VirnetX Holding Corporation — Q1 2013 Form 10-Q
Reporting period: Three months ended March 31, 2013; unaudited. Comparisons are with the three months ended March 31, 2012 unless otherwise noted. Dollar amounts are in thousands except per-share data.
Business context
VirnetX develops secure real-time communications technology and software. Its business model centers on licensing its patent portfolio and GABRIEL Connection Technology; the company reported that GABRIEL was in beta testing. Revenue remains dependent on licensing and patent-enforcement outcomes.
Financial performance and liquidity
| Metric | Q1 2013 | Q1 2012 / comparison |
|---|---|---|
| Revenue | $293 | $0 |
| Operating expenses | $9,822 | $7,223 |
| Operating loss | $(9,529) | $(7,223) |
| Gain on derivative liability | $1,606 | $269 |
| Interest income, net | $34 | $74 |
| Income tax expense (benefit) | $2 | $(2,173) |
| Net loss | $(7,891) | $(4,707) |
| Loss per share, basic and diluted | $(0.15) | $(0.09) |
| Cash used in operating activities | $(7,493) | $(4,086) |
The filing does not report a gross profit or gross margin measure. SG&A rose $2,551 to $9,518, including a $1,747 increase in legal fees related to patent litigation; R&D increased $48 to $304.
At March 31, 2013, cash and cash equivalents were $17,577 and short-term investments were $21,091, totaling $38,668. Working capital was $47,580, versus $53,862 at year-end 2012. Total assets were $54,341 and current liabilities were $6,693, including a $2,566 derivative liability. The balance sheet lists no borrowings or debt. The company attributed the decrease in cash and investments primarily to litigation costs and operating losses.
Management said available cash and short-term investments were expected to fund operations, working capital and legal expenses for at least the next 30 months. Investing activities provided $5,392, mainly reflecting investment maturities and purchases; financing activities provided $17 from option exercises.
Material changes and unusual items
- Revenue of $293 came from royalties associated with negotiated agreements covering historical product sales; no damages, expense reimbursements or other non-royalty settlement amounts were recognized.
- Net loss worsened by $3,184 year over year, in part because Q1 2012 included a $2,173 income tax benefit while Q1 2013 had only $2 of tax expense. The 2013 warrant revaluation gain was larger, but non-cash.
- Stock-based compensation expense was $1,585, compared with $873 a year earlier.
- The Series I warrant derivative liability fell from $4,172 at December 31, 2012 to $2,566 at March 31, 2013. Its Level 3 fair value depends on valuation assumptions and can create material non-cash earnings volatility.
- The company disclosed a non-cancelable, ten-year promotional and marketing agreement costing $4,000; $250 had been prepaid. The remaining balance was due when the facility became available, anticipated by the lessor in 2014 or 2015.
Outlook, litigation and risks
- A jury had awarded VirnetX more than $368 million against Apple in a prior patent case. The district court denied Apple’s request for a new trial and reduction of damages, awarded interest and post-verdict damages, but denied a permanent injunction. The parties did not agree on an ongoing royalty; further court action and a possible appeal remained. VirnetX had not recognized the award or royalties in its financial statements and said there was no assurance of when or whether it would receive proceeds. Any proceeds would be subject to a 25% SAIC share after specified litigation costs.
- In the Cisco case, the jury found no infringement but found the patents-in-suit valid and enforceable. VirnetX sought a new trial and judgment as a matter of law; court decisions were pending.
- Avaya litigation was scheduled for trial in September 2013. VirnetX announced it intended to withdraw its Apple complaint at the ITC and pursue relief in district court; an ITC termination order followed in April 2013.
- Management’s strategy depends on future licensing fees and royalties, but the company reported minimal licensing revenue and warned that it might not secure further licenses or realize expected value from its patents. Litigation is costly, outcomes uncertain, and adverse results could consume resources or hinder commercialization.
- Other disclosed risks include patent challenges, FRAND licensing constraints, reliance on a limited number of potential customers, product and security risks, and volatility in the stock price and warrant valuation. Management stated disclosure controls were effective at March 31, 2013.
Important facts for investors to verify
- Whether the Apple award survives post-trial proceedings or appeal, and whether any ongoing royalty is ordered or collected.
- Outcomes and timing of the Cisco and Avaya cases and their effect on legal spending and potential licensing revenue.
- Whether the company can convert its patent portfolio and beta-stage technology into recurring commercial revenue, given Q1 revenue of $293 and operating cash use of $7,493.
- Whether the stated 30-month liquidity runway remains reasonable as litigation costs, operating losses and the $4,000 promotional commitment develop.
- Potential earnings and balance-sheet effects from changes in the fair value of the Series I warrant liability and from tax valuation allowances.