Document Security Systems: Cinderella?

Document Security Systems has yet to post a profit, is in a legal tussle with no less than Europe's central bank and has short sellers circling it like vultures. Yet, six months from now you could be glad you bought some DSS stock.

What the company (symbol DMC) has going for it begins with technology. In an age when counterfeiters and identity thieves are a growing problem, DSS sells ways to foil the bad guys. For example, if you print a check, birth certificate, driver's license -- basically any document -- on its SafetyPaper and try to reproduce it with a copier or scanner, hidden messages appear on the copy, alerting anyone that the document is false. Another of its products insures that a photocopy of a document, say a prescription form, comes out black.

Already DSS has made sales to local, state and federal government agencies, banks, financial, medical and pharmaceutical companies, publishers, software companies, firms in the food and entertainment industries, and paper suppliers and printers. Some of its higher-profile clients include mega printing company RR Donnelley Sons, Boeing, Boise Cascade and the states of Kentucky, Colorado and New York.

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While it's not making money yet, the company had its first positive cash flow from operations in its 2006 third quarter. Here's the best news: It should book sales of about $5 million for 2006, and it should turn profitable when its annual sales rate hits $11 million. That will happen this year, says chairman Patrick White. Given that DSS is only about four years old and much of its first couple of years were spent cleaning up its patent rights and doing other housekeeping, it's off to a quick start.

So, DSS has good products, good growth and a financial picture that should get lots more investor attention when it posts that first profitable quarter. What about the European Central Bank fracas and the short seller vultures? The first could make DSS the Cinderella story of the year, though it's a long shot, and the second will result in vulture fricassee and probably a boost in its stock price.

The European Central Bank story sounds like a movie plot. DSS, which has filed a lawsuit against the ECB, claims that when the Europeans started printing euros in 2002, they used some of DSS's patented anti-counterfeiting technology. DSS contends that with more than 34 billion euro notes printed, the ECB owes it between $60 million and $155 million -- that includes a bulk-purchase discount. White says the company will also take legal action against countries it believes have infringed its patents.

The timing of the ECB lawsuit's outcome is unclear: The resolution could come as early as this spring or it could drag on for a year in the appeals process. White won't speculate on what impact a big settlement will have on the stock's price, which closed at $10.60 per share on January 5. But with about 13 million shares outstanding, it's safe to say the share price wouldn't stand still. Again, though, the European-Central-Bank-pays-up scenario looks like a hail Mary.

Much more promising is the short-seller situation. Short sellers profit when the price of a stock falls. They do this by borrowing shares, then selling them with the intent of buying them back after the share price drops. They then return the shares they borrowed, and profit from the price difference.

Short sellers, eager for a stock price to fall, often try to convince other investors a company is in trouble. In the case of DSS, one short seller said he believed that the company would run out of money. True, DSS was short on cash, but last month it raised $4.4 million in a private placement.

Other accusations by the shorts have been downright nasty. Particularly, they've derided the origins of the public company that eventually became DSS. Remember I said part of the DSS story sounds like a movie plot? The company started back in the mid 1980s as a penny stock venture to produce movies. The company, then named New Sky Communications, never made any money at it, but it did make one good movie, Lady in White (a great rental around Halloween).

Not many independents make money producing movies, but Charles LaLoggia, then the head of New Sky, gave it a good try. I know this first hand because I wrote about New Sky more than a decade ago while working as a business reporter in Rochester, N.Y., where New Sky was based, and where DSS remains. True, DSS didn't have auspicious roots, but credit LaLoggia (who also wrote an investment newsletter for years) for using the shell of New Sky to help start a going concern with real potential.

When the short sellers' doomsday scenarios don't pan out, the pressure they put on the stock price will evaporate and shares should rise. Shares have traded as high as $15 in the past year.

Does DSS literally own a license to print money? We'll know soon. Even without winning that suit, it will make money the old fashion way, by growing sales.