions. The math is what it is.
    http://ncblog.cloudapp.net/wp-content/uploads/2011/04/DCF-for-VHC_LicenseGrowthScenario.pdf

    Unless you believe that VHC’s future cash flows are going to be meaningfully greater than what is already implied by the stock price, then you should not own the stock.

    In my opinion, no matter how good VHC’s IP is, the likelihood of VHC’s future cash flows being meaningfully higher than what is already baked into the stock price is low – especially when compared to other stocks in the market.

    Another key point that I have not see from the speculators is that opportunities like the one you describe for VHC do not exist in a vacuum. Do you realize how much competition VHC will attract if its future is really as bright as you believe it to be. Big companies (with far greater resources) are probably already looking for a way to break the potentially monopolistic hold that VHC’s technology may give it on securing 4G communications, etc.

    Also, you must understand that patents do not prevent competition, they only slow it down temporarily. I know this b/c New Constructs has a patent, too.

    In summary, as an “investor” looking at VHC, I need not be as expert in its technology and IP as you b/c VHC’s extremely high valuation takes it off my radar screen no matter what the technology.

  10. trojanhorse says:

    David, I know this is a waste of time because you likely had some motive to put out a negative spin. That seems obvious based on your avoidance to speak to anything other than lawsuits. However, here is another view of the company’s value by a Chief Market Strategist for ICM Capital -

    http://www.investorvillage.com/smbd.asp?mb=8852&mn=5386&pt=msg&mid=10306810

Leave a Message

Your email address will not be published. Required fields are marked *