MGT Joins Vringo and VirnetX in Wall Street’s Hottest New Sector: Patents

Submitted by Lisa Bailey as part of our contributors program.

Just this week, we have seen two courtroom victories within the stock market’s hottest new sector: patents. VirnetX (VHC) just won $368 million from Apple (AAPL) and Vringo (VRNG) just won a 3.5% royalty + $30 million from Google (GOOG). In the wake of this success, a new firm has entered the scene: MGT Capital Investments (MGT). Like its successful peers, MGT’s strategy matches the high-profile, mega-dollar criteria. It is suing for what could be billions in damages from corporations like MGM Resorts (MGM), Caesars Entertainment (CZR), Penn National (PENN) and WMS Gaming (WMS).

On May 10, 2012, MGT announced the acquisition of a majority interest in a slot machine-related patent. Last Friday afternoon, MGT made a public announcement that the law firm it had hired to help with the monetization of this patent had filed a lawsuit on behalf of MGT. The plaintiffs in this case are three major casino operators and two slot machine manufacturers, listed above. This lawsuit offers a potential for significant return to investors in MGT common stock.

The downside risk is somewhat limited due to MGT’s micro-cap market capitalization of less than $16 million as of the date of writing. MGT also has relatively low operating expenses and has hired one of the leading intellectual property law firms in the nation, Nixon & Vanderhye. With zero debt and about $7 million in cash, MGT might not have to raise additional capital for years or–if it prevails in the lawsuit–ever.
This is good news for investors in common stock. In particular, for shareholders of firms like VirnetX and Vringo, the possibility of holding through a court decision without a single dilutive capital raise sounds like an elusive dream. (Both firms diluted shareholders heavily along the way to their respective jury trials.)

Background on the ‘088 Patent

Steve Brandstetter and James Devlin filed a patent application in October of 2001 and the U.S. Patent And Trademark Office granted patent 7,892,088 (the ‘088 patent) in February of 2011. This patent relates to gaming on networked slot machines and the chance for one or more of players to participate in a separate bonus event. The bonus event must occur on a separate display and is in addition to any individual winnings on the slot machine.

Typical assertion of a patent like this allows the patent holders to assess past damages from the time when the patent was granted and seek future licensing or royalty fees. The enforceability of the patent could stretch over 20 years in total.

Patent litigation is a complex undertaking that requires hiring of a team of lawyers, negotiating with the companies that infringed on the patent, and eventually receiving a payment or encountering defeat. The whole process can take months and cost millions in legal fees. This is why Brandstetter and Devlin partnered with MGT, which will now manage the patent assertion process.

MGT acquired a 55% interest in the ‘088 patent in exchange of $200,000 in cash, a 4-year warrant to buy 350,000 MGT shares at an exercise price of $4.00 per share, and a consulting contract at $5,000 per month with Steven Brandstetter. Also, MGT has the option to purchase an additional 25% in exchange for $1 million in cash (which they have not yet exercised) and 4-year warrants to buy 250,000 MGT shares at $6.00 per share. Thus, currently, MGT and its shareholders own 55% of patent 7,892,088 with the option to increase this stake to 80%, should they choose to do so.

Yes, Risks, but With a 10-Bagger Potential

Investing in any company pursuing high-stakes litigation carries risks, including the need for extensive funding of a multi-year lawsuit. In general, there are a few likely scenarios. Under the most negative scenario for MGT, the court will find the patent claims unfounded. The reward in this case is negative, up to the amount of expenses incurred in pursuing the patent case. On the positive side, however, the reward could be in the hundreds of millions or even billions of dollars. According to the American Gaming Association, casinos in the United States recorded $36 billion in revenues for 2011, deriving over 60% of these revenues from slot machines. Even a small percentage of these revenues as a reward for MGT would mean a 10-bagger return or more for MGT shareholders.

Depending on the outcome of the negotiations, the royalty percentage or the court order, MGT could receive a large, new source of revenue over the 20-year life of the patent. A $500 million present value of future payments by the casinos and slot machine manufacturers has been bullishly forecasted by one writer. After paying the lawyers’ contingency fee of about 33-40%, followed by paying J&S a 20% share, about $250 million is left for MGT and its shareholders. This is more than ten times the current market value of MGT. Any investing professional will agree that the odds of increasing an investment by a multiple of ten in a few years are extremely low.

Unique Investment Opportunity

Regardless of the risks and outcomes, MGT common stock presents a unique investment and diversification opportunity. Most companies with high beta or correlation to the market are biotechnology, finance, and energy and precious metals exploration companies. If a gold explorer strikes gold, shareholders are rewarded, and if not, they lose their investment. However, gold exploration depends not only on the geological and management teams but also the price of gold. If the price of gold suddenly plummets, many gold projects will become unprofitable. Similarly, a competing biotechnology company may have a discovery making the recent medical discovery of another medical company less valuable. In contrast, investing in MGT and its intellectual property is not correlated to another event, asset or market value. Nevertheless, it still dependent upon the time, effort, and skill that MGT devotes to the patent monetization process. Thus, even if the stock market plummets or gambling revenues slide, MGT could still claim and receive significant patent infringement payments. The reward potential is dependent almost entirely on MGT negotiation and litigation skills, the gaming industry’s ability and desire to fight these efforts, and the court system.

The Patent Sector: Wall Street’s Newest Buzz Stocks

MGT is positioned in one of Wall Street’s hottest sectors. Recently, courts have sided with patent holders, even in lawsuits wherein patents were extremely broad in nature. Such was the case in a Californian court which ruled that Samsung had infringed on Apple’s patents, ordering the company to pay a massive $1 billion to Apple. According to an article in the World Intellectual Property Organization, about 25% of patent lawsuits in the U.S. are successful. A 25% success rate is in fact significant given the costs and large awards in most cases that are successful. More recently, the recent victories of high-profile companies like Vringo and VirnetX have reignited the patent sector with over $500 million in lawsuit damages awarded within the past week alone.

Conclusion

MGT’s recent announcement transforms the company from an illiquid, debt-laden stock to an active and debt-free opportunity to pursue a large legal award. The stock has already doubled in price since the announcement of its business model pivot, but the market capitalization is still very low due to the small number of shares outstanding.

Ultimately, the outcome of their legal battle is far from certain. As in any case, there are many details that could lead to an unexpected outcome. MGT is trying to monetize a patent with a potential for a large win, but it could fail outright and lose a few million dollars in fruitless expenditures. In any case, shares of MGT are likely to experience significant volatility as the battle over monetizing the ‘088 patent progresses.