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VIRNETX HOLDING CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
[November 09, 2012]

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.

10 -------------------------------------------------------------------------------- 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.

11 -------------------------------------------------------------------------------- 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.

12 -------------------------------------------------------------------------------- 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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