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VIRNETX HOLDING CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
(Edgar Glimpses Via Acquire Media NewsEdge) Note About Forward-Looking Statements
Certain statements in this report, other than purely historical information,
including estimates, projections, statements relating to our business plans,
objectives, and expected operating results, and the assumptions upon which those
statements are based, are "forward-looking statements" within the meaning of the
Private Securities Litigation Reform Act of 1995, Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
Forward-looking statements may appear throughout this report, including without
limitation, the following sections: "Management's Discussion and Analysis," and
"Risk Factors." These forward-looking statements generally are identified by the
words "believe," "project," "expect," "anticipate," "estimate," "intend,"
"strategy," "future," "opportunity," "plan," "may," "should," "will," "would,"
"will be," "will continue," "will likely result," and similar expressions.
Forward-looking statements are based on current expectations and assumptions
that are subject to risks and uncertainties which may cause actual results to
differ materially from the forward-looking statements. A detailed discussion of
risks and uncertainties that could cause actual results and events to differ
materially from such forward-looking statements is included in the section
titled "Risk Factors" (Part II, Item 1A of this Form 10-Q). We undertake no
obligation to update or revise publicly any forward-looking statements, whether
because of new information, future events, or otherwise.
Company Overview
We develop software and technology solutions for securing real-time
communications over the Internet. Our patented GABRIEL Connection Technology™
combines industry standard encryption protocols with our patented techniques for
automated domain name system, or DNS, lookup mechanisms, and enables users to
create a secure communication link using secure domain names over wired or
wireless (4G/LTE) networks. We are currently beta testing our GABRIEL Connection
Technology™ as part of our Secure Domain Name Initiative, or (SDNI), on various
platforms including PCs, smart phones and tablets. We also intend to establish
the exclusive secure domain name registry in the United States and other key
markets around the world.
Our portfolio of intellectual property is the foundation of our business
model. We currently own 20 patents in the United States and 26 foreign patents,
as well as several pending U.S. and foreign patent applications. Our patent
portfolio is primarily focused on securing real-time communications over the
Internet, as well as related services such as the establishment and maintenance
of a secure domain name registry. Our patented methods also have additional
applications in operating systems and network security. We have submitted a
declaration with the 3rd Generation Partnership Project, or 3GPP, identifying a
group of our patents and patent applications that we believe are or may become
essential to certain developing specifications in the 3GPP LTE, SAE project. We
have agreed to make available a non-exclusive patent license under fair,
reasonable and non-discriminatory terms and conditions, with compensation, or
FRAND, to 3GPP members desiring to implement the technical specifications
identified by us. We believe that we are positioned to license our essential
security patents to 3GPP members as they move into 4G.
We have an ongoing Gabriel Licensing Program under which we offer licenses to
our patent portfolio, technology and software, including our secure domain name
registry service, to domain infrastructure providers, communication service
providers as well as to system integrators. Our Gabriel Connection TechnologyTM
License is offered to OEM customers who want to adopt the GABRIEL Connection
Technology™ as their solution for establishing secure connections using secure
domain names within their products. We have developed GABRIEL Connection
Technology™ Software Development Kit (SDK) to assist with rapid integration of
these techniques into existing software implementations with minimal code
changes and include object libraries, sample code, testing and quality assurance
tools and the supporting documentation necessary for a customer to implement our
technology. Customers who want to develop their own implementation of the
VirnetX patented techniques for supporting secure domain names, or other
techniques that are covered by our patent portfolio for establishing secure
communication links, can purchase a patent license. The number of patents
licensed, and therefore the cost of the patent license to the customer, will
depend upon which of the patents are used in a particular product or service.
These licenses will typically include an initial license fee, as well as an
ongoing royalty.
We intend to license our patent portfolio, technology and software, including
our secure domain name registry service, to domain infrastructure providers,
communication service providers as well as to system integrators. We believe
that the market opportunity for our software and technology solutions is large
and expanding as secure domain names are now an integral part of securing the
next generation 4G/LTE wireless networks. We also believe that all 4G mobile
devices will require unique secure domain names and become part of a secure
domain name registry.
In connection with the settlement of our lawsuit against Microsoft Corporation
in 2010, Microsoft became our first licensee. Pursuant to the Settlement and
License Agreement between us and Microsoft, Microsoft paid us $200 million,
which has been recognized as gain on settlement and Microsoft was granted a
worldwide, irrevocable, nonexclusive, non-sublicenseable fully paid up license
for our patents for Microsoft products. We have also signed Patent License
Agreements with Aastra USA, Inc. Mitel Networks Corporation, NEC Corporation and
NEC Corporation of America, to license certain of our US patents, for a one-time
payment to VirnetX and an ongoing royalty for all future sales through the
expiration of the licensed patents with respect to certain current and future
IP-encrypted products. We intend to seek further license of our technology,
including our GABRIEL Connection Technology™ to enterprise customers, developers
and original equipment manufacturers, or OEMs, of chips, servers, smart phones,
tablets, e-Readers, laptops, net books and other devices, within the
IP-telephony, mobility, fixed-mobile convergence and unified communications
markets including 4G/LTE. We have published our royalty rates and guidelines on
our website. All licenses with current royalty payment obligations have adhered
to these guidelines and have met or exceeded these rates and we will use these
rates and guidelines in all future license negotiations.
We have three intellectual property infringement lawsuits pending against
multiple parties in the United States District Court for the Eastern District of
Texas, Tyler Division, pursuant to which we allege that Apple, Inc., Cisco
Systems, Inc., and Siemens Enterprise Communications and Avaya Inc. infringe on
certain of our patents. We seek damages and injunctive relief in all the
complaints. We have one complaint pending with the United States International
Trade Commission (ITC) against Apple, Inc. On October 31, 2012, a jury trial
began regarding our Compliant against Apple. On November 6, 2012, jurors found
that Apple infringed four of our patents. (see Legal Proceedings). The hearing
against Cisco, Avaya and Siemens is now scheduled for jury selection on March 4,
2013. Our complaint against Apple in the ITC, is now scheduled for hearing,
in-front of Administrative Law Judge (ALJ) E. James Gildea, on July 10, 2013
with a target completion date for the investigation set for February 21, 2014.
Our employees include the core development team behind our patent portfolio,
technology and software. This team has worked together for over ten years and is
the same team that invented and developed this technology while working at
Science Application International Corporation, or SAIC. SAIC is a FORTUNE 500®
scientific, engineering and technology applications company that uses its deep
domain knowledge to solve problems of vital importance to the nation and the
world, in national security, energy and the environment, critical infrastructure
and health. The team has continued its research and development work started at
SAIC and expanded the set of patents we acquired in 2006 from SAIC into a larger
portfolio with 46 issued U.S. and foreign patents and numerous pending U.S. and
foreign patent applications. This portfolio now serves as the foundation of our
licensing business and planned service offerings and is expected to generate the
majority of our future revenue in license fees and royalties. We intend to
continue our research and development efforts to further strengthen and expand
our patent portfolio.
We intend to continue using an outsourced and leveraged model to maintain
efficiency and manage costs as we grow our licensing business by offering
incentives to early licensing targets or asserting our rights for use of our
patents. We also intend to expand our design pilot in participation with leading
4G/LTE companies (domain infrastructure providers, chipset manufacturers,
service providers, and others) and build our secure domain name registry.
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Index
Competition
We believe our technology and solutions will compete primarily against various
proprietary security solutions. We group these solutions into three main
categories:
Proprietary or home-grown application specific security solutions have been
developed by vendors and integrated directly into their products for our
target markets including IP-telephony, mobility, fixed-mobile convergence, and
unified communications. These proprietary solutions have been developed due to
the lack of standardized approaches to securing real-time communications. This
approach has led to corporate networks that are isolated and, as a result,
restrict enterprises to using these next-generation networks within the
boundaries of their private network. These solutions generally do not provide
security for communications over the Internet or require network
administrators to manually exchange keys and other security parameters with
each destination network outside their corporate network boundary. The
cost-savings and other benefits of IP-based real-time communications are
significantly limited by this approach to securing real-time communications.
A session border controller, or SBC, is a device used in networks to exert
control over the signaling and media streams involved in establishing,
conducting and terminating VoIP calls. A traditional firewall or network
address translation, or NAT, device typically block information like endpoint
IP addresses and port numbers required by signaling protocols, such as SIP and
XMPP, to reach and communicate with their intended destination. SBCs are used
in physical networks to address these limitations and enable real-time session
traffic to cross the boundaries created by firewalls and other NAT devices and
enable VoIP calls to be established successfully. However, SBCs must decrypt
and analyze every single data packet for the information to be transmitted
successfully, thereby preventing end-to-end encryption. This network design
results in SBCs becoming a single point of congestion on the network, as well
as a single point of failure. SBCs are also limited to the physical network
they secure.
SIP firewalls, or SIP-aware firewalls, and application layer gateways, manage
and protect the traffic, flow and quality of VoIP and other SIP-related
communications. They perform real-time network address translation, dynamic
firewall functions; support multiple signaling protocols, and media
functionality, allowing secure interconnection and the flow of IP media
streams across multiple networks. While SIP firewalls assist in analyzing SIP
traffic transmitted over the corporate network to filter out various threats,
they do not necessarily encrypt the traffic. As a result, this traffic is not
entirely secure from end-to-end nor is it protected against threats like
man-in-middle and eavesdropping.
New Accounting Pronouncements
In May 2011, the FASB issued a new accounting standard update, which amends the
fair value measurement guidance and includes some enhanced disclosure
requirements. The most significant change in disclosures is an expansion of the
information required for Level 3 measurements based on unobservable inputs. The
standard is effective for fiscal years beginning after December 15, 2011. This
standard did not have an impact on our consolidated results of operations and
financial position, when adopted on January 1, 2012.
In June 2011, the FASB modified the presentation of comprehensive income in the
financial statements. The revised standard requires an entity to present the
total of comprehensive income, the components of net income, and the components
of other comprehensive income either in a single continuous statement of
comprehensive income or in two separate but consecutive statements and must be
applied retrospectively. This standard eliminates the former option to report
other comprehensive income and its components in the statement of changes in
equity. The revised standard does not change the items that must be reported in
other comprehensive income or when an item of other comprehensive income must be
reclassified to net income. The modification of the standard did not have an
effect on our consolidated results of operations and financial position, when
adopted on January 1, 2012.
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Index
Results of Operation
Three and Nine Months Ended September 30, 2012
Compared with Three and Nine Months Ended September 30, 2011
(in thousands, except per share amounts)
Revenue - Royalties
We had $368 in revenue for the three and $404 for the nine months ended
September 30, 2012. Revenues for the three and nine months ended September 30,
2011 were $3 and $20, respectively. Our revenue in 2012 was royalties earned
from license agreements with our customers. All license agreements entered into
for 2012 have been priced in accordance with our standard royalty rates and
guidelines.
For the three and nine months ended September 30, 2012, the Company recognized
royalty revenue of $368 and $404 respectively, as part of settlement agreements
entered into with customers during the patent infringement actions (see "Legal
Proceedings"). In accordance with the Company's revenue recognition policy
related to a licensee's product sales from prior periods, the amounts recognized
resulted from negotiated agreements with licensees that utilized our patented
technology prior to signing a patent license agreement with us. We record the
consideration as revenue when we have obtained a signed agreement, identified a
fixed or determinable price, and determined that collectability is reasonably
assured. The Company, in the patent infringement actions did not request, nor
did it receive any amounts allocable to settlement fees, expense reimbursement,
damages or any other amount unrelated to historical sales. Revenue to be earned
from forward licensing agreements entered into as a result of the litigation
will be recognized as the earnings process is completed, license fees are fixed
and determinable, and in accordance with the Company's revenue recognition
policy.
Our revenue in 2011 was limited to the royalties earned under a single license
agreement through our Japanese subsidiary. We expect the revenue from our
Japanese subsidiary will continue to be insignificant in the future.
Research and Development Expenses
Our research and development expenses decreased by $20 to $253 for the three
months ended September 30, 2012, from $273 for the three months ended September
30, 2011, and increased by $78 to $783 for the nine months ended September 30,
2012 from $705 for the nine months ended September 30, 2011. This increase was
primarily due to the increase in wages and medical costs for our employees.
Selling, General and Administrative Expenses
Selling, general and administrative expenses include management and
administrative personnel, as well as outside legal, accounting, and consulting
services.
Our selling, general and administrative expenses increased by $5,576 to $9,486
for the three months ended September 30, 2012, from $3,910 for the three months
ended September 30, 2011, and by $17,946 to $27,949 for the nine months ended
September 30, 2012, from $10,003 for the comparable period in 2011. This
increase is primarily due to an increase in legal fees of $5,302, for the three
months ending September 30, 2012 and $17,195 for the nine months ending
September 30, 2012, compared to the three months and nine months ended September
30, 2011 as a result of the increase in legal fees associated with the current
patent infringement actions as well as increase in wages and medical expenses
for our employees. We expect to incur the same levels or increased legal fees
over the next quarter as we enter the final phase of preparation for trials in
these infringement actions and expect to report losses from operations as a
result. See Note 8 of the financial statements for additional information
regarding these infringements actions. Management believes our legal expenses
will decrease materially after our current court schedule is complete.
Other Income and Expenses
For the three months ended September 30, 2012, the non-cash gain related to the
periodic revaluation of our Series I Warrants liability was $1,409, which
compares to a non-cash gain of $8,555 for the three months ended September 30,
2011, and for the nine months ended September 30, 2012, the non-cash loss was
$570 as compared to the non-cash loss of $3,634 for the nine months ended
September 30, 2011. The balance of the liability for the Series I Warrants
decreased to $3,854 at September 30, 2012, from $4,699 at December 31, 2011. The
gain from the revaluations of the warrant liability in the three months ended
September 30, 2012 and 2011 were primarily the result of decrease in our common
share price during the periods.
Interest income increased by $66 to $110 for the three months ended September
30, 2012, from $44 for the comparable 2011 period, and increased by $140 to $313
for the nine months ended September 30, 2012, from $173 for the nine months
ended September 30, 2011.
Liquidity and Capital Resources
As of September 30, 2012, our cash and cash equivalents totaled approximately
$20,842 and our short-term investments totaled approximately $32,078, compared
to cash equivalents of approximately $49,482 and short-term investments of
approximately $14,438 at December 31, 2011. Working capital was $56,082 at
September 30, 2012 and $68,114 at December 31, 2011. The decrease in cash and
investments during the periods reported are primarily attributed to costs
incurred for legal expenses in defense of our patent infringement actions, and
losses incurred during the periods reported.
We expect that our cash and cash equivalents and short-term investments as of
September 30, 2012, will be sufficient to fund our operations and provide
working capital for general corporate purposes and legal expenses for at least
the next 48 months, which is in line with management expectations. Over the long
term, we expect to derive the majority of our future revenue from license fees
and royalties associated with our patent portfolio, technology, software and
secure domain name registry in the United States and other markets around the
world.
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Index
Income Taxes
The income tax benefit for the three months ended September 30, 2012 was $3,133,
which was a negative effective income tax rate of 40 percent. The income tax
benefit for the nine months ended September 30, 2012 was $8,896, which was a
negative effective income tax rate of 31 percent. The tax benefit was lower than
the benefit calculated using the statutory U.S. federal rate primarily as a
result of the change of the valuation allowance, stock based compensation
expense and non-deductible derivative loss.
The income tax benefit for the three months ended September 30, 2011 was $1,460,
which was a negative effective income tax rate of 33 percent. The income tax
benefit for the nine months ended September 30, 2011 was $3,100, which was a
negative effective income tax rate of 22 percent.
At September 30, 2012, we have federal and state net operating loss
carry-forwards of approximately $912 and $39,002 respectively, expiring
beginning in 2027 and 2012, respectively.
Our tax years for 2005 and forward are subject to examination by the U.S. tax
authority and various state tax authorities. These years are open due to net
operating losses and tax credits remaining unutilized from such years.
Contractual Obligations
There have been no material changes to the contractual obligations disclosed in
our Annual Report on Form 10-K for the fiscal year ended December 31, 2011.
Off-Balance Sheet Arrangements
None.
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