Network-1 Security Solutions, Inc. — Q3 2011 Form 10-Q
Reporting period: Three and nine months ended September 30, 2011. The filing identifies the registrant as Network-1 Security Solutions, Inc. Its principal business is acquiring, licensing, and protecting intellectual property; it reported 11 licenses for its Remote Power Patent as of quarter-end.
Financial performance
| Metric | Q3 2011 | Q3 2010 | Nine months 2011 | Nine months 2010 |
|---|---|---|---|---|
| Royalty revenue | $1.222 million | $32.560 million | $6.611 million | $32.850 million |
| Gross profit | $0.881 million | $23.053 million | $4.728 million | $23.328 million |
| Operating income | $0.411 million | $21.834 million | $1.767 million | $20.020 million |
| Income before taxes | $0.421 million | $21.853 million | $1.809 million | $20.039 million |
| Net income | $0.248 million | $21.805 million | $8.580 million | $19.991 million |
| Net income per diluted share | $0.01 | $0.76 | $0.28 | $0.70 |
Cash and liquidity: Cash and cash equivalents were $23.072 million at September 30, 2011, versus $21.348 million at December 31, 2010. Working capital was approximately $22.289 million. Net cash from operating activities for the first nine months was $2.024 million, compared with $21.014 million a year earlier; cash increased $1.724 million. The company reported no long-term debt and no off-balance-sheet arrangements. Total liabilities were $1.955 million.
Margins: Gross margin was approximately 72% in Q3 2011 and 71% for the first nine months of 2011, calculated from reported revenue and gross profit. These comparisons are affected by the prior-year settlement.
Material changes and unusual items
- Revenue and operating income fell sharply year over year because 2010 included approximately $32.320 million of upfront patent-litigation settlement payments. Excluding those payments, 2010 royalty revenue was $240,000 for Q3 and $530,000 for the first nine months.
- 2011 nine-month net income includes a one-time, non-cash $7.0 million deferred tax benefit recognized in Q2 as management concluded that part of its net operating loss carryforwards was more likely than not to be used. The deferred tax asset was $6.860 million at September 30; future use may be limited by tax ownership-change rules.
- The company repurchased and cancelled 247,050 shares for approximately $314,000 at an average $1.26 per share under a program authorizing up to $2.0 million of repurchases over 12 months.
- A $1.0 million contingent payment to BAXL was payable after the company reached the specified $25 million net-royalties threshold and was recorded as additional patent expense.
Outlook, risks, and contingencies
- Cisco accounted for 75% of Q3 and 90% of nine-month 2011 revenue. Management said Cisco royalties declined from Q1 through Q3 under the agreement’s annual rate structure and anticipated Q4 2011 royalties would be lower than Q3. The agreement provides annual royalty caps of $8 million through 2015 and $9 million thereafter, but actual payments may be lower and depend on conditions, including continued patent validity. Cisco may stop paying if the company materially breaches its obligations.
- In September 2011, the company filed patent-infringement litigation against 16 networking-equipment manufacturers, seeking reasonable-royalty damages. The outcome and any recovery are uncertain; counsel’s contingent fee ranges from 12.5% to 35% of net recovery depending on when a result is achieved.
- The company stated it believed available cash was sufficient for operational and capital requirements for the foreseeable future. No quantified revenue or earnings guidance was provided.
- Other risks include reliance on patent licensing and enforcement, possible changes in patent law or court rulings, concentration in Cisco revenue, and potential limits on NOL utilization. The filing also notes that Cisco royalties are subject to lower-rate matching provisions if certain other licenses are granted.
Important facts for investors to verify
- Whether Cisco royalty receipts continue, and how the annual rate structure affects future quarterly revenue.
- The status, timing, costs, and potential outcome of the 16-defendant patent litigation and the continued validity and enforceability of the Remote Power Patent.
- The assumptions supporting realization of the $6.860 million deferred tax asset and any Section 382 or state-law restrictions on NOL use.
- Future patent-related legal fees, contingent payments, executive royalty bonuses, and the remaining share-repurchase authorization.
- The company’s dependence on a small number of patent licenses; the filing reports Cisco as the dominant source of revenue.