VirnetX Holding Corporation — Q3 2014 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2014. Financial statement amounts below are in thousands of dollars, except per-share data. VirnetX develops secure communications technology and derives revenue primarily from patent licensing.
Financial performance and liquidity
| Metric | Three months ended Sept. 30, 2014 | Nine months ended Sept. 30, 2014 | Comparable 2013 period |
|---|---|---|---|
| Revenue | $292 | $809 | $1,612 quarter; $1,911 nine months |
| Operating expenses | $6,542 | $20,185 | $6,745 quarter; $23,152 nine months |
| Operating loss | $(6,250) | $(19,376) | $(5,133) quarter; $(21,241) nine months |
| Net loss | $(4,468) | $(17,227) | $(5,134) quarter; $(20,054) nine months |
| Loss per share, basic and diluted | $(0.09) | $(0.33) | $(0.10) quarter; $(0.39) nine months |
- Revenue fell sharply year over year, particularly in Q3. The 2013 comparison included $1.5 million of historical royalties recognized under a settlement; 2014 revenue largely reflects recognition over time of previously received license fees.
- For the nine months, SG&A declined $3.0 million to $19.1 million, mainly from $4.1 million lower patent-litigation legal fees, partly offset by higher stock compensation and related payroll taxes. R&D increased $64,000 to $1.1 million.
- Q3 included a $1.817 million noncash gain from remeasuring Series I warrant liabilities; the nine-month gain was $2.126 million. These gains reduced reported net loss but did not provide operating cash.
- Cash and cash equivalents were $8.498 million and available-for-sale investments were $15.939 million at September 30, totaling $24.437 million, versus $38.988 million at year-end 2013. Working capital was $20.566 million, down from $33.971 million. No borrowings or other debt are reported in the supplied balance sheet.
- Operating cash use was $14.636 million for the nine months, compared with $1.859 million used in 2013. The prior-period cash flow benefited from a $14.963 million reduction in prepaid taxes. Investing activities provided $3.884 million net, and financing activities provided $77,000.
- Management said cash and investments should fund operations, working capital and legal expenses for the foreseeable future. The filing reports no gross margin measure; given the licensing-based revenue and operating losses, a conventional margin comparison is not clearly informative.
Material developments, outlook and risks
- The August 2013 license/settlement agreement has a stated total value of $10 million over five years. VirnetX reported cumulative receipts of $5 million through September 30, 2014; deferred revenue was $2.375 million. It recognized $792,000 of this agreement’s fees in the first nine months of 2014.
- VirnetX was beta testing its GABRIEL Connection Technology and pursuing a secure domain name registry and licensing opportunities. Management expects future revenue primarily from patent-license fees and royalties, but reported that licensing revenue remains minimal and success is uncertain. No quantified revenue or earnings guidance was provided.
- Management expects legal fees to remain at the same or higher levels over the foreseeable future while patent cases continue, and expects operating losses as a result; it anticipates legal expense may decline materially after the current court schedule is complete.
- In the Apple appeal, the Federal Circuit affirmed patent validity and certain infringement findings but vacated the prior damages award and remanded damages and certain FaceTime infringement issues. VirnetX sought rehearing in October 2014; the outcome remained pending. A separate ongoing Apple royalty order set a 0.98% rate for specified products, and Apple appealed. Other Apple proceedings remained pending, with one trial scheduled for October 2015.
- The Microsoft infringement case remained pending, with trial scheduled for July 2015. The Cisco jury found no infringement; the case was closed. VirnetX’s claims and litigation outcomes are uncertain, and adverse outcomes could affect expected licensing revenue and consume substantial resources.
- Risks highlighted include reliance on licensing and a limited customer base, patent validity and enforcement uncertainty, costly litigation, possible need for additional capital, FRAND restrictions on some licensing terms, product-development and market-adoption uncertainty, and potential dilution. Series I warrants are Level 3 derivative liabilities; share-price changes can materially affect reported earnings without affecting cash.
- A $3.75 million non-cancellable lease obligation was disclosed and included in prepaid expenses. The filing reports no off-balance-sheet arrangements. Management said disclosure controls were effective and reported no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Progress and final outcomes in the Apple appeal, rehearing petition, ongoing-royalty appeal, and the scheduled Apple and Microsoft trials; distinguish court rulings from realized cash receipts.
- Cash burn, legal spending and management’s “foreseeable future” liquidity assessment, including the timing and cash impact of the $3.75 million lease obligation.
- Terms, collectability and future revenue recognition under the five-year license agreement, and whether VirnetX can secure additional licenses or recurring royalties.
- Patent enforceability, potential obligations to Leidos tied to patent-generated value, warrant-liability sensitivity, and potential dilution from outstanding options and warrants.