Over the past month, there has been a heated debate on Unilife (NASDAQ:UNIS) between longs and shorts. Ten articles have been published on Seeking Alpha, and additional commentary has been written on a variety of sites like thefocusedstocktrader.com on the long side, and thestreetsweeper.org on the short side.
Shorts have pointed out a decade-long track record of futility and shareholder value destruction, a long history of promotional contract announcements that yield negligible revenue, massive ongoing dilution and a crowded competitive landscape dominated by multibillion-dollar competitors. The long thesis, in contrast, has been relatively devoid of compelling fundamental arguments. Instead, longs have highlighted how the stock has "popped out of a wedge" and that the CEO boasts about "sitting with a hand of aces," as if highly inconclusive contract announcements will attract investors despite Unilife's numerous precedents of much-heralded customer signings ultimately leading to inconsequential revenue. Stock promotion can only last so long, and history has shown that when informed short sellers spar against day trading stock promoters, the short sellers typically win out, relatively quickly. At some point, sending a thousand tweets to one's 130 followers stops having an impact.
We doubt that many investors are long UNIS because they believe in Unilife's long-term business viability. Rather, the long thesis is premised on the success of the stock promotion. If the promoters can successfully flood the internet with sound bites about Royal Flushes with a liberal helping of the caps lock key, enough momentum traders can pile in to drive the stock price up and into the hands of greater fools. Longs think that the active stock promotion will continue over the near future, because there is a clear and obvious reason for why it's occurring: Unilife is running out of cash and needs to do a secondary offering soon.
Unilife's "At-the-Money" Agreement Provides Minimal Liquidity
Even after accounting for the $10m of upfront proceeds from the Hikma and Sanofi announcements, Unilife is nearly out of cash. Cash and short-term investments were $7.4 million on September 30th, 2013 compared to an annual cash burn that has exceeded $40 million in each of the past two years. Given this burn rate, Unilife likely consumed its Hikma and Sanofi cash during the current fiscal quarter. This could again leave the business with ~$5m of cash by year-end. Making matters worse, Unilife must pay one of its equipment suppliers $4.8m, as announced on November 27th.
Unilife's proponents take solace in a $45m at-the-money ("ATM") share sale authorization struck in October 2012. However, UNIS had just $19.2m of remaining capacity as of September 30th, 2013 (UNIS 10Q3 2013). This provides Unilife with less than six months of additional liquidity, much lower than that implied by the full authorization. Given the dire cash balance one might expect at year-end, we expect that Unilife has already begun drawing on its remaining $19m of ATM capacity.
In preparation for these potential secondary sales, Unilife has been busy trumpeting deals to support its share price. On a recent conference call, Unilife confirmed that it employed deal announcements as a means to pump its share price before secondary offerings: "The only reason we would do it and not have done a secondary offering either on the back of the Sanofi deal or the back of the MedImmune deal was simply because of our confidence of the deals that are in process..." (Q1 F2014 Call).
Unilife Shares Fell 30% after the October 2012 ATM Announcement
While long investors currently view the ATM arrangement as beneficial, the immediate reaction to the October 2012 announcement was wretched. Originally reported on October 4th, 2012, the $45m Cantor Fitzgerald-led secondary authorization resulted in a violent 32% pullback in the stock. Unilife investors, long yearning for legitimate profitability to replace share sales, quickly capitulated after the announcement. Even though the ATM resulted in no immediate share sales or dilution, the mere hint of further secondaries shook investor confidence.
Following this precipitous decline, Unilife was quick to reassure investors that it had no intention of actually exercising its ATM rights, "we have not drawn down this facility nor do we have any immediate plans to do so... The main reason that we put the ATM in place, that was to strengthen our position at the negotiation table" (Q1 F2013 Call). And yet, just one year later, Unilife has exercised 60% of the original ATM agreement.
While the long case hinges on further price spikes precipitated by Unilife's 'aces,' Unilife's long history suggests that rapid declines, like that shown above, are much more likely.
How Will the Market React to Future Secondary Offerings?
Knowing that violent price corrections could occur if liquidity becomes a concern, Unilife will probably seek a new fundraising vehicle well before its current ATM capacity expires. Should it choose a second at-the-money facility, the market could have a similar reaction as it did in early October 2012. If they wish to avoid this, Unilife will instead choose to implement an underwritten, fixed-price offering.
Unilife's past three underwritten offerings were launched at substantial discounts to the current market price. The 2011 and 2012 secondaries were offered at an average of an 11% discount. Not content with a straight-forward discount, Unilife's February 2013 offering called for a warrant grant alongside the common stock issuance. For every three shares purchased in this offering, subscribers received a free warrant with a strike price of $3.00.
As would be expected, underwriters are actively competing with one another to win a potential secondary mandate. Cantor Fitzgerald released bullish commentary and price target upgrades on December 3rd, just in time for a holiday season secondary offering before the bankers' bonus season. Jefferies, the co-manager of Unilife's follow-on offering in November 2011, followed suit on the same day, boosting its own price target. We wish both underwriters the best of luck in their gripping race to win the UNIS placement mandate -- may the most bullish analyst win!
Given that UNIS is running out of cash, underwriters are gushing about highly inconclusive contract announcements, and stock promoters are intensifying their use of exclamation points and poker references, it's clear that a stock offering is on the horizon.
So that begs the question: how large a discount to the current share price will the offering be priced at? While prior offerings have been struck at less than a 10% discount, we think that the ultimate deal price for Unilife's next secondary will be at a much larger markdown to today's ~$4.20-ish trading level. Unlike prior times, Unilife is facing a barrage of heavy criticism from legions of savvy short sellers. In addition to our earlier short-biased report, Unilife has been subject to scathing censure from StreetSweeper, Rick Pearson, Adam Gefvert, and Forbes, to name a few. The company's lengthy history as a public company in both the United States and Australia, as well as Shortall's well-documented background as a seasoned executive at a variety of business failures, have provided plenty of fodder for short theses.
Any institutional investor considering a future follow-on offering will likely be well aware of the heaps of negative commentary being currently directed at the company. Such an investor must be willing to pick a fight with a multitude of reputable activist short sellers. We're not sure there are many that want to become involved in that sort of situation, unless they can invest at a wide discount to the current trading price.
Furthermore, these investors will probably be aware that once a deal gets done, the stock promotion is probably going to abate until the company is back in the market to raise more capital. In contrast, the short sellers will be as incentivized as ever to continue sharing diligence regarding the company's lack of business viability.
The result will be that institutional investors considering a fixed-price secondary offering will likely request a steep discount to the latest trading price. Recognizing the high risk that UNIS might break the deal price, we could see a discount of 20% or more. In turn, underwriters want to maintain constructive relationships with their institutional clients. If they price a deal at too high an offering price, and investors get burned by poor trading after the secondary, the underwriters' reputations will be damaged in the marketplace. Investors will be less likely to subscribe to their deals in the future. As such, placement agents are incentivized to price a deal at a sufficient discount that their investors will turn a profit, at the expense of current shareholders who are becoming materially diluted.
A discount of 20% could imply an offering price as low as $3.50. At $3.50, UNIS would be valued at a $350m+ market capitalization, which we think is still wildly overvalued. We wrote in our earlier article that the company is probably worth less than $100m.
Investors Beginning to Show Indifference to Increasingly Vague Agreements
After reporting its much-hyped Hikma agreement on November 20th, momentum-oriented investors have clung to the belief that additional announcements will continue to drive Unilife's share price higher. But Unilife's more recent announcements indicate that the strength of these 'aces' is quickly decaying. The December 2nd, 2013 Novartis report appears to be regurgitating a November 2011 agreement with a "Global Pharmaceutical Company." Furthermore, the Novartis agreement failed to disclose milestone payments, revenue targets, or production minimums. This lack of detail is surprising in view of Unilife's promotional style and willingness to broadcast financial details if they existed.
The superficial announcements continued on December 16th with a press release concerning an ocular drug delivery system. Once again, Unilife failed to disclose any substantial details related to the deal's profitability. Even more concerning for Unilife believers, the report completely failed to drive UNIS's share price higher. The meager 0.9% gain indicates that the marginal impact from Unilife's announcements is rapidly falling. Without this 'catalyst' of deal announcements to drive the share price higher, the basis for the momentum-driven long thesis begins to break down. And once these momentum investors begin their exit, the market will shift its attention to the underlying economics of Unilife's deals. The company's unwillingness to actually set earnings or cash flow guidance for 2014, or even 2015, indicates that the fundamentals are a topic that Unilife is loath to confront.
The current season of stock promotion at Unilife appears no different from previous episodes. Rather than relying on fundamentals disclosed in 10-K and 10-Q filings to support the share price, Unilife prefers a bombardment of vague press releases. This gives management cover to further dilute its shareholders, either through at-the-money offerings or fixed-price block trades. Such a strategy has attracted the day trading crowd. But this group has the attention span of a five-year-old, and will only remain captivated while UNIS's share price is rising.
Unfortunately, UNIS's share price has stopped rising. Rather, it's declining. New deal announcements are falling on deaf ears. Short sellers' criticism is reaching a fever pitch. The smart money day traders have moved on to greener pastures.
Soon, investors will once again start to ask the tough questions: where is the revenue, what is the timeline, and when, if ever, will Unilife return sustained free cash flow to investors?
At this point, any hint of further secondary offerings will severely impact investor psyche. Any sign of weakness could cause UNIS to swiftly surrender its recent 70% gains.
Additional disclosure: Read our full disclaimer at kerrisdalecap.com/legal-disclaimer-3. This is not a recommendation to buy or sell any investment. We may transact in the securities of UNIS at any time subsequent to publication.