Friday, June 7, 2013

Upcoming Virnetx Royalty Rate Judgment Likely To Affect Apple's Stock Price

After having attained a 52 week high of $705, Apple (AAPL) has fallen back to $445. There are many factors that have influenced this decline one of which is a decline in profit margins. On March 31, 2012, Apple had a reported profit margin of 47.37%. Over the last year this has declined to a profit margin of 37.5%. It is typical for stocks to suffer price declines as their profit margins erode. As profit margins decline, P/E ratios also typically decline. The P/E ratio has declined from 17.1 on March 30, 2012 to 10.7 most recently.

Further declines in profit margins will most likely cause further declines in share price. One key upcoming event could have a significant impact on Apple's profit margin, the setting of a royalty rate for Apple's products that infringe on Virnetx (VHC) patents. Apple was sued by Virnetx for infringing on its data security patents with the trial concluding in November, 2012, with a Virnetx victory. After many motions and negotiations no settlement has been reached between Virnetx and Apple. Judge Davis is expected to rule shortly (probably within the next two weeks) on a royalty rate for the offending products. The royalty rate could be set anywhere between .5% to 1.5% and possibly even more. As this royalty rate will apply to all infringing products, (iPhone, iPad, and others supporting Face Time and iMessage), this will have a direct effect on Apple's profit margin which will also impact stock price.

How much impact there will be on the profit margin will depend on the royalty rate set. Virnetx has an established royalty rate structure both published and through agreements with other licensees. Virnetx's published royalty rate is between 1 and 2 percent for customers in good standing. This royalty rate has been validated through licenses with 4 different companies, Siemens (SI), NEC, Mitel (MITL), and Aastra (AATSF.PK). The average rate agreed to by these companies through negotiations is 1.52%, right in the middle of the 1 to 2 percent published rat! e. Whatever rate is set will further reduce Apple's profit margin.

While the original trial was for infringement by the iPhone 4 and iPad 3rd generation, in the recent ruling by Judge Davis, Apple's motion to rejoin the setting of the royalty rate with the penalty portion of the ruling was denied. While this was a widely expected ruling, there is an interesting footnote:

The Court notes that a request for an ongoing royalty goes beyond simply performing a mathematical calculation to determine future damages. Post-judgment damages are analyzed differently than pre-judgment damages. See Amado v. Microsoft Corp., 517 F.3d 1353, 1361- 62 (Fed. Cir. 2008). Additionally, an ongoing royalty applies to accused products and modified versions of those products, so long as those modified versions are not "colorably different" from the adjudicated products. Creative Internet Advertising Corp. v. Yahoo! Inc., 674 F. Supp. 2D 847, 854 (E.D. Tex. 2009). Therefore, the trial court must also determine the issue of whether modified versions are or are not "colorably different" from the adjudicated products when resolving a request for an ongoing royalty.

Based on this footnote, I believe that is it highly likely that any royalty rate will apply to the latest versions of the infringing products as well as the older versions. With the potential hit of up to 1.5% to Apple's bottom line, further erosion of its stock price can be expected.

Apple could prevent a decline in profit margins by raising its price on the affected products but in the current competitive situation, this is unlikely. The other way to prevent further erosion of the profit margin would be to buy Virnetx with some of its offshore cash stockpile. This would provide benefit to shareholders both by preventing further profit margin decline and providing another income stream. The patents that would be acquired are required to support 4G LTE advanced. This will require any cell phone manufacturer to obtain a license ! from Appl! e in order to support the latest 4G standard.

It is also widely expected that Apple will appeal the decision but this will likely only delay, not eliminate the profit margin decline. The addition of these patents to Apple's already formidable patent portfolio would insure the use of these key security patents in its future products without further cost as well.

Disclosure: I am long VHC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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