VirnetX Holding Corporation (AMEX: VHC) Company must Re-file with the ITC as Commission Terminates Investigation - Rationale Behind Decision Appears Inconsistant

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VirnetX Holding Corporation (AMEX: VHC) Company must Re-file with the ITC as Commission Terminates Investigation - Rationale Behind Decision Appears Inconsistant Powered By Docstoc
					                                                                                                         quity Re
                                                                                                        Eq      esearch
                                                                                                                   August 21, 2012

 B                                R
 Pr                                   $25.50         etX  ding Co
                                                 Virne Hold             on
                                                                orporatio (AMEX VHC)
  2-Week Range:
 52                                41.93-11.01
                                                       any                ith      C
                                                 Compa Must Re-file wi the ITC as Comm    mission
 Av Daily Vol. (M
  vg.           MM):                     1.78
                                                 Termin         estigation – Rationa Behind
                                                       nates Inve                  ale    d
 Diluted Shares (MM):                    50.6
                                                 Decisi Appear Inconsi
                                                                 rs       istent
  hares Short (MM
                M):                    ~13.6
 M               B
 Market Cap (US$ B):                    $1.34
                                                       MENT SUMM
                                                 INVESTM       MARY

  nsiders Own:                         ~20%
                                                 Last eveening the Co ommission op  pted to term             vestigation,
                                                                                                minate the inv
  tated Book Val./Sh:                   $1.27            g                          mplaint against Apple. Th decision
                                                 requiring VirnetX to re-file its com                        he
 N Cash/Sh.:                            $1.22            i            odd           f            g
                                                 appears inconsistent/o in light of the following facts:
 N Cash (M):
 Net                                      $62
 LT EPS Growth:
  T                                      15%       a) Pattent ‘181 was granted late last year, an was the o
                                                                       s              e            nd           only patent
                                                      con               n
                                                         nsidered when the ITC ag    greed to hear the case last December.
 Dividend / Yield                         n/a
                                                        ey             g,             was          ve
                                                      Ke point being the patent w a derivativ of the orig       ginal patent
  iscal Year Ends:                       Dec.         portfolio legally assigned to V              AIC
                                                                                      VirnetX by SA in Decem    mber 2006.
  2-mos. Target:
 12                                        $65          hus,
                                                      Th the statem   ment made by the Commiss                  not
                                                                                                   sion – “does n possess
                                                                                     rs            as           al
                                                      all substantial riights” appear inaccurate a the origina portfolio
 ($           2012
                 2E       2013E   2014E
                                                      wa legally assiggned to Virnet and more specifically, p
                                                                                      tX,         e              patent ‘181
                                                      wa developed and granted – VirnetX is the only com        mpany with
 M                   $
                     $0    N/A     N/A                  gal           o              81            as
                                                      leg rights to patent ‘18 (SAIC ha no legal standing).
 Ju                  $0
                     $     N/A     N/A                Fu               n               n,
                                                        urthermore, in our opinion the origin ITC filing included
                                                                                                  nal           gs
  ept               $.5
                    $      N/A     N/A                                               AIC
                                                      documentation indicating SA had assig       gned all paten rights to
 D                 $2
                    2.0    N/A     N/A                VirrnetX – this documentati     ion was sent once again, in recent
                                                                                                  t,             ,
                                                      we               ted            ic
                                                        eeks as indicat via a publi legal filing w              d
                                                                                                   which implied there may
 FY                 2.5
                   $2       $18      $65
                                                      hav been a proc                cal
                                                                        cedural/cleric error.
 G                        609%     261%
                                                   b) Th inclusion o SAIC in thi hearing was rejected a fe months
                                                        he             of            is                        few
 EPS             2E
              2012        2013E   2014E                  o             haw
                                                      ago by Judge Sh – for the reasons stated in section a – logically,
                  70)     $0.07    $0.51                 ere           on           to           d
                                                      the is no reaso for SAIC t be included as it has no direct legal
                                                         s              81.         the           n             egal
                                                      ties to patent ‘18 Despite t impression (based on le filings)
                                                      VirrnetX may h   have had a s strong desire to include S  SAIC as a
                                                      par                           mains unclear as the Comp
                                                         rticipant, we believe it rem                          pany would
                                                      der               fit
                                                         rive no benef – thus, it may be poss                  e
                                                                                                 sible the true desire for
                                                      inc               ated
                                                         clusion origina from the defendant (st                tactic).
                                                                                                 tandard legal t

                                                 Descriptio Based in Zep     phyr Cove, NV, VirnetX was inc  corporated in 20005. Through
                                                 the acquisiition of certain ppatents from Sc                ons              l
                                                                                             cience Applicatio International Corporation
                                                             2               any             ed
                                                 (SAIC) in 2006, the compa has develope a series of tec      chnologies and cuurrently has a
                                                 patent por  rtfolio (GABRIE                  n
                                                                             EL) focused on securing real-    -time communic  cations – its
Ro              o,
  obert V. Tango Jr.                                                                          censing business model. The company has
                                                 intellectual property (IP) iis core to its lic               s
                                                            s                n              nd
                                                 evolved its core encryption technology an currently poss                    le
                                                                                                              sesses IP capabl of securing
(212) 940-9244                                   communica   ations transmiss                t
                                                                             sions over next generation net   tworks (4G/LTE), a critical
  bert.tango@gilf               om               element to standards define by the 3rd Gen
                                                                             ed                              ship Project (3GP
                                                                                             neration Partners               PP).

GIL            URITIES INCO ORPORATED                                                                                       Page 1 of 6
  ease refer to page 6 of this document for importan disclosures
Ple             p                       f          nt          s
                                                                               VirnetX Holding Corporation

                         The ITC hearing focuses solely on injunctive relief, not damages, thus SAIC’s inclusion
                         is not logical. The implication that VirnetX had a desire to include SAIC appears
                         unwarranted – despite the implication based on the Commission’s determination
                         released last evening.

                     a) The ITC agreed to the hearing last December, and has accumulated numerous pages of
                        documents since that time. It seems apparent that VirnetX included the necessary
                        documentation indicating SAIC had assigned its original patent portfolio to VirnetX and
                        paid $35m (one time royalty). Based on public legal filings, it appears documents related
                        to this fact were misplaced and/or overlooked for reasons that appear unclear at this
                        time. However, VirnetX provided the necessary documents once again, implying the
                        ITC had been provided the necessary filings 2x, yet it concluded the company did not
                        have all substantial rights. This conclusion appears inconsistent, as all necessary filings
                        were on hand, in our opinion. Furthermore, the timing of this discovery (lack of
                        evidence regarding the substantial rights) came just prior to the scheduled hearing on
                        September 5th.

                         Net, the company will re-file its complaint and we believe the strength of the evidence
                         will result in the ITC to hear the case at a later date. Last night’s decision will cause
                         hesitation near-term, as it is assumed there is a crack in a core legal argument. However,
                         the fact the ITC agreed to hear the case last December (it receives an overwhelming
                         number of requests) was a positive – the fact it was dismissed at such a late date based
                         on conclusions that probably could have been drawn months ago appears odd in our

                         Looking forward, investors should focus on the following:

                     a) The Federal trial begins in early November and Judge Davis has been consistent in all
                        actions dating back to the MSFT trial; furthermore, his recent Markman opinion,
                        sanctions placed against AAPL, and settlement by NEC, leave us to believe VirnetX key
                        legal arguments have merit – most importantly, the ITC decision has no impact or
                        influence on the Federal case being heard this November
                     b) At the current time, 4 litigants remain (3 have settled) – it is possible others may opt not
                        to go to trial but rather elect to establish licensing arrangements with VirnetX
                     c) Non-litigants may be in active discussions with the company – assuming a deal with a
                        non-litigant were struck, we believe it would demonstrate the importance/substance of
                        VirnetX encryption technology and patent portfolio
                     d) The company’s cash position of approximately $62m leaves its financial condition in
                        very good standing

                         We reiterate our Buy rating and $65 target.

GILFORD SECURITIES INCORPORATED                                                                      Page 2 of 6
                                                                               VirnetX Holding Corporation


                         We believe an investment in VirnetX Holding may involve the following risks:
                        On-going Litigation May be Lengthy – Outcome Remains Uncertain. On-going litigation will
                         continue for several months/quarters – the ITC hearing with AAPL officially begins on
                         September 5th. Despite a favorable Markman opinion and settlement by Aastra, many
                         variables remain. We anticipate highly sophisticated legal tactics will be utilized by
                         existing litigants – a very common practice with intellectual property cases. It is unclear
                         how the various legal systems may view the evidence, presenting a risk regarding the
                         potential for settlements and/or timing licensing arrangements.

                        Trading Risk due to the view the company is a “Concept”. Because the company is in the very
                         early stages of establishing a core business model (licensing agreements), investors have
                         limited tangible evidence of a consistent revenue/cash flow stream - thus determining
                         an appropriate valuation remains speculative. “Concept” models may be volatile until
                         some degree of confidence and understanding regarding its business is achieved.

                        4G/LTE deployments May be Delayed due to a Weak Macro Environment. On-going macro
                         concerns have caused service providers to delay their investments in 4G/LTE
                         infrastructure between 2 and 4 months, in our opinion. Early stage shipments of
                         equipment were expected to begin by late Q4 2011/early Q1 2012 – to date
                         deployments have been limited (China most active) – some degree of acceleration may
                         occur during the 2H 2012, albeit at a moderate pace., Therefore, certain 4G/LTE
                         participants potentially seeking to establish a relationship with VirnetX may pause near-

                        Royalty Rate Debate will Persist and Cause Uncertainty. Debate regarding what royalty rate
                         VirnetX could obtain will persist. The investment community is wary of the potential
                         royalty rate range that the company could obtain (1% to 2% is our assumption)
                         depending on the player and product/application it is providing. Despite concerns
                         within the investment community that the company may structure deals at a rate below
                         the aforementioned range, we feel this risk/concern is not material.

GILFORD SECURITIES INCORPORATED                                                                       Page 3 of 6
                                                                                                                 VirnetX Holding Corporation

Valuation Analysis

Case study - QCOM's QTL division: we estimate approximately 205 customers licensing technology at royalty rates ranging between 1.5% and 4%

GS 4G/LTE estimated investment cycle (hardware and operating systems): $450b (more than 700 potential players)
Total dollar value of equipment (hardware and operating systems) shipped meeting all requirements set by the 3GPP: ~$125b
Average royalty rate: 100 bps

Potential royalty revenue stream:           $1.250 b
Estimated operating margin:                   75%
Estimated operating profit:                 $0.938 b
Estimated LT tax rate:                        36%
Estimated LT net income:                    $0.600 m
LT diluted share count:                         0.06 m
Estimated LT EPS:                           $10.00
Discount at 15% for 8 years:                 $3.27
Multiple assumption:                       20
Price per share:                                $65

Valuation/price target excludes any potential cash settlements related to on-going litigation

GILFORD SECURITIES INCORPORATED                                                                                                               Page 4 of 6
                                                                                                                             VirnetX Holding Corporation

VirnetX Holding Corporation (VHC)
Quarterly Earnings Model
FY Dec ember
($ in millions)
                                                                       Q1 12A     Q2 12A     Q3 12E    Q4 12E
                                      2009A      2010A       2011A     Mar-12     Jun-12     Sep-12    Dec-12     2012E      2013E     2014E     2015E     2016E     2017E

Total royalty revenues                0.026      0.068       0.021     0.000      0.036      0.500     2.000      2.536     18.000    65.000    140.000   265.000   435.000

Cost of revenues                                                                                                            1.800     6.500     14.000    31.800    52.200
   Gross profit                                                                                                             16.200    58.500    126.000   233.200   382.800

Royalty expense                                  59.207
Researc h & development               0.864      2.412       1.464      0.256     0.274      0.300      0.450     1.280      1.440     1.625     2.100     2.385     2.610
SG&A                                  12.250    33.764      15.932     6.967      11.496     12.000    11.000    41.463     22.500    16.700    15.400    15.900    16.530
(Gain on settlement)                            (200.000)

Operating profit/(loss)              (13.088)   104.685     (17.375)   (7.223)   (11.734)   (11.800)   (9.450)   (40.207)   (7.740)   40.175    108.500   214.915   363.660

Gain/(loss) in value of securities    0.559     (30.516)     (5.595)   0.269      (2.248)    0.000      0.000     (1.979)   2.000     4.000      6.000     8.000    10.000

Interest & other inc ome, net          0.0       1.310       0.228      0.074     0.128      0.065      0.060     0.327      0.250     0.300     0.400     0.500     0.700
Pretax inc ome/(loss)                (12.524)   75.479      (22.742)   (6.880)   (13.854)   (11.735)   (9.390)   (41.859)   (5.490)   44.475    114.900   223.415   374.360

Income taxes (benefit)                0.000     34.062       (5.480)   (2.173)    (3.590)      0         0        (5.763)   -1.976    16.011     41.364    80.429   134.770

Net inc ome                          (12.524)   41.417      (17.262)   (4.707)   (10.264)   (11.735)   (9.390)   (36.096)   (3.514)   28.464    73.536    142.986   239.590

Earnings per share (GAAP)            ($0.33)     $0.84      ($0.35)    ($0.09)   ($0.20)    ($0.23)    ($0.18)   ($0.70)    ($0.07)   $0.51      $1.27     $2.38     $3.86

Diluted shares                        37.911     49.066      50.028    50.658     50.874     51.500    52.000     51.258    53.000    56.000     58.000    60.000    62.000

M argin analysis
Gross profit margin                                                                                                          90.0%     90.0%     90.0%     88.0%     88.0%
Researc h & development                                                                                                      8.0%      2.5%      1.5%      0.9%      0.6%
SG&A                                                                                                                        85.0%     22.5%      11.0%     6.0%      3.8%
Operating margin                                                                                                            (43.0%)   61.8%      77.5%     81.1%     83.6%
Pretax margin                                                                                                               (30.5%)   68.4%      82.1%     84.3%     86.1%
Tax rate                                                                                                                    36.0%     36.0%      36.0%     36.0%     36.0%
Net margin                                                                                                                  (19.5%)   43.8%      52.5%     54.0%     55.1%

Revenue analysis
YOY growth                                                                                                                  609.8%    261.1%     115.4%    89.3%     64.2%
Sequential growth

EPS analysis
YOY growth                                                                                                                            -866.7%    149.4%    88.0%     62.2%
Sequential growth

GILFORD SECURITIES INCORPORATED                                                                                                                           Page 5 of 6
                                                                                        VirnetX Holding Corporation


 I, Robert Tango, certify that all the views expressed in this research report accurately reflect my personal views of
 the subject companies. I certify that I have not and will not receive compensation with respect to the issuance of
 this report.


 In the normal course of business, Gilford Securities seeks to perform investment banking and other services for
 various companies and to receive compensation in connection with such services. As such, Gilford Securities
 intends to seek compensation for investment banking services from the subject company in the next three months.

 The analyst owns shares in the subject company.


 Buy:      The stock should outperform its industry or peer group by 20% or greater within a 12-month timeframe.

 Sell:     The stock is expected to underperform its industry or peer group by 20% or greater within a 12-month
           timeframe, or fundamentals have deteriorated significantly and the stock is expected to materially

 Hold:     The stock does not have enough upside or downside potential to rate it a Buy or Sell. It is either fairly
           valued or carries too much uncertainty for a Buy or Sell rating.

 Distribution of Gilford ratings (As of 06-27-12)

  Category               Coverage                     IB Services*
     Buy                    59%                            6%
     Hold                   34%                           10%
     Sell                    7%                            0%
 * Percentage of companies within this category for whom Gilford has provided
   investment banking (IB) Services within the last 12 months.


GILFORD SECURITIES INCORPORATED                                                                                Page 6 of 6

Description: last evening the Coommission oppted to termminate the invvestigation,Last everequiring VirnetX to re-file its comgmplaint against Apple. Th decision he appears inconsistent/o in light of the following facts: