VirnetX Holding Corp (NYSE:VHC): Initiating with Outperform; See significant Upside - Cowen

Cowen is initiating VirnetX Holding Corp (NYSE:VHC) with Outperform rating >40% upside target this morning calling it an unique IP play with ample upside.

Real-time peer-to-peer communication, including video chat, should be among the compelling applications end-users adopt as all-IP 4G LTE wireless networks and two-camera smartphones proliferate. Cowen believes VHC’s intellectual property sits at the heart of that market opportunity, making connections between end-users on tomorrow’s 4G networks as convenient and secure as those found on today’s voice networks. Over the next 1-5 years, the firm expects most major device OEMs to license, or otherwise be made aware of, patents VirnetX has uniquely declared as essential to the 3GPP’s LTE Series 33 specification. They expect VHC to appreciate > 40% relative to the market over the next year as its model tracks toward our $185MM C14 revenue forecast.

VirnetX is basically pre-revenue today; its (almost) only source of income the last twelve months was a $200MM settlement from Microsoft in 2Q10 that allowed MSFT limited use of the company's IPR. Looking forward, strong growth in VirnetX's core market (and increased licensee count) should drive EPS from ($0.32) in C11 to $1.25/est. diluted share in C14.

VirnetX Declares Its IPR Essential to LTE Standard. VirnetX has declared its IP "essential" to the 3GPP standards body which governs the LTE technology specification. That declaration makes OEMs of LTE equipment aware VHC believes its technology must be licensed to avoid infringing its patents (IPR). VirnetX’s key IPR automates the setup (lookup) of VPN connections between trusted peers, as called for in the Series 33 specification. We do not believe the 3GPP will (can) find a workaround for VirnetX’s patents, especially now that VHC has agreed to FRAND licensing.

Royalty Revenue From Massive 4G Market Likely. Cowen sizes the LTE market at $38B in 2014, growing at a ~34% 10-year CAGR through 2021. VHC should see $175MM of licensing revenue from that C14 TAM; they expect its LTE equipment royalties will increase sharply beyond C14 as its licensee count grows. VHC’s SDNI initiative, which automatically performs the lookup and key exchange (registry) services needed to connect trusted peers across networks, should see modest revenue near-term. SDNI has potential to become a highly valuable asset 4G operators utilize to deploy Skype-like (sold to MSFT for ~$8.5B) services, only using industry standard VPN.

- Strategic LTE Position Makes VirnetX an Acquisition Target

Cowen's Take: they believe VirnetX'ss core patents would be highly useful to a company with a weak relative position in the 4G LTE standard's patent stack (or no position whatsoever). They believe companies in this group that want to manufacture 4G LTE devices and/or equipment - including Apple, Cisco, and others - will recognize their margins will be inferior to what could be achieved if they did not have to pay for the use of competitor IPR. Patent stacking means that an OEM who has no/limited patents could face as high as a 12-15% total payment to 4G LTE IPR holders without patents to cross-license. 3G patents are likely somewhat lower today (in the 12% range) because Qualcomm has struck deals to pass through others patents for the 5%+ it charges (minus cross-licenses, its rate nets closer to 4%). To be competitive in the emerging tablet or converged 4G device market, many tech sector giants are likely to be looking for key 4G LTE IPR and they believe VHC fits the bill.


Cowen versus Consensus
Sell-side coverage of VHC is currently very limited. Thomson First Call shows the last set of estimates for VHC were provided in early April (i.e., before the company's 4/27/11 1Q11 March quarterly results report and conference call), and consisted of only a FY11 top and bottom line estimate. Therefore, Cowen assumes there is no standing consensus for VHC. They note the company does not provide full financial guidance.

Notablecalls: VHC is an animal of a stock. It's up 10-fold over the past 18 months, seemingly without any real analyst coverage. Cowen is the first Wall Street firm to officially pick up coverage and they sure are positive on the name.

What Cowen is essentially saying is that all the tech heavyweights (AAPL, CSCO, MSFT etc) need VHC's LTE 4G IP. That means not only revenues but makes the company a takeover candidate.

I also suspect Cowen's initiation serves as a prelude for a flurry of other firms picking up coverage.

Note there's about 20% short interest in the name.

All in all, I think VHC is likely to trade up in the n-t. It's a big mover, so worth keeping on radar. I would not be surprised to see a 7-10% move.