Netlist: Short Opportunity Following Appeals Ruling

Introduction

I've been covering chip manufacturer Netlist (OTCQB:NLST) on SA since July 2021, and I've written a total of four articles about it so far. The latest of them was in January 2023 and in it I said that the company was likely to remain in the red for the foreseeable future and that it was unlikely to secure more license fees or settlement payments anytime soon from its patent infringement lawsuits.

Well, Q2 2023 sales slumped by over 80% year on year while the operating loss almost tripled to $14.3 million. On the legal front, a federal jury in Texas awarded Netlist over $303 million in a patent infringement case against Samsung (OTCPK:SSNLF) in April 2023, but just last week the Ninth Circuit Court of Appeals reversed the district court's decision. As a result, the market capitalization of Netlist has slumped by almost 40% over the past week to $332.1 million as of the time of writing. In my view, the prospects for the business look grim and considering the short borrow fee rate is 9.45%, I think that this could be a good time to open a small short position. Let's review.

Overview of the recent developments

If you aren't familiar with the company or my earlier coverage, here's a short description of the business. Netlist was established in 2000 and is a supplier of modular memory subsystems that specializes in hybrid memory solutions.

Yet, the vast majority of its sales currently come from the resale of products of South Korea's SK Hynix (OTC:HXSCF). The two companies inked a 5-year product purchase and supply agreement back in April 2021 after the Korean firm paid Netlist a $40 million license fee to end a lawsuit over patents infringement. The issue here is that reselling SK Hynix chips isn't particularly profitable, and Netlist hasn't managed to book a positive operating result in a single quarter since the supply agreement was signed. With the global chip demand facing a downturn over the past several months, Q2 2023 was particularly underwhelming for Netlist, with net sales slumping by 81.9% year on year to $10 million. The decrease wasn't concentrated only in the resale of third-party products as sales of Netlist's proprietary products went down by 76.8% to just $1.4 million during the quarter.

With the gross profit margin shrinking to 2.3%, and legal fees almost tripling to $9 million, the operating loss soared to $14.3 million during Q2 2023.

While legal expenses are typically a non-recurring item, I would argue that this isn't the case here as the market valuation of Netlist has been linked more with its intellectual property (IP) portfolio than its financial results over the past few years. While the company claims that its IP has an important role in the artificial intelligence market, I think its lawsuits are what's attracting investors here.

It should now be clear that Netlist's IP portfolio is important to the memory industry's rapid move to DDR5 and AI. - source here

You see, Netlist has been suing the likes of Samsung, Alphabet (GOOG, GOOGL), and Micron (MU) over patent infringement for several years now. The lawsuits against Samsung and Alphabet are mainly linked with U.S. Patent No. 7,619,912 (known as the '912 patent) that relates generally to technologies to implement rank multiplication while the ones against Micron are over patented RDIMM and LRDIMM technology, which also includes the '912 patent. Netlist was trading below $1.00 in 2020 as few people thought these patent infringement lawsuits could go anywhere but the $40 million deal with SK Hynix fueled speculation that similar or more valuable agreements could be coming in the future, sending the share price over $9.00 in 2021. Yet, most of the license fee has already been spent on mounting legal fees and there are no indications that Samsung, Alphabet, or Micron have any interest in settling with Netlist. The expectations of some retail investors for court rulings in favor of the company seemed validated in April when a jury in Marshall, Texas (infamous because of patent trolls), ruled in favor of Netlist, and Samsung was ordered to pay over $303 million. However, a court filing from October 17 showed that the Ninth Circuit Court of Appeals reversed the district court's entry of declaratory judgment and remanded it for further proceedings. This means that the fight against Samsung is pretty much over and I'm not optimistic that the lawsuits against Alphabet and Micron are going to result in a positive outcome for Netlist. The case against Micron in the Eastern District of Texas is related to the same patents as the Samsung trial from April. Overall, I think that the market valuation here is likely to decrease significantly over the coming months as sentiment is turning negative following the new Samsung ruling and that Netlist could be back below $1.00 per share before the end of 2023.

In my view, the business of Netlist is close to worthless at the moment, and considering that data from Fintel shows the short borrow fee rate is 9.45% as of the time of writing, I think that this could be a good time to open a small short position. That being said, it could be best for risk-averse investors to avoid this stock as there are no call options available to hedge the risk here as Netlist is traded on the OTCQB. If I decided to open a small short position here, my strategy would include a holding period of up to three months and my stop loss level would be at about $1.90 as this is my personal risk tolerance level at the moment (about 40% increase from the current share price). I would take profits at about $1.00 per share. Taking into account the history of price volatility for this stock, opening anything but a small position would be very risky.

Turning our attention to the upside risks, I think that the major one is that microcap stocks can soar for spurious and unknown reasons. Netlist itself is a good example of this its share price has spiked on several occasions over the past years.

Another risk here is that there could be another jury ruling in favor of Netlist in Marshall over the coming months, which could boost the share price.

Investor takeaway

In my view, Netlist investors were overoptimistic that the SK Hynix license agreement was just the beginning as more similar deals were on the horizon. This has been proven incorrect over the past two years and the new ruling on the Samsung lawsuit is likely to dampen market sentiment over the coming months. The financial results of Netlist are deteriorating, and I think that the share price of the company could go down below $1.00 before the end of this year. Yet, it could be best for risk-averse investors to avoid Netlist there are no call options available and the company's share price has a history of wild swings over the past years.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

If you like this article, consider joining Microcap Review. I post my portfolio and shortlist there and you can also find exclusive ideas from our community of investors. I like to focus on undervalued companies that the market is ignoring, like an island of misfit toys.