Warning signs: Graham Whitcomb Spot the next blow-up
Having named Unilife as a top short of 2014 – and its share price is now down 99% – Intelligent Investor used three filters to avoid disaster
Have you ever noticed that when a company pays its executives more than it earns in revenue, it tends to do really well? Me neither. Management compensation is one of the first things I look at when analysing a stock because it does a great job at showing who the executives are working for. It makes me wonder if they are managing the company for the benefit of shareholders, or are they more interested in lining their own pockets.
In 2012, the chief executive of Unilife Corporation, Alan Shortall, was paid a salary of $US420,000. Stock awards and options, however, bumped his total remuneration to over $US6 million – in a year when the company made just $US5.5 million in revenue. Then, in 2015 when the syringe maker’s sales hit $US13.2 million, the combined remuneration of top management reached $US13.8 million. Alarm bells come in many tones but this one was crystal clear.
The collapse of Unilife has been one of this year’s most spectacular corporate disasters. $10,000 invested in the company in early 2015 would be worth around $50 today – a 99.5% fall.
When investing, you don’t have to do many things right to earn a decent return but you do need to avoid train wrecks like Unilife. As Warren Buffett likes to say, the first rule of investing is never lose money; the second rule is never forget the first rule.
HOW TO TUNE YOUR RADAR
So how do you sidestep the next Unilife? Picking failures is a different ballgame from picking winners. You can always make arguments that a stock is worth substantially more than its current share price because you’re valuing an unknowable future. However, we’d like to suggest one particular cocktail of factors leads to disaster more than any other: overpaid management, too much debt and an overvalued share price.
Assessing management’s capability and honesty is arguably the most important of the three factors but it is also the most subjective. The giveaways may be subtleties in language or unusual behaviours – none of which may be important on their own but together tell a different story.
In December 2014, the Intelligent Investor analysts went to Unilife’s annual shareholder meeting – strictly for educational purposes. Almost all of us were reaching for the smelling salts before the presentation was over and, as one colleague later put it, “more red flags were flying over the company than at a 1960s communist rally”. We called out Unilife as one of our top stocks to avoid just a couple of weeks later when the shares were still trading at 58 cents (the share price is now under 1¢).
The first red flag was overly promotional language – Unilife’s chief executive used phrases such as “explosive growth opportunity” followed by “you can’t make this stuff up”. Good managements tend to use matter-of-fact language and don’t sugarcoat bad news or consistently blame it on external factors. Anything else, and in my experience, it might suggest management is not being straight with you.
Other things to be wary of include management talking endlessly about industry trends or the potential market size, rather than the specifics of the company’s strategy or product. Also watch out for too much jargon in presentations – some managements bamboozle shareholders with complexity.
The excessive use of stock options – which quietly transfers the company’s ownership to insiders – also seems to me to be a well-trodden path to bigger problems. In particular, be suspicious of no “high watermark”
clauses that mean management can keep issuing shares at a low price, even if targets are missed. Without a watermark clause, you lose one of the only incentives an option-hungry management has to focus on growing the company.
Nepotism is another problem. A chief executive may slowly increase his or her grip on a business by hiring friends and family to top positions. Checks and balances on decision-making are gradually eroded and you can end up with less experienced managers running the show. Shortall’s brother was recruited as senior vice president in 2009 despite almost no apparent industry experience. How well would our Olympic swim team do if the committee had to choose whole families rather than individuals?
The bottom line is you can’t do a good deal unless you have good people. However, the biggest corporate blow-ups almost always have one other factor at play: a dirty balance sheet.
A FOUR-LETTER WORD
Unilife hasn’t turned a profit in 15 years. In 2013, the company’s auditor even went so far as to say Unilife had “incurred recurring losses from operations and has limited cash resources, which raise substantial doubt about its ability to continue as a going concern”.
The company kept itself alive through a string of capital raisings and by taking on debt. Tapping investors for equity isn’t always bad but in Unilife’s case it resulted in constant and excessive dilution. In the decade to 2014, the share count increased tenfold. Even for rapidly growing companies, it would be hard for shareholders to come out ahead after so much dilution.
Unilife’s balance sheet was also in a shambles – net debt had grown from $US5m to $US54m in the three years before our recommendation, and has grown to $US117m since. The company had no tangible book value in 2014, meaning a bankruptcy would leave the stock next to worthless.
The most distasteful part, however, was that Unilife had requested that it be allowed to omit certain lending covenants from its public filings. This made it practically impossible for investors to assess whether the company was close to default. Maybe that was the point; who knows? When a company starts playing smoke and mirrors with its balance sheet, we suggest one action: Don’t walk. Run.
MARGIN OF SAFETY
Finally, there was the share price. With a 2014 market cap that was 24 times revenue, Unilife was being priced for significant growth despite its history of miserly performance, such was the magnetism of its story. If there’s one sin that will do you in as an investor, it’s overpaying.
With all these reasons to dislike Unilife when we first came to the stock in late 2014, you might think our decision to avoid it must have been howlingly obvious at the time. But it wasn’t. There were plenty of counter-arguments and many smart investors saw reason to invest.
Predicting failure is hard enough; predicting when a company will fail is even harder. Indeed, Unilife’s stock rose 60% in the month immediately after our recommendation before things started to unravel. If you want to sleep well at night, be prepared to look foolish during the day.
One last point is that taking a cautious approach to stocks – demanding a margin of safety, and steering clear of overpaid and underperforming managements and dirty balance sheets – means you will have plenty of missed opportunities. Ugly stocks can still be beaten down too far, only to have their share prices rebound spectacularly as things improve.
These missed opportunities are annoying but they should be celebrated. They’re a reminder that you have strict investment criteria – and, with that, you’re far more likely to avoid the next disaster-in-waiting.
“More red flags were flying over the company than at a 1960s communist rally”