In my last post, I tried, in as clear a manner as possible, to explain why owning Unilife (NASDAQ:UNIS) stock is tantamount to shooting oneself in the foot with a very large gun. The company is in a terrible spot when we use the Porter's 5-Forces analytical framework, it's been punishing shareholders for years with dilutive offerings and unmet promises, and perhaps worst of all, offers investors absolutely zero margin of safety. I didn't think it was possible to value the company fundamentally since the financials are a mess (to put it very, very gently), and I don't believe a single word that comes out of CEO Shortall's mouth. I still think that is the case, but, after reading many a comment, I've decided to give it a crack so that those of you utilizing the "believe everything the promotional CEO says/hope & pray" investing method can see how self-defeating that really is.
I fully expect most people long UNIS will have stopped reading at this point since "the stock is up 100% since I bought, loser!" and "why should I believe you instead of a millionaire CEO?" and other similar retorts of the irrelevant and non-sequitur variety. For the rest of you who aren't wearing blinders and aren't otherwise plagued by confirmation bias, please read on.
When we ask, "what is a stock worth?" there isn't necessarily one correct answer, rather there are at least two, and sometimes more. Many people, mostly short-term traders, firmly believe a stock is worth "whatever someone is willing to pay for it," e.g. the price of stock is purely a function of the quantity supplied and the demand for the stock at a given price. This is all well and good but the problem is that unless one has a strong background in financial economics or econometrics, it's pretty difficult to quantify supply/demand dynamics at some indeterminate point in the future and at other prices. This is where fundamental analysis comes in to help. By understanding the industry and the company, we can come up with some (hopefully) reasonable assumptions with which to estimate the stock's intrinsic value utilizing a fairly robust framework, in this case, with discounted cash flows.
Before I get into the extremely generous assumptions I've used, the model, and the outputs, I have to address something that no one seems (to want) to talk about. In the notes to the firm's financial statements from the last 10-k, we can see that the firm has (clearly) generated operating losses for the past many years, which generally creates a deferred tax asset. Without getting into the nitty gritty details, accounting standards require management determine if there is >50% chance that some or all of these deferred tax assets will be able to be used before expiring (20yrs for carryforwards). If so, the firm has to reduce the value of the DTAs with a valuation allowance by the amount (or %) they think will be realizable. Unilife management has determined that not only is there >50% chance some of the operating losses/deferred tax assets will not be utilized, but that exactly zero % will be. For those who were wondering, this is why a firm with persistent losses has no deferred tax asset on the balance sheet. UNIS management itself has determined that they will not be able to generate future pre-tax income to take advantage of ANY of the losses generated thus far. Let me restate: UNIS management may tout current and soon-to-be announced revenue generating deals all they want, but when push comes to shove, they don't expect to generate operating profits in the future. The question that immediately comes to mind is, "if management doesn't expect the company to earn profits, why should I expect it to?" The answer is simple: You shouldn't.
I'd also like to digress for a bit to talk about the firm's much heralded patent portfolio, which, as of the last 10-k, consisted of 96 patents in 24 jurisdictions including China, among others. Why any company would file a patent in china is completely beyond me; it's essentially an invitation for Chinese firms to steal your IP and make your products cheaper, faster, etc. I'd also imagine that, since those 96 patents are spread among so many jurisdictions, few are in the US, but that's really a moot point since UNIS really doesn't have the resources to defend any of their valuable patents against the likes of a Becton, Dickenson. All I'm saying is that those who fall back to using the firm's patent portfolio to rationalize the current/future value are doing themselves a disservice, at best.
One last thing I should probably elaborate upon is that due to Unilife's rather unenviable financial position, there is a non-zero chance the firm will face bankruptcy before Shortall's many promises of greatness come to fruition. Using the popular Altman Z-Score to evaluate UNIS' prospects on this front, we get a value of 0.62. For the uninitiated, a score below 1.8 indicates a high probability of bankruptcy. Unilife's outlook doesn't look so pretty, does it? For some perspective as to how bad it really is, consider that the year before Borders declared bankruptcy, it's Z-Score was 1.79, almost triple Unilife's.
Now that we've got these rather important facts out of the way, let's get into the valuation exercise I've done for your edification. Some major assumptions I've made (all very much giving UNIS the benefit of the doubt, and then some):
- EVERY income statement line gets better. Revenue growth accelerates substantially, margins expand A LOT, and expenses (as % of sales) decrease significantly and quickly. I think these improvements are completely unrealistic, but again, I'm giving UNIS the benefit of the doubt and then some.
- Within 5 years, UNIS will achieve industry average price/sales valuation and the attendant revenue, even though it's currently at ~80x P/S; it will also achieve industry average margins as well, despite being nowhere close at any time over the past several years. These are also completely unrealistic assumptions in the realm of reality, at least.
- Zero debt repayment; capital structure/leverage will improve over time as retained earnings go from very negative to eventually positive.
- Zero income taxes (DTA's/NOL's will be available in future years when there is taxable earnings).
- Zero net interest expense (unrealistic, but in Unilife's favor).
- Steady depreciation & amortization of $5mm/yr; unrealistic, but as I said, giving UNIS the benefit of the doubt.
- Steady CapEx of $2mm/yr, i.e. no big factory/equipment/etc expenses, everything in place now is sufficient and doesn't need to be replaced, added-to, etc.
- If/when needed, the company will be able to issue new shares at only ~10-15% discount to market. This also takes into consideration the $19.2mm remaining on the Controlled Equity Offering Sales Agreement as of the last 10-q.
- The above also assumes UNIS will have no problem raising additional equity capital when needed, which may or may not be the case. Also assumed the firm sells shares rather than issue debt of whatever variety. Given the firm's historical, current, and projected financial situation, I don't think UNIS would be able to tap credit markets at anything approaching friendly terms, if they could at all.
- Beta and current ERP/risk-free rate for a company like this render CAPM useless for establishing cost of equity. Therefore I've calculated the price/share using discount rates from 10%-25%. I think 20% or 25% are the most realistic given the very high risk and uncertainty in UNIS shares.
Notice I've highlighted several cells in yellow? Those are the ones that should cause you to scratch your head the most, especially if you consider the trajectory it took to get to those numbers. The chances UNIS gets to there, by then, is approximately zero. Here's what the basic cash flow statement looks like:
Notice how Operating Cash Flow goes from very negative in 2017 to pleasantly positive in the terminal years? Probably not going to happen, and by probably, I mean definitely.
All things considered, this set of assumptions is so extraordinarily generous for UNIS, to the point that I don't think there's any chance a few of them come to fruition, let alone all of them. That means the valuations I've obtained from this model are much, much higher than you should reasonably expect. So, what's the stock actually worth?
As I stated earlier, I'm partial to using a 20% or 25% discount rate to reflect UNIS' inherent riskiness and high opportunity cost, but if you're clairvoyant, you can see what the stock is worth at 15% as well. If we assume an equal probability of each stock price, UNIS is worth $0.56, although it closed Friday at $4.70. Using EXTREMELY generous assumptions, we see that Unilife is overvalued by a massive 738%! In order for the stock price to reflect (uber-generous) fair value, it would need to drop 88% from current prices! Even if you're in the "stock prices are solely based off supply & demand" camp, you can't ignore the fact that using an EXTREMELY generous (read: unrealistically positive) set of assumptions, I can't get a value for UNIS that's anywhere close to where it's been trading, not even in the parking lot let alone in the ballpark. There is literally 0% chance UNIS will achieve all or even most of these generous assumptions (revenue, margins, etc), so if you plan on holding the stock longer term/for more than a few days as a trading/speculative position, I implore you to consider the huge downside you're very likely to face. Remember, UNIS has a long and storied history of exaggerating the timing and magnitude of deals and milestone payments, issuing equity even when Shortall has said they'll be able to fund internally, etc, etc. If you continue to believe a CEO who has repeatedly failed to deliver on his promises, be my guest. Just remember, those who fail to learn from history are doomed to repeat it.