Saturday, 16 July 2016

United Guardian, Obscure Micro Cap, Great ROE, Great ROIC, Not Cheap Enough (Yet)

As I progress along my investing journey, I'm beginning to think in terms of not just attempting to find good and cheap stocks.  Both of these characteristics are transitory.  A company can be both good (based on return measures) and cheap (based on market valuation measures) at any point in time: It can continue to be good and cheap, and get cheaper, and cheaper, and cheaper (to the investor's chagrin).

Critical to developing a durable investment thesis is understanding what catalysts, changes, or under-appreciated events might eventually close the gap between the current state of cheap and an intelligent investor's conservative estimates of fair value (or range of fair values), in excess of current market value as measured by EV.

What's been missing from my analysis is an attempt to a) understand the significant current issues impacting valuation, b) determine possible catalysts which could sway investor focus away from current issues impacting valuation, and most importantly, c) develop an understanding of whether a company will be able to reinvest probable future cash flows and earn sustainable high returns on invested capital in excess of its cost of capital.

A company can appear to be super cheap (based on accepted conventional measures of valuation), but if it can't reinvest its future cash flows and earn sustainable high returns on invested capital in excess of cost of capital, it won't grow (in theory), and as a direct consequence, shouldn't appreciate in value.  The opposite is often the case.  I think this is why nose-bleed P/E stocks with extreme optimism surrounding consensus opinion on the way up tend to under-perform due to lofty expectations not being met.  Some call this P/E compression.  Expansion on the way up, and compression on the way down.  One of my favourite authors over at gurufocus had an article on Whole Foods Markets articulating exactly this, link here.

I find c) to be the most difficult concept to understand and exploit, because it requires peeling back the layers of current issues vs. probable catalysts, and forecasting normalized cash flows not currently appreciated as possible by the consensus while staying objective and realistic.  It's fairly easy to identify measures of cheap: it's fairly difficult to forecast how a company is going to overcome the "reasons" surrounding current cheapness (it has to be cheap for a reason), reinvest future normalized cash flows, and earn high returns on invested capital that very few other participants believe are possible.

The caveat to c) is developing a conservative appreciation of this potential (or range of potential) before investor consensus prices this in.  The best value investing opportunities seem to arise when the pendulum of pessimism prices in the demise (or diminution) of a going concern, and careful analysis reveals that this degree of pessimism is unwarranted.  The above approach is difficult to execute, because it requires sitting on your hands most of the time and being incredibly disciplined by way of not swinging at every pitch.  And my experience is, it;'s incredibly tough to sit on your hands because we, as investors, are led to believe that there are loads of temporarily cheap stocks at any one point in time.  This state of affairs is a direct consequence of bullish prevailing bias enveloping the financial universe.  Turn on the financial news, at any point in time there is no shortage of talking heads articulating a thesis as to why XYZ is currently cheap (at 40x ttm).  But, I've digressed enough. Onto the original subject of my blog:

United Guardian

I've posted about United Guardian in the past.  I owned a small amount earlier this year and got stopped out. For now, I have the company on watch.  It appealed to me when I first bought it because I thought that the company exhibited pretty substantial return metrics, and I based my purchase on these metrics alone.  But a cursory understanding of return metrics is often insufficient.

Over the last 10 years, the company has generated gross margins at or above 60% consistently, pretax operating margins of 44%, and net margins of over 30%, coupled with ROE in excess of 25%, and ROIC in excess of 25%.  I'd hazard a guess that consistency in operating metrics such as these would result in a a higher relative trading multiple, and indeed this had been the case up until recently (any by recently, I'm referring to prior to 2014).  I believed that high enough gross and operating margins over time were symptomatic of sustainable competitive advantage by way of pricing power.

As the company grew its top and bottom lines between 2006 & 2013, investors awarded the company a high multiple.  Between 2006 & 2013, sales and net earnings grew at a 3.4% & 11% CAGR respectively, even while the company experienced production shortages of its main pharmaceutical product between 2011 & 2013. The higher CAGR in net earnings relative to sales appeared to be a result of the company's ability to generate high returns on invested capital.  The company outsources the sales/marketing function attributable to its major product line, and so avoids the overhead ordinarily attributable to running a sales/marketing team.  At its peak in late 2013, the company was valued at 22x trailing earnings.

Since the end of 2013, something interesting has happened to ROE & ROIC, per below:

Between end of 2013 and now, both ROE & ROIC have dropped from 41% to 24% currently (ROE and ROIC are basically identical, the company has no interest expense so there's no difference between EBIT and EBT, so NOPAT  = NI)

Over the same period, revenue has dropped from $15.4M to $11.9M in the current ttm period, and NI has dropped from $5.9M to $3.67M .  While gross, operating and net margins have appeared to have held up, top and bottom lines are off by about 23% and 38% respectively.  There are a couple of possible explanations for the drop off in both revenue and earnings, more on this later. Suffice it to say, it has not been a fun ride being a shareholder between end of 2013 and now, see chart below:

While investors appeared to applaud the consistency of earnings growth between 2009 and 2010, the opposite has been true since the stock peaked in early 2014.

The company is tiny.  It's entire Enterprise Value is around $60M.  One insider, President and Chairman of the Board Ken Globus, owns 30.5% of the float.

The 2015 proxy statement is all of 17 pages, and the 2015 annual report all of 28 pages, link here.

The company is fairly easy to understand, from the 10K:

The company makes personal care and cosmetic ingredient products, under its Lubrajel products line, which accounted for 84% of revenues in fiscal 2015.  The company also makes pharmaceutical and healthcare products, the most significant of which is Renacidin Irrigation, which accounted for 9.6% of revenues in fiscal 2016.

The Lubrajel line consists of oil and water-based moisturizing/lubrication products, and from my understanding, these products are used as additives in the formulation of other personal care / healthcare products. The company relies on a marketing partner, Ashland Specialty Ingredients, to sell its lines of Lubrajel products.

The problems (as of late) facing the company appear to be as follows:
  • Reliance on the Lubrajel product line for a material (+80%) portion of its revenues
  • Reliance on a focused sales channel of this same product line into China (and exposure to any/all Chinese regulatory issues)
  • Intense competition by way of Chinese copies of its Lubrajel products in Asia and Europe
  • An inventory issue by virtue of its marketing partner, Ashland, accumulating excess inventory to last through Q2 2016.  As a result, the company previously warned that Q4 2015 and first half 2016 sales would decrease significantly vs. the first three Q's of 2015.  If the inventory issue is unresolved through first half 2016, excess unsold inventory plus competition could potentially result in pricing and margin pressure.  Certainly, this type of issue makes forecasting future sales difficult on the part of the individual small investor.

Based on the above, I can understand why the stock has come under pressure, and certainly, after having developed a better understanding of the issues potentially facing the company, I've relaxed my initial competitive advantage and pricing power assumptions.  A 22x peak 2014 P/E adjusted for a non-recurring spike in Ashland purchases of inventory quickly morphs into a 35x P/E after normalizing earnings to between $3M to $4M.

The question is, were net earnings of $5.9M an abberation due to Ashland accumulating excess inventory? And if so, what are go-forward normalized sales of the Lubrajel product line likely to be once all excess inventory is worked off?  With muddy visibility concerning growth prospects attributable to the Lubrajel product line, it makes sense that investors would tread cautiously until valuation reverts to a slow to no-growth state (i.e., P/E of 14x or less), suggesting further weakness in the price of the stock.

A Potential Silver Lining 

In 2015, the company obtained FDA approval to begin marketing Renacidin 30ml, an irrigating solution used to prevent and treat incrustations in urinary tract catheters, in a small, single dose plastic bottle.  (Ask me if I know what an incrustation is, good old google be praised, it's a formation of a crust).

All joking aside, prior to this FDA approval, Renacidin has been marketed and sold in a much larger 500ml dose format, and prior to 2010, accounted for almost 20% of sales.

The company experienced production issues with the 500ml format due to an issue with a 3rd party external manufacturer/supplier between 2010 and 2013, and according to the 2015 annual report, sales in 2015 were still "significantly lower than they were prior to those production curtailments, and the Company is continuing its efforts to try to recover some of the customers it lost as a result of those production curtailments and the consequent inventory shortage".  The theory now is that single doses will result in higher take rates and higher sales vs. the existing 500ml bottle.

Further comments from the 2015 annual report are reproduced below:

There are a couple of ways to look at this:

  • There could be potential pent up demand for the new single 30ml dose plastic bottles, which could translate into a jump in sales as promised post product introduction in April 2016.  The company may need to spend significantly on marketing the product though, and any adoption of the 30ml dose plastic bottle would naturally occur after the market absorbs the company selling off its remaining inventory of 500ml glass bottles (I'm not sure what the take rates or product usesage life of these 500ml bottles are).  In the company's Q1 letter to shareholders, the President noted that there should be no overlap between the two products, so I take this to mean that the 500ml bottles will have a short enough life cycle to have been used up once the 30ml bottles are ready for sale.
  • On the other hand, the company may not be able to fully replace the customers it lost previously unless the 30ml bottle really takes off.  And the problem I'm having here, I'm not sure how to even begin researching this!  In the company's Q1 letter, the President was pretty conservative in addressing the market potential, and made guarded statements along the lines of it being too soon to know whether the new single-dose form of Renacidin will have the hoped for impact on sales.

How do you estimate the market potential of the new single dose 30 ml bottle?

Really tough question, as there appears to be extremely limited information concerning pricing by product.  I was able to determine annual sales dollars by product for both Renacidin and Lubrajel going back to 2007 using a combination of extracting data from previous yearly 10K's and with reference to the following analysis of the company, courtesy of Value Investors Club, link here:

Conservatively, I'd guess that management would target at least a return to 2010 sales of $2.39M. Optimistically, though, I wonder if the opportunity isn't larger than $2.39M.  Critical to any analysis: will a 30ml single dose result in higher repeat useage?

I'm going to repost the author's analysis from Value Investors Club below.  Caveat, I have no idea where he got his 2.5-3.0x the price of the 500 ml bottle on a per ml basis assumption from.  I wonder if he spoke to the President or if the President addressed this in one of quarterly letters to shareholders:

So, conservatively, management will want to at least target a return to $2.39M in revenue, and optimistically, our author subscribes to the idea of $9-$10M from new 30ml bottles (in theory) in the medium term.

I've determined that there are 16.67 doses in a 500ml bottle, so does this mean that expected sales of the new 30ml doses are going to be 16.67x the old 500ml bottles in terms of unit sales (with no growth)?  In this case, I've estimated unit sales as follows, under two scenarios, 1) the company charges the same price per ml for the new 30ml dose plastic bottles it did for the 500ml bottles, and 2) the company charges 2-3 x the old per ml price for the 30ml plastic bottle (as per our author's estimates).  I've recast the historical results below (# bottles  = historical # of bottles x 16.67 in each case):

Objectively, with no per ml price increase per 30ml bottle, I've estimated a possible return to $2M - $2.4M in sales, and with a 2-3x per ml price increase per 30ml bottle, I've estimated possible sales of between $5-$6M.

I suspect that the company wouldn't have gone to all this trouble to get FDA approval if there was no opportunity in terms of pricing power in relation to its 30ml product.

If I take the average of the two ranges, I come up with close to $4M in potential sales if comparable unit sales in terms of 30ml doses return to pre 2011.

Tying it all together

The difficulty here is attempting to determine where Lubrajel line sales will stabilize.  Peak sales of $14M in Lubrajel might well have been a function of over purchases by Ashland, while pre 2011 Lubrajel sales averaged just under $10M.

If Renacidin 30ml reaches $4M in potential sales in the short term, the percentage of Lubrajel sales at $10M falls to 71%, and the percentage of Renacidin sales increases to 29%.  Under the assumption that the company is able to maintain trough gross margins of 56% and net margins of 26% (circa 2008), the company would potentially earn $3.6M, compared to expected net annualized earnings of $2M for fiscal 2016.  

At an average historical low P/E of 14x, I get a target value of $50.4M, less cash and securities of say $12M, I get an EV of $38M.  This works out to a target price of between $10 and $11 per share.

About that cash and final thoughts

A final comment about the $12M in cash, which works out to approximately 16% of total capitalization.  Surely, there are better uses for this cash than to keep it in the corporate coffers. Possible uses include: paying out a special dividend to shareholders, or an accretive acquisition to further diversify product mix.  

Another out of the box possibility? An eventual takeout by Ashland.  This would be a drop in the bucket for Ashland, who are already marketing the Lubrajel line.  At last check, Ashland had cash on hand of $1.3B.  United Guardian has an EV of $60M.  A takeout would be an afterthought, and if the stock got to $10 to $11 per share, I'd revisit the idea of buying the shares.

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