Document Security Systems’ Hidden Value Will Be Discovered in 2013

Submitted by Sarah Harris as part of our contributors program.

When Document Security Systems (NYSE MKT: DSS), through a recently acquired subsidiary, announced a suit against Facebook (FB), LinkedIn (LNKD), BroadVision (BVSN), Jive Software (JIVE), and privately-held Novell for patent infringement on October 3, 2012, its share price jumped to a high of $4.30. Since then, the stock has gone through relatively volatile trading, closing at $2.60 as of date of this writing. Dramatic price spikes on a small stock such as DSS (valued around $50 million) – trading at low volumes relative to its 21 million outstanding shares – are not unusual. DSS, however, is more than a short-term stock play and has hidden value that will not be discovered until later in 2013, given some recent developments discussed below.

Overview of DSS

DSS is a leading specialist in fraud and counterfeit protection for all forms of printed documents and digital information and is looking at a market that will grow significantly. Counterfeit goods account for over $600 billion in annual losses with digital piracy at $75 billion. Less than 1%, approximately, is being spent to combat the problem, but this amount is expected to multiply as companies are increasing the offensive against piracy. The global licensing industry is a $200 billion market and DSS has yet to fully maximize the licensing potential of its patents.

Even as DSS continues to operate in its specialized niche, its recent merger with Lexington Technology Group (LTG), a focused, private firm, intent on monetizing IP portfolios, signals an expanded direction: monetization of IP portfolios through litigation. Even at an ultra-conservative win of $10 million from each of the 5 defendants in the new suit, gross suit proceeds will be a significant portion of the revenues DSS posted for the first nine months of this year. For a tech company intent on monetizing its numerous patents with more planned in the pipeline through operations, licensing, and patent enforcement, these are exciting developments.

Small but Growing and Here to Stay

DSS is focused on developing and marketing secure technologies. From initial reliance on licensing for the bulk of its revenues, the company has built manufacturing, operating, and marketing capacity in four segments: Printing, Plastics, Packaging, and Digital. The company owns numerous patents for optical deterrent technologies used in the production of consumer packaging, vital records, RFID/ID cards, smart cards, passports, coupons, and checks, among others. As a leading developer and integrator of cloud computing data security, radio frequency identification systems, and security printing technologies, DSS provides protection against product diversion, counterfeit, and theft. The company provides government-mandated technology in U.S. Social Security cards and counts global blue-chip brands Coke (KO), Pepsi (PEP), Kellog (K), Pfizer (PFE), and Procter & Gamble (PG) as clients. DSS has been included in Deloitte’s Technology Fast 500 list since 2008.

Financial results of DSS operations show the early-stage challenges of a tech company developing market presence. As of September 30 of this year, revenues have grown but remain small at $12 million. DSS reported a 33% gross profit with selling and overhead expenses still accounting for half of gross earnings. Research and development, on the other hand, has more than doubled over the same period last year. The company has reported operating losses for the past four years, but has sufficient cash to cover its cash burn rate with $1 million in cash and a credit line support.

On the whole, DSS maintains a healthy balance sheet with a debt-equity ratio of less than 0.5 and a current ratio of less than 1.10. In addition, DSS has identified a number of technological concepts and ideas, which may result in new patent applications.

Joining the Hot Sector of Patent Suits

Patent suits have become Wall Street’s hottest beacon for lucrative windfalls. Recent patent wins have been extremely rewarding for patent holders with Apple (AAPL) winning $1 billion against Samsung, VirnetX (VHC) gaining $368 million from Apple, and Vringo (VRNG) taking home $30 million and a 3.5% annual stream through royalties from Google (GOOG).

In October of 2011, DSS filed a suit against Coupons.com, specifically, for breach of contract, misappropriation of trade secrets, unfair competition, and unjust enrichment. DSS alleged that Coupons.com had used DSS’ copy protection technology, revealed under a non-disclosure agreement, on billions of web coupons since 2006. In August this year, the District Court dismissed the claims of “unfair competition” and “unjust enrichment” and the case has proceeded on the remaining charges.

Recognizing its limited ability to enforce and protect its patents, DSS entered into a merger with Lexington Technology Group (LTG), wherein the latter will own 55% of the merged entity. LTG is a private company focused on monetizing acquired and internally-developed patents through licensing, customized solutions, strategic partnerships, and litigation. Its wholly-owned subsidiary, Bascom Research, which eventually will become DSS’ subsidiary after merger completion, initiated the patent suit on October 3, 2012 against Facebook, LinkedIn and three companies. The suit alleges that these companies infringed on the following specific patents:

US Patent No. 7,111,232 (the ‘232 Patent) “Method And System For Making Document Objects Available To Users Of A Network”
US Patent No. 7,139,974 (the ‘974 Patent) “Framework for Managing Document Object Sorted on a Network”
US Patent No. 7,389,241 (the ‘241 Patent) “Method for Users of a Network To Provide Other Users with Access to Link Relationships between Documents”
US Patent No. 7,158,971 (the ‘971 Patent) “Method for Searching Document Objects on a Network”

The patents have apparent significance to business networks and social media platforms, and therefore, require quick resolution for large-cap companies, such as Facebook ($56 billion) and LinkedIn ($12 billion), which have bigger operational issues on their plate. Apple’s recent settlement with HTC, to include a 10-year licensing deal, instead of dragging out a case to resolution in open court, sends an important signal towards preference for settling out of court.

A Win-Win Merger

Aside from delivering an existing portfolio and pipeline of patents, DSS also provides privately-held LTG with access to the equity markets. As an operating entity, DSS also increases the possibility and returns of an IP suit. In exchange, LTG expands DSS ability to optimally monetize IP assets beyond traditional commercialization of its own portfolio.

For starters, Kramer Levin, a top-flight IP litigation firm responsible for a case against Facebook in favor of Leader Technologies, is representing the DSS/LTG suit on a contingency basis. LTG has already retained IP monetization heavyweight, IPNAV – also on contingency – to research other potential infringements. Over the years, IPNAV has had the experience of generating almost $700 million settlements for its IP clients.

LTG is also supported by board advisers Warren Horowitz (Altitude Capital Partners), who produced settlements from LG Electronics, Nokia, eBay, and Research in Motion; and Jeff Ronaldi, who was responsible for a $600 million settlement from Microsoft. The DSS/LTG suit has been filed with the Eastern District of Virginia, known as the “rocket docket” for its fast-paced trials and a near 70% rate of decisions favoring IP claimants.

Stacked-Up Bottom Line

So, what does this all mean for DSS? VirnetX prevailed over Microsoft (MSFT), with a judgment of $105 million, but settled at $200 million. The stock is on a five-month high at $32.76, as of November 26, 2012, growing by over 70% over the same period last year, and has a market cap of $1.7 billion. Vringo’s stock price is up to $3.75 on November 26, 2012, a spike of over170% over the same period last year, with a market cap close to $130 million.

Facebook is expected to earn revenues of $5 billion in 2012 with growth conservatively estimated at a floor of 20%. If DSS/LTG generates a low 1% royalty fee from Facebook alone, DSS/LTG could receive $50 million, growing at the same pace. Even if you exclude any past damages recovered from Facebook and other entities and the potential proceeds from other suits in the future, DSS will receive royalties twice the value of its revenues to date for the year.

Conclusion

Imagine the price spike on a micro-cap stock like DSS – an operating tech company already a recognized leader in its field, now backed up by an experienced IP monetization firm. The intellectual property space is heating up and the recent developments at DSS show the company is getting more involved in that area than ever before. Bottom line: a 100% gain on share price in the near-term is achievable. At $2.60 a share and a market capitalization of less than $60 million, DSS is, currently, a diamond in the rough.

Consult with a licensed financial advisor for financial advice. Stock investing has the potential for significant financial losses.