VirnetX Holding Corporation — Q3 2011 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2011. Financial statement amounts are in $ thousands, except per-share data. The interim financial statements are unaudited.
Business context
VirnetX is commercializing patents and security technology, including GABRIEL Connection Technology, through licensing and planned software and secure-domain-name services. Revenue remained negligible and came from a single license agreement. The company was beta testing GABRIEL and pursuing a 4G/LTE design pilot and a secure domain name registry; these initiatives had not yet produced material revenue.
Financial performance and liquidity
| Metric | Q3 2011 | Q3 2010 | Nine months 2011 | Nine months 2010 |
|---|---|---|---|---|
| Royalty revenue | $3 | $15 | $20 | $60 |
| Operating expenses, net | $4,183 | $2,449 | $10,708 | Income of $108,151 |
| Income (loss) from operations | $(4,180) | $(2,434) | $(10,688) | $108,211 |
| Net income (loss) | $5,879 | $(25,420) | $(11,049) | $44,256 |
| Basic EPS | $0.12 | $(0.54) | $(0.22) | $1.00 |
- Q3 net income reflected a noncash $8,555 gain from revaluing Series I warrants and a $1,460 income-tax benefit, despite a $4,180 operating loss. For the nine months, the warrant revaluation produced a $3,634 noncash loss.
- Q3 general, selling and administrative expense rose to $3,910 from $2,256, primarily because of higher wages and legal fees. Nine-month expense fell to $10,003 from $30,667, largely because 2010 included substantial Microsoft-litigation legal costs. Nine-month R&D expense declined to $705 from $1,943.
- Cash and cash equivalents were $50,620 and investments were $14,611 at September 30, 2011. Current assets were $75,647 versus current liabilities of $3,751. The balance sheet reports no borrowings; liabilities included a $2,739 derivative liability and $1,012 of accounts payable and accrued liabilities.
- For the nine months, operating activities used $16,758 of cash; investing activities provided $28,834, chiefly from net investment sales; financing activities provided $3,909. Cash increased $15,985 to $50,620.
- No meaningful operating margin comparison is indicated by the very small royalty revenue and large operating losses. The filing does not provide a meaningful revenue-based margin measure.
Material changes and unusual items
- The 2010 nine-month comparison includes the $200 million Microsoft settlement, presented as a gain on settlement, and $59,239 of SAIC royalty expense. These items explain much of the substantial year-over-year change in reported operating results; the settlement also included a fully paid-up license to Microsoft and dismissal of two lawsuits.
- During 2011, the Series I warrant liability fell from $14,364 at year-end 2010 to $2,739. The filing reports $15,259 of settlements in its Level 3 liability reconciliation and a $3,634 loss included in earnings. Warrant fair value is sensitive to VirnetX’s share price and other valuation assumptions.
- At September 30, the company had $10,023 of prepaid taxes and a $2 current deferred tax benefit; the filing reports a $3,100 income-tax benefit for the nine-month period. Deferred tax assets remain subject to a valuation allowance because of the company’s loss history.
- The filing states that prior-period financial statements were restated for warrant accounting and that a material weakness had existed in accounting for complex, non-routine transactions. Management said disclosure controls were effective as of September 30, 2011, and described an as-needed remediation plan involving outside consultants.
Outlook, risks and contingencies
- Management estimated that September 30 cash and cash equivalents would fund operations, working capital and legal expenses for at least 36 months. This is an estimate, not a guarantee; the company expected substantial ongoing legal costs and said it would receive no proceeds from pending claims unless resolved in its favor.
- No formal financial guidance was provided. Management expects future revenue primarily from patent licenses and royalties and planned technology and registry offerings, but cautioned that licensing, product adoption and registry success are uncertain. It does not expect near-term net income comparable to the period benefiting from the Microsoft settlement.
- Two patent-infringement lawsuits were pending against Aastra, Apple, Cisco, NEC, Siemens, Mitel and Avaya. The filing describes outcomes as uncertain and defendants as substantially better resourced. After quarter-end, VirnetX filed a further Apple lawsuit on November 1, 2011, and an ITC complaint on November 4 seeking import-related relief.
- Other key risks include patent challenges, the limits imposed by FRAND licensing commitments, intense competition, lengthy sales cycles, customer concentration, potential security or system failures, regulatory changes, and volatility in results and share price. The company disclosed approximately $28,955 of uninsured cash deposits at September 30.
- On October 30, 2011, VirnetX entered a new headquarters lease at $2,790 per month through October 2013. No off-balance-sheet arrangements were reported.
Important facts for investors to verify
- Whether VirnetX can convert its patent portfolio, GABRIEL technology, LTE efforts and registry plans into recurring, material revenue beyond the single small royalty stream.
- Developments and expected costs in the pending district-court and ITC litigation, including the potential outcomes and timing of claims against Apple and other defendants.
- Cash burn, investment liquidity and the assumptions supporting management’s estimate of at least 36 months of funding, particularly as legal expenses continue.
- Series I warrant valuation, settlements and dilution exposure, along with progress addressing the prior material weakness in complex-transaction accounting.
- Tax-asset realizability and the treatment of the Microsoft settlement and related SAIC obligations in comparisons with 2010.