Universal Biosensors trapped in twilight zone

Universal Biosensors is stuck in no man’s land after the stock suffered its worst two-day whipping on record, with the market essentially pricing the stock as though the medical device maker is going out of business.

Shareholders should get comfortable as Universal Biosensors isn’t likely to be going anywhere for a while. On the one hand, the 67.3% sell-off in the first two days of the week is unjustified on fundamentals; but on the other hand, the amount of anger towards management will keep the stock under a dark butt for the near term at least.

Investors are now torn between the fundamentals of the business and mistrust towards the people running the company after they revealed this week the details allowing LifeScan to walk away from making royalty payments (called a service fee) to Universal Biosensors.

Universal Biosensors developed a blood glucose diagnostic device with LifeScan, a Johnson & Johnson subsidiary. For every strip (a consumable used with the device) LifeScan manufactures, it pays Universal Biosensors between US1.25 cents and US75 cents.

Management said on Monday that LifeScan can choose to make a one-off lump sum payment once it has paid $US45 million ($48 million) in service fees. The lump sum payment will be between two to three-times the service fees paid over the last four quarters.

While LifeScan may have prevented Universal Biosensors from revealing the exact details of the exit clause before, the stock would not be trading on scorched earth valuation levels right now if management had been more upfront about this risk. This just isn’t good enough.

LifeScan has so far paid a little over $7 million and will likely reach the $US45 million mark around the middle of calendar 2017, based on my market adoption assumptions. At that point, one can assume LifeScan will choose to make the lump sum payment as it is in its financial interest to do so.

I estimate that this lump sum should be worth around $33 million, and that is not enough to be much of an offset to the loss of the future revenue steam from LifeScan. This is because the service fee flows through fully to Universal Biosensors’ earnings as there is no cost involved.

While LifeScan’s service fee is expected to constitute about 20% of group revenue in 2017 (Universal Biosensors is developing a coagulation testing device with Siemens, which is expected to be launched in the September quarter this year), it makes up more than half of its earnings before interest and tax.

If I removed the service fee from 2017 onwards and added the $33 million to Universal Biosensors’ cash flow, my price target tumbles to 28 cents from 87 cents a share.

This means the stock remains firmly in value territory based on the numbers and the fact that it is trading around its asset backing (this includes cash and hard assets with debt and interest repayments largely offset by the lump sum payment from LifeScan) is a damning indictment. Stocks only trade to their asset backing if the business is priced to go bankrupt or when the market has lost total faith in the leadership.

The market is clearly adding a “management discount” of around 40% to valuation. As a shareholder, I empathise with the sentiment. It is clear that Universal Biosensors hasn’t done a good enough job communicating with the market and managing expectations.

The timing for this couldn’t be worse either. Trust between investors and the life science company executives has been tested with recent disasters in the sector, such as QRxPharma (QRX).

Industry insiders I have spoken with used colourful and unprintable language to describe the board of Universal Biosensors and the company has given more reason for investors to doubt the launch date for the coagulation device, which was originally scheduled for the end of last year. One would hope that the board has learnt from the painful experience.

But there is little doubt that the LifeScan deal is a good outcome for Universal Biosensors, even though it isn’t as lucrative as the market had been led to believe. I also believe that the coagulation testing kit will hit the market in the coming months.

More than ever, management needs to successfully pull off the Siemen’s deal and investors should head for the exits if Universal Biosensors gives any further reason to doubt the success of the coagulation device.

As I mentioned two weeks ago, stocks like Universal Biosensors are only meant for investors with a high tolerance for risk. For those with an iron stomach, the stock will look tempting but I would be reluctant to encourage anyone else to buy even at what appears to be bargain basement prices.

Those that hold the stock should hang on as I don’t think their interests would be served by selling the stock at this level. This is why I have decided to downgrade the stock to “hold” even though my revised price target of 28 cents a share is well ahead of its current price.