VirnetX Holding Corporation — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012. Unaudited consolidated financial statements; amounts below are in millions of dollars unless otherwise noted. VirnetX develops secure real-time Internet communications technology and primarily seeks to monetize its patent portfolio through licensing and litigation.
Financial performance
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Revenue | $0.368 | $0.003 | $0.404 | $0.020 |
| Operating expenses | $9.739 | $4.183 | $28.732 | $10.708 |
| Operating loss | $(9.371) | $(4.180) | $(28.328) | $(10.688) |
| Net income (loss) | $(4.719) | $5.879 | $(19.689) | $(11.049) |
| Basic loss per share | $(0.09) | $0.12 | $(0.39) | $(0.22) |
Revenue was derived from settlements relating to past sales by companies using VirnetX technology. The company said it did not receive settlement fees, expense reimbursement, or damages in these amounts. It did not provide gross profit or a gross margin; the reported results show substantial operating losses relative to revenue.
Q3 2012 included a $1.409 million noncash gain from revaluing Series I warrants, compared with an $8.555 million gain in Q3 2011. For the nine-month period, warrant revaluation produced a $0.570 million noncash loss, versus a $3.634 million loss in 2011. Income tax benefits were $3.133 million for Q3 and $8.896 million for the nine months; deferred tax assets were subject to a partial valuation allowance.
Liquidity, cash flow and capital
- At September 30, 2012, cash and cash equivalents were $20.842 million and investments available for sale were $32.078 million, totaling $52.920 million. At December 31, 2011, the comparable total was $63.920 million.
- Working capital was $56.082 million, down from $68.114 million at year-end 2011. Current liabilities were $5.840 million, including a $3.854 million derivative liability. The filing reports no debt.
- For the first nine months of 2012, operating cash use was $12.508 million; investing cash use was $17.679 million, reflecting investment purchases net of maturities; financing provided $1.547 million. Cash declined by $28.640 million.
- Stockholders’ equity was $56.233 million. Common shares outstanding were 51,102,240 at September 30 and November 3, 2012. The company had 4.773 million options outstanding at quarter-end.
Changes versus prior comparable periods
- Revenue rose from a very low base, to $0.368 million in Q3 and $0.404 million for the nine months, largely reflecting license-related settlements. The company described ongoing royalties under its newly signed agreements, but reported revenue remained small.
- Operating expenses increased sharply, primarily because of patent-litigation legal fees. General, selling and administrative expense rose by $5.576 million in Q3 and $17.946 million year to date; management attributed most of the increases to legal fees.
- The company moved from Q3 2011 net income to a Q3 2012 loss, in part because the prior-year quarter had a much larger noncash warrant revaluation gain. The nine-month net loss also widened.
- Cash and investments declined by $11.000 million from year-end 2011, which management attributed primarily to litigation costs and operating losses.
Outlook, developments and risks
Management expected cash and investments at September 30, 2012 to fund operations, working capital and legal expenses for at least 48 months. It expected legal fees to remain at or above current levels in the next quarter as trials approached, with operating losses expected, and anticipated legal expenses would decline materially after the current court schedule was completed. The company was beta testing its GABRIEL technology and planned to pursue further licensing and secure-domain-name services; it cautioned that future results may vary significantly.
As of the filing date, VirnetX had licensing agreements with Aastra, Mitel and NEC; financial terms were not disclosed. Patent suits and an ITC matter involving Apple and other defendants remained material contingencies. The filing states that patent litigation outcomes are uncertain and that judgments may be difficult to obtain or collect. After quarter-end, on November 6, 2012, a jury awarded VirnetX $368.2 million in its Apple case. Post-trial motions were expected, an appeal remained possible, and management was assessing the verdict’s effect. This subsequent event was not revenue reported for Q3. The ITC had also instituted an Apple investigation, with a hearing scheduled for July 2013 and a target completion date of February 2014.
Other disclosed risks include reliance on licensing and a limited number of potential customers, challenges to patent validity or enforceability, high and unpredictable litigation costs, product-development and market-adoption uncertainty, and volatility in results and share price. Series I warrant fair value is a Level 3 estimate; the filing says a $1 increase in share price, all else equal, would increase the liability by approximately $0.2 million. Management stated disclosure controls were effective as of September 30, 2012; the filing also discussed prior restatements and a historical material weakness involving warrant accounting.
Important facts for investors to verify
- Whether the $368.2 million Apple verdict survives post-trial motions or appeal, and whether any award is ultimately collectible.
- The cash, investment and working-capital position, and whether litigation spending remains consistent with management’s stated 48-month funding estimate.
- The amounts, timing and terms of revenues and royalties under the Aastra, Mitel and NEC licenses, which the filing did not disclose.
- Future legal costs and case outcomes, including the Apple ITC investigation and litigation involving other defendants.
- Tax-asset realizability, uncertain tax positions, and the effect of warrant revaluations and stock-based compensation on reported results and dilution.