Netlist Stock: Insiders Sell As Retail Buys Litigation Hype (NLST) (2024)

Company Overview

Until recently, Netlist (OTCQB:NLST) had been a relatively unknown penny stock. Founded in the year 2000, the firm competes in the highly competitive and commoditized industry of memory module production and sales (semiconductors, NAND, DRAM, etc.). Netlist sells their own products and is also a re-seller of other companies' products (e.g. Samsung (OTCPK:SSNLF)).

As one might expect, this has historically resulted in Netlist achieving a very slim gross margin. Over the past ten fiscal years through 2020, the company has never had a positive cash flow from operations.

Source: Compiled by author

Without some sort of revolutionary new product, I think that it is obvious that Netlist is not a viable competitor within their industry as they are going up against giants such as Samsung, SK Hynix, Micron (MU), Intel (INTC), etc. Netlist's stock price and market cap at the end of 2020 of $0.60 and ~$120M respectively were about what you might expect for a company in this position.

But since then, it has been off to the races for Netlist's share price, with the stock trading as high as $10.20 per share on 7/22/21 before settling back to between $6.00 and $7.00 recently. What could have driven the market cap from ~$100 million to more than $2 billion?

Source: Compiled by author

Patent Litigation

This is a headline from Barron's: "NetList Spikes; Rumors It Will Settle Google Patent Suit". You might think that this article is related to Netlist's current surge, but the article is actually over 11 years old and is from March 3, 2010.

While Netlist has failed to create a sustainable and meaningful business over the past ten-plus years, they have simultaneously been engaging in multiple bouts of drawn out patent litigation suits. One particular lawsuit development helped kick off the great 2021 share price appreciation.

On April 5th, Netlist announced that they had settled their litigation against SK Hynix in exchange for a $40M royalty payment and a supply agreement wherein the company can purchase $600M of Hynix product over five years. Obviously, this settlement alone doesn't square with a ~$2B market cap appreciation, so there must be something more.

Netlist Vs. Google Lawsuit

After Hynix, investor attention quickly pivoted to Netlist's ongoing case against Google (GOOG) (GOOGL). My understanding of the case is that years ago, Netlist developed a technology which would allow computers and servers to access a superior amount of RAM, and thus run faster servers. Netlist allegedly met with Google to discuss a license agreement, but Google allegedly declined to work with Netlist and instead copied the technology and utilized it in their servers.

After the Hynix settlement, retail investors took it as a sign that Netlist's likelihood of a favorable outcome against Google had increased. They also began speculating that Google might have to pay Netlist billions of dollars as a result. Right on queue, promotional YouTube videos began popping up with headlines such as "Netlist Stock at $7.55 Going to $40.00 or More? Google Settlement". One party apparently even felt passionate enough about the litigation to launch a website with the domain "googlecheatednetlist.com".

But speculations for a billion-dollar settlement (or more) are, in my opinion, unfounded. At this point, we know little in the way of financial details or how the courts will even approach the evaluation of Netlist's claims.

Pointed Earnings Call Questions

On August 3rd, Netlist CEO Chuck Hong received what seemed to be skeptical questions with respect to the size of a potential Google outcome, with the first question concerning Google's potential ability to limit the patent infringement timeframe to a very short period:

Analyst, Craig-Hallum: It sounds like if Google is successful, they'll limit the infringement timeframe to early last year when the patent was issued. Let's just ask the very simple question. Is that a correct interpretation so there'll be a fairly limited period of time?

CEO, Hong: Sorry, I just wanted to provide some background on intervening rights. I think there was a lot stated in the script. But in layman's terms, intervening rights is a concept that is very arcane. It’s very rarely brought up. There's very little case law, in fact. And it's an arcane concept within patents, but yes, I think you have the right interpretation, Richard.

Source - Q2 2021 earnings call

This would significantly reduce potential recoveries against Google if the approach is successful. Hong was then pressed on his previous statements mentioning "billions" in "potential size".

Analyst, Craig-Hallum: Another question on this topic here at Google, I think in the last conference call, you characterized the potential size here and in terms of billions of dollars of product that's infringed. It doesn't sound like you've gotten much of any information from Google in the past quarter here. But would you update that thought process I know just using the “billions of a very wide number”. But is that something that still holds true here or could that be conceivably even larger?

CEO, Hong: Well, again, I thank you. There are many ways to extrapolate to get to a number, one way is to know, one way is to look at all of the servers that they have installed throughout the world in their data centers and apply an average memory capacity for each server. And that's – it’s going to be a little different from server-to-server depending on the application. But I think the industry has a good sense of what the average gigabyte per server is and how many servers are out there that have been installed, at least approximate numbers. So that's one way to get there. [...] So I don't think the number that we're looking at has changed, I think, it will have to be substantiated by discovery from Google.

Source - Q2 2021 earnings call

This isn't the first time that Netlist has thrown around "billions" in connection with a litigation settlement. In fact, they had previously discussed "multibillions of dollars" in connection to the appropriate size of a Hynix settlement. From the Q3 2017 earnings call:

Analyst: It's my understanding that, per public filings, SK Hynix has already made an offer of settlement, but obviously you guys are far apart. Is it an issue? Is it a monetary value issue? Is it a perpetual licensing issue? Did they just want to make a one-time settlement or any color on that probably be helpful?

CEO, Hong: [...] The second-half of your question as to, I don't know that we put out anything that talks about publicly the numbers that are being negotiated, and we're unable to talk about that. But yeah, I think, as we've indicated in the scripted remarks, the financial results that they're recording quarter-after-quarter over the last year and it would seem unabated going forward, multibillions of dollars of sales of RDIMMs and LRDIMMs, as well as multibillion dollars of profits generated. All of that, we believe, are covered by a number of our patents. So, the magnitude of the dollars that they're generating as well as the infringement should indicate the size of the – what the appropriate size of the dollar settlement that is being discussed.

Source - Q2 2017 earnings call

And as we now know, Hynix ended up settling for a much more humble $40M payment. This $40M was even less than the sell-side analysts at Craig-Hallum had been expecting. They had been estimating that both the Hynix and Google outcomes could be closer to the $100M range:

Without financial details, it is difficult to estimate financial outcomes. While we have always viewed the value potential from each to be in excess of $100M, since NLST’s market cap has increased by ~$300M since June 2020 (when details regarding the Alphabet case became public), it seems considerable success has been discounted into the stock". (Statement from Craig-Hallum analyst, Richard Shannon)

Craig-Hallum discontinued coverage on Netlist the day after the Q2 2021 earnings call while maintaining a $2.50 price target, which would imply nearly 60% in downside from current levels. This is a rare and eyebrow-raising move from a sell-side investment bank, as these firms are generally among the most enthusiastic cheerleaders of potential clients' stock prices.

Litigation Timeline

Below are the current court deadlines for Netlist Vs. Google:

Source: Compiled by author

I've highlighted a few key dates which could be illuminating. On 11/8/21, Netlist will be due to deliver their assessment of its theoretical recoveries along with factual supporting details (although Netlist could contend that they are unable to provide a response while specifying what further information would be required). Google would then in turn be able to respond to these contentions on 12/8/21.

Finally, the Markman Hearing is scheduled to be held on 3/9/22. At this hearing, the judge will decide on key definitions within the claim/patent. This could give an indication of which party is ultimately likely to prevail in a jury trial.

We still have many months to go before we'll begin to gain clarity on the Google case. But in the meantime, some NLST investors aren't waiting to offload their holdings.

Follow The Money

If you're playing a poker game and you look around the table and can't tell who the sucker is, it's you.

The above is a popular proverb (famously referenced by Warren Buffett) which I believe can be applied to the situation at Netlist. Let's examine the players sitting at the table in Netlist's case:

1. Institutional investors
2. Company insiders
3. Opaque financier, Lincoln Park Capital
4. Retail investors

Institutional Investors

There is a bit of a catch with my proverbial first seat for institutional investors. It's empty. NASDAQ's website lists one lonely investor which holds a measly $784k investment. This would imply that institutional investors own less than 0.05% of Netlist's shares.

Source

Company Insiders

Turning to seat two, Netlist's two reporting insiders have been dumping millions worth of their stock holdings at an alarming pace.

Source: Compiled by author from Form 4s

In the month of July along, Netlist's CFO sold stock on 7 out of 21 trading days for more than $3.3M in proceeds.

Perhaps more striking is the fact that Netlist's CEO sold one million shares on June 16, 2020, which is the same day that Netlist's stock surged after issuing a press release announcing a successful advance in their litigation against Google. Netlist's website does not list any subsequent press releases concerning updates on their Google litigation. Investors should soberly consider the fact that Mr. Hong parted with 1,000,000 shares at $0.67 cents at the time of the last Google-oriented press release while they are now holding the stock at +$6.00 today and largely depending on the same settlement thesis.

Red Flag Financier: Lincoln Park Capital

A curious party sitting at the Netlist table is financier Lincoln Park Capital. This is a name that, in my opinion, should set off alarm bells for investors. Utopia Capital Research has completed a thorough examination of public companies that Lincoln Park has been involved with and had this to say:

Lincoln Park Capital LLC is arguably the most prolific so-called “vulture funds” currently operating in the realm of small/micro/nano caps. [...] Since 2018, Lincoln Park has been involved with 43 different companies. The vast majority have since experienced significant decreases in their share prices, in some cases greater than 99%. The average annualised rate of return for 42 of these 43 companies is a horrific -42%.

The piece mentions Lincoln's use of Securities Purchase Agreements (SPAs) to purchase shares at potentially massively discounted prices, often in tandem with extreme share count dilution. We see this same arrangement at Netlist. Netlist has executed three separate Purchase Agreements with Lincoln since 2019 [1], [2], [3].

While the legal documents are dense and may be difficult for a layman to follow, I'll attempt to summarize the terms and illustrate how Lincoln makes an extraordinary return.

The PA dated 7/12/21 was for purchases of up to $17.4M in Netlist stock by Lincoln. According to the terms, Netlist would inform Lincoln on the date that the company would like to sell newly created stock to Lincoln, and Lincoln would stand ready to give cash to Netlist at the Purchase Price. There are some nuances to the Purchase Price calculation, but under ordinary circ*mstances, it is calculated as follows:

The lesser of the lowest sale price for our common stock during the purchase date of such shares; or the average of the three lowest closing sale prices for our common stock during the ten consecutive business days prior to the purchase date of such shares.

Just reading the formula doesn't quite give one the full impression of the potential returns here. So I have calculated an illustrative purchase price and corresponding discount that Lincoln would capture over the last year using the 2021 PA's formula. The visual results are below:

Source: Compiled by author

At a minimum, Lincoln is guaranteed to buy NLST stock at the day's lows but has the potential to earn massive returns if they are called to buy stock while the share price is appreciating. As I understand the PA, Lincoln faces no lock-up restrictions and is free to immediately sell the shares on the open market.

Furthermore, Lincoln is slated to receive up to 200,500 free "commitment shares" as part of the 2021 PA which were valued at ~$1.2M at the time of the transaction. Below is a breakdown of Lincoln's disclosed figures from Netlist's annual/quarterly filings and the implied costs per share paid by Lincoln.

Source: Compiled by author

It's hard for Lincoln to lose under this arrangement. I'd argue that this is also a sweet deal for management. They are able to obtain the cash that is needed to keep the company alive (and also keep their jobs/stock awards) with little questions asked and few strings attached. But it isn't such a clear win for the rest of the shareholders. Since the end of FY 2018, stock issuances to Lincoln have resulted in 43% dilution to common shareholders.

Source: Compiled by author

Retail Investors

This leaves our final and most enthusiastic proverbial player, retail investors, the only apparent buyer of Netlist stock. Does retail have a unique insight into the litigation outcome with Google which trumps that of management, Lincoln, and the non-existent institutional investors? It appears that all parties involved are sellers to retail (including me). "If you can't tell who the sucker is"...

Corporate Governance And A Window Into The Firm Itself

Glassdoor employee reviews paint a picture of a firm with a "toxic [and] hostile" environment, with criticisms being particularly levied against Netlist's CEO. One especially ironic comment was that "The board of directors need to be informed of CEO's attitude with employees."

It would be interesting to see the results of a hypothetical complaint made to Netlist's board regarding the conduct of the CEO. The board is after all composed of one individual - founder, director, and CEO, Chuck Hong. While Netlist had previously experienced an instance of two board members resigning over a disagreement with the company, the exit of the last remaining board members was not accompanied by a press release or an 8-K, but was quietly done as part of Netlist's annual proxy vote. The "Board" advised investors that they had:

determined it to be in the best interests of its stockholders to reduce the number of directors serving on the Board to one director and to dissolve all committees of the Board effective immediately after the Annual Meeting

Apparently, it is in the best interest of investors to have no audit, compensation, or corporate governance committees. Such unconventional disregard for the minimum level of typical corporate governance standards should again be highly suspect. This structure also likely ensures that Netlist remains untouchable for the vast majority of institutional investors and would not be eligible to uplist to a more liquid exchange such as the NASDAQ or NYSE.

Conclusion: NLST Stock Forecast

Stocks go up when there are more buyers than sellers. As I've highlighted, there are almost no institutional investors buying NLST stock and the structure of the board makes the stock untouchable for many large investors. Management has been selling a huge portion of their stock holdings. Lincoln has been selling their NLST stock as well (as evidenced by the fact that they have never exceeded an ownership threshold that would require SEC reporting). NLST also has a very low short interest at ~1%, so there is not a strong base of short sellers that could be potential buyers of the stock.

I believe the only buyer of NLST stock has been misguided retail investors who have unfounded expectations of a massive Google settlement. Once the last retail buyer is "in" (if they aren't already) things do not typically end well, and cracks may already be appearing. After briefly exceeding $10 per share on 7/22, NLST sold off nearly 40% and traded as low as $6.31 the very next day.

I agree with Craig-Hallum in believing $2.50 to be a realistic target price for the stock, which would imply a ~$560M market cap and significant downside.

Risks To A Short Position

While Netlist does trade with a decent amount of liquidity, it is a volatile stock that is subject to headline risk. The most obvious risk is an announcement of a Google settlement that would come in vastly higher than is typical for patent litigation cases, i.e., at over $1 billion in cash to Netlist. In the meantime, Netlist's upside should be relatively limited as it should not exceed what could be conceived of as even a highly optimistic settlement amount.

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