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; are they managing the company for the benefit of shareholders, or is it just a vehicle to line their own pockets?
In 2015, the combined remuneration of the top executives at Unilife Corporation (ASX: UNS) hit US$13.8m while revenue was a meagre US$13.2m. Alarm bells come in many tones, but this one was crystal clear.
In December 2014, we called out the syringe maker as one of our top stocks to avoid in a special report on short selling. Unilife’s share price was 58 cents on the day the report was released. Today it hit an all-time low of 0.7 cents – down 99% – following yesterday's announcement that the company may soon be bankrupt.
When investing, you don’t have to do many things right to earn a decent return, but you do need to avoid trainwrecks like Unilife. As Warren Buffett likes to say, the first rule of investing is never lose money; the second rule is to never forget the first rule.
So how do you avoid the next Unilife? We’d like to suggest one particular cocktail of factors leads to disaster more than any other: shady management, too much debt, and an overvalued share price.
How to tune your radar
A few weeks before our special report, the Intelligent Investor analysts went to Unilife’s annual shareholder meeting. Almost all of us were reaching for the smelling salts before the presentation was over.
The first red flag was overly promotional language – Unilife’s chief executive Alan Shortall used phrases like ‘explosive growth opportunity’ followed by ‘you can’t make this stuff up’ (hint: they always can).
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 it might suggest management is trying to mislead you.
Other things to be wary of include managements talking endlessly about industry trends or the potential market size, rather than the specifics of the company’s strategy or product.
The excessive use of stock options – which quietly transfers the company’s ownership to insiders – is also a well-trodden path to dodgyville. So too is nepotism: Shortall’s brother was recruited as senior vice president in 2009 despite almost no industry experience.
As the saying goes, you can’t do a good deal with bad people. However, the biggest corporate blowups almost always have one other factor at play: debt.
Watch the balance sheet
Unilife hasn’t turned a profit in 15 years – it 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 had 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 US$5m to US$54m in the three years prior to our recommendation, and has grown to US$117m since. The company had no tangible book value in 2014, meaning a bankruptcy would leave the stock next to worthless.
The most uncomfortable part, however, was that Unilife had requested that it be allowed to omit certain lending covenants from public filings. This made it impossible for investors to assess whether the company was close to default.
When a management starts playing smoke and mirrors with the company’s balance sheet, we suggest one thing: Don’t walk. Run.
Finally, there was the share price. With a 2014 market cap that was 24 times revenue, Unilife was being priced for significant growth. If there’s one sin that will do you in as an investor, it’s overpaying.
Given Unilife’s 99% share price fall, you might think the reasons for our initial avoid recommendation must have been howlingly obvious at the time. But they weren’t. There were plenty of counter-arguments and many smart investors fell for the sham: indeed, the 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.
We didn’t make our Unilife recommendation certain it would fail. But by using a few key investing filters – management, debt, and price – you’re more likely to avoid the next disaster-in-waiting.
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