Business context and reporting period
Network-1 Security Solutions, Inc. filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2012. Its business centers on acquiring, licensing and protecting intellectual property. Revenue primarily comes from licensing its Remote Power Patent covering power delivery over Ethernet; the company reported 13 licenses and relied on royalty revenue to fund operations.
Financial performance
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Royalty revenue | $1.418 million | $1.222 million | $7.809 million | $6.611 million |
| Gross profit | $1.025 million | $0.881 million | $5.468 million | $4.728 million |
| Gross margin | 72.3% | 72.1% | 70.0% | 71.5% |
| Operating income | $0.343 million | $0.411 million | $3.585 million | $1.767 million |
| Net income | $0.194 million | $0.248 million | $2.854 million | $8.580 million |
| Operating cash flow | Not reported quarterly | Not reported quarterly | $2.091 million | $2.024 million |
Q3 revenue rose 16%, but operating income and net income declined as general and administrative costs increased, including legal and potential patent-acquisition costs. Nine-month revenue rose 18%; operating income increased mainly because 2011 included a $1.0 million additional patent expense. Nine-month net income fell because 2011 included a $6.86 million deferred-tax benefit, a significant noncash one-time item. Basic/diluted EPS was $0.01/$0.01 for Q3 2012 and $0.11/$0.10 for the nine months.
Balance sheet, liquidity and capital
At September 30, 2012, cash and cash equivalents were $22.213 million, marketable securities $0.552 million, working capital $23.652 million and total assets $30.600 million. Total liabilities were $0.668 million; the company reported no long-term debt. Cash increased $1.552 million from year-end 2011. Nine-month financing cash outflow was $0.539 million, including $0.487 million for shares delivered to fund withholding taxes and $0.052 million for treasury-stock repurchases. Management believed current cash and projected licensing revenue should fund operations for the foreseeable future, while cautioning that this might not be the case.
Material changes, outlook and risks
- Cisco accounted for approximately 80% of revenue in the first nine months of 2012, down from 90% in the comparable 2011 period. Cisco royalties vary with product sales and the agreement’s rate structure; annual caps are $8 million through 2015 and $9 million thereafter, but actual payments may be lower.
- The company settled with Motorola and Transition Networks in 2012; GarrettCom settlement was reached in October 2012. Each settlement includes a patent license and fees or royalties. Litigation against other manufacturers remained pending, and a motion to dismiss or sever was awaiting decision.
- The USPTO granted an ex parte reexamination of the Remote Power Patent in September 2012. Management believed the process could validate the patent, but an adverse final ruling not overturned on appeal could materially harm the company because its current revenue stream depends on the patent’s validity.
- A September 2012 agreement gave the company the right, subject to material closing conditions, to acquire four issued patents and one pending application for $1.0 million cash and $0.5 million in stock.
- The company reported a $6.194 million deferred tax asset and approximately $24.980 million of NOL carryforwards. Future use may be limited by ownership-change rules. The filing gives inconsistent NOL tax-benefit estimates and expiration dates in different sections.
- No formal revenue or earnings guidance was provided. The filing notes that Cisco royalties tend to be highest in the first calendar quarter and decline during subsequent quarters. A new one-year CEO employment agreement was entered into on November 1, 2012, with a $415,000 annual base salary and a 500,000-share option grant.
Investor verification points
- Track the patent reexamination and remaining infringement litigation, including settlement economics and timing of any royalty receipts.
- Assess Cisco concentration, royalty calculations, contractual conditions and the potential effect of lower-rate licenses.
- Verify the closing status and funding impact of the proposed patent acquisition.
- Reconcile the filing’s differing NOL tax-benefit estimates and expiration dates, and monitor deferred-tax-asset recoverability.
- Review cash concentration: the filing reports $21.963 million above FDIC insurance limits at September 30, 2012.
- Confirm the outlook for cash generation and operating costs; the reported nine-month period may not indicate full-year results.