VirnetX Holding Corporation — Q1 2012 Form 10-Q
Reporting period: Three months ended March 31, 2012. The interim financial statements are unaudited. Dollar amounts below are in thousands unless stated otherwise.
Business context
VirnetX develops and seeks to license patented technologies for securing real-time Internet communications, including its GABRIEL Connection Technology and planned secure domain name registry services. Its business model depends primarily on patent licensing and royalties. Microsoft was its first licensee under a fully paid-up license; the company reported no material operating revenue in the quarter.
Financial performance and liquidity
| Metric | Q1 2012 | Q1 2011 |
|---|---|---|
| Revenue — royalties | $0 | $17 |
| Research and development expense | $256 | $196 |
| General, selling and administrative expense | $6,967 | $2,573 |
| Operating loss | $(7,223) | $(2,752) |
| Derivative fair-value gain (loss) | $269 | $(5,130) |
| Interest income, net | $74 | $60 |
| Income tax benefit | $2,173 | $700 |
| Net loss | $(4,707) | $(7,122) |
| Basic and diluted loss per share | $(0.09) | $(0.14) |
| Net cash used in operating activities | $(4,086) | $(11,966) |
Gross margin is not meaningful given the absence of revenue. SG&A included $5,103 in legal fees, up from $929 in Q1 2011; management attributed most of the expense increase to patent litigation. The derivative gain is non-cash and reflects remeasurement of Series I warrants.
At March 31, 2012, cash and cash equivalents were $39,957 and available-for-sale investments were $19,935, totaling $59,892. Working capital was $64,362, compared with $68,114 at December 31, 2011. Total assets were $73,127; current liabilities were $8,616, including a $4,430 derivative liability. The filing reports no borrowings or other debt. Cash and cash equivalents decreased by $9,525 during the quarter, while operating activities used $4,086 and investing activities used $5,529, largely reflecting net investment purchases.
Changes and material developments
- Revenue fell to zero from $17, while net loss narrowed by $2,415, primarily because the prior-year period included a $5,130 non-cash warrant remeasurement loss, versus a $269 gain in 2012.
- Operating expenses rose by $4,454, driven principally by litigation costs; R&D expense increased by $60.
- Cash and cash equivalents declined $9,525 from year-end, while investments rose $5,497.
- After quarter-end, on April 25, 2012, the court issued a Markman claim-construction order in the Aastra/Apple/Cisco/NEC litigation. The company said certain adopted interpretations were favorable; trial was scheduled for November 5, 2012.
- On May 3, 2012, VirnetX announced a patent license agreement with Aastra USA involving a one-time payment and ongoing royalties on specified current and future products. The filing does not provide the payment amount or royalty rate.
Outlook, risks and contingencies
Management expected available cash and short-term investments to fund operations, working capital and legal expenses for at least 36 months from March 31, 2012. It did not expect near-term net income and said future revenue was expected mainly from patent licenses and royalties. This is not a guarantee: the company reported minimal licensing revenue and no assurance of successful licensing or favorable litigation outcomes.
Three patent infringement lawsuits were pending against multiple defendants, and a separate ITC complaint targeted Apple. VirnetX warned that litigation is costly and uncertain and that adverse outcomes could materially harm the business. Other key risks include the validity and enforceability of patents, difficulty obtaining licensees, competition, long sales cycles, and reliance on a concentrated customer base. The Series I warrant liability is valued using Level 3 assumptions; management estimated that, all else equal, a $1 increase in share price would increase the liability by approximately $200 and could create a non-cash loss. The company also disclosed that prior financial statements had been restated for warrant accounting, while management concluded disclosure controls were effective as of March 31, 2012. No formal financial guidance was provided.
Important facts for investors to verify
- The economics, timing and enforceability of the May 2012 Aastra license agreement; the filing does not quantify its payment or royalties.
- Subsequent developments and potential costs or outcomes in the patent lawsuits and Apple ITC proceeding.
- Whether licensing, GABRIEL technology and the proposed secure domain name registry can generate sustained revenue, given zero Q1 2012 revenue.
- The assumptions and sensitivity underlying the $4,430 Level 3 warrant liability and its potential effect on reported earnings.
- Cash use relative to management’s stated 36-month funding expectation, particularly if litigation costs rise or licensing proceeds do not materialize.