Everyone should read the valuation coming from the Shareholder Action Group. It provides a very detailed and tight argument which demonstrates how the Qiagen offer significantly undervalues Cellestis.
We've all been talking a lot about Value. Specifically, we have been contending that the Qiagen offer of $3.55 per Cellestis share does not represent the true value of the Company. In fact, we are saying that Cellestis is worth significantly more than $3.55 and that the offer is neither "fair and reasonable", nor, "in the best interests" of the current shareholders.
Obviously, to support the valuation component of that contention we must, at some point, try to value Cellestis sensibly and, most importantly, justify that valuation to ourselves.
I am going to attempt to help you to do that here. I apologize right now that the approach I am going to take is going to make this a long post. However, I see my task as not to simply give you a dollar value for your share but, instead, to give you the understanding and the tools to justify a value for yourself.
There are a number of ways that we might value a Company such as Cellestis. However, the most sensible (and most commonly used) is to use a DCF (Discounted Cash Flows) method to arrive at a NPV (Net Present Value).
The basis of a DCF is founded in a very simple and straightforward concept. Cash received in the future is worth less to you than cash that you receive today. This is a concept that none of us should have any difficulty in understanding.
The real use of a DCF calculation is to compare a potential or held investment with another, alternate, investment. The most common comparison is between an equity investment and a zero risk investment (usually Government Bonds or an Interest Bearing Deposit (IBD) ).
If we examine the future cash flows from the two investments and discount those cash flows back to a NPV, using the same Discount Rate then we can see how the values of the two investments compare.
So that is the basics. There are those who might try to "complexify" the concept of a DCF/NPV but as you can see for yourself, there is no magic or great mathematical prowess required. On the other hand, however, it does require some effort and careful thought.
A DCF valuation is trying to calculate a value today, based upon what will happen in the future. Nobody and nothing can predict the future. All any of us can ever do is to absorb every piece of information that we can and make some well founded assumptions about the future. This is what you are going to have to do to develop your own valuation of Cellestis. I am going to take you through my assumptions, reasoning and justifications. Hopefully they will make sense to you but you are quite welcome to make your own.
Let's start by downloading this VALUATION SPREADSHEET . This spreadsheet contains all the formulas for doing a DCF valuation of Cellestis and has been built to allow you to put in your own assumptions about the future. This spreadsheet will work happily in Excel or OpenOffice.
You can see that this spreadsheet is quite straightforward. It essentially describes the Profit and Loss Statement of Cellestis. The grey shaded columns are the actual figures for FY2009 and FY2010. For subsequent years, we can describe the future as we see it. Whatever we do to it, it will calculate a NPV value of Cellestis.
Let's start at the top - Revenue. That is, Sales.
We can start with the well known estimations that the Directors made at the November 2010 AGM.
"Revenue growth of between 30% and 40% is expected for full fiscal year 2011.. ..our goal in financial year 2012 is to achieve similar revenue growth as this fiscal year."
and
"Sales of ~1.9 Million tests in FY2010. Estimated sales of between 2.6 Million and 2.9 Million in FY2011"
If we start with those assumptions we can use the lowest growth figure that they have projected - 30%. You can see that I have put this 30% growth figure into the spreadsheet for the years 2011 and 2012.
Before going any further, have little glance down at row 29 where we calculate the number of tests that our revenue estimates. We show 1.9m tests for 2010 (the actual figure for 2010) and 2.47m in 2011 (slightly lower than the bottom range of numbers that the Directors estimated). This just tells us that we are certainly not overestimating our growth projections for these years. In fact we are probably being conservative.
Now, we have dealt with 2011 and 2012. What about 2013 onward? Given that Cellestis is really only now hitting its stride, we might anticipate similar or even greater growth in future years. There is also the concept of a tipping point that may well occur at some point (the publication of the latest trial results from the CDC that are due within months may well assist with this). However, I am going to be super conservative and calculate my value on the presumption that sales growth actually slows going forward.
I have therefore decided to continue the growth for 2013 and 2014 at 30% and for subsequent years through to 2020 at 20%.
As an aside. These figures are purely based on sales of QFT-Gold TB. I have made no allowance for the additional sales that may be generated by QFT-CMV and the other potential tests that the Directors have alluded to.
Clearly, projected sales are the most important factor contributing to the value of Cellestis. Whilst I have been quite conservative with my projection, you may want to see the impact of describing other scenarios. You can change these figures at any time and as often as you want to achieve your own understanding of the value of Cellestis.
Cost of Sales. These are just the direct costs that are associated with making sales. Primarily, these would be the costs of manufacturing/purchasing the test kits that the Company sells. This is a scalable cost in that if you sell twice as many kits then your costs will be twice as much i.e. the cost of each test remains constant. Of course there is an argument that as volumes increase, costs may decrease due to economies or power of scale. However, again, I have been conservative and assumed that the current Cost of Sales of 30% will remain constant.
Other Income. For Cellestis, this is the interest earned on Cash held. I have set this at 5%, which seems reasonable. It is automatically calculated by the spreadsheet.
Now we need to look at expenses.
The biggest expense that Cellestis has, by far, is Marketing. It is composed of many individual costs that can be attributed to actually achieving Sales. Advertising, Conferences, Sponsorships and Marketing team salaries will all be included in this figure.
Unlike Cost of Sales, this is not a scalable expense. The impact of Marketing tends to have some cumulative effect, meaning that as Sales increase, the Marketing costs as a percentage of Sales will decrease. This is especially so for a Company like Cellestis because their customers are repetitive. Unlike selling Television sets, once a potential customer has become a customer they will reorder continually, as long as the Company continues to service them well and QFT remains an appropriate solution for them. In the early years of a Company of this type, Marketing expenses will be high, as a percentage of sales. Over time, this percentage will reduce.
It is actually quite hard to estimate what this percentage will be into the future. However, once again, I have decided to be ultra conservative again and to reduce the Marketing expenses, when expressed as a percentage of sales, by only 2% per year. Even with this reduction, the spreadsheet tells us that Marketing expenses in 2020 would still be almost four times ($41m) the amount being spent at the moment. I truly believe that this expense will lower than this but let's go with it.
Management expenses. These are the expenses that directly relate to running the business. Things like management salaries, office overhead etc. In 2009 these costs were 6.4% of Sales and in 2010 they were 4.8% of Sales. In the interests of being conservative (again!) I am setting the Management expenses at 6% of sales for 2011 through to 2014, then dropping to 5% for 2017 and 4% after that. This still results in Management expenses of almost $14m in 2020, compared with an average of a little more than $2m for the last two years (2009 and 2010).
Research and Development (R&D). Again, I have continued the historical R&D expense at 3% of Sales. Because Cellestis may well benefit from an increased R&D budget in the future I have decided not to lower this percentage going forward. This means that by 2020 the R&D budget increases from the 2010 figure of $1.3m to over $10m.
Share options. This is a non-cash expense that is required by Australian accounting standards. Historically, this has been less than 1% of Sales. I have simply estimated a future expense of 1% of Sales per year.
Legal. Again, 1% of Sales going forward seems reasonable. This increases the allowance for legal expenses to increase from less than half a million dollars to around $3.4m per year over the projection.
Depreciation. The low depreciation expense of Cellestis is one of the significant benefits of this Company's business model. Cellestis do not run a manufacturing plant that would incur significant depreciation. Essentially, the only depreciation would be office equipment, vehicles and R&D equipment. I have projected a 1% of Sales as the depreciation cost. Bear in mind that, as for many expenses, this expense is unlikely to be scalable with sales and would in reality most likely actually decrease in time as a percentage of Sales.
We now have in place our projection of future Sales, Cost of Sales and Expenses. This allows the spreadsheet to calculate the Net Profit Before Tax (NPBT).
I think you would have to agree that I have been extremely conservative with my projections. Feel free to go back and adjust any of the abovementioned figures to suit your own estimates.
It is interesting to note that, having done all that work, our figures for 2011 and 2012 are very similar to the figures that Qiagen themselves have notified to their own shareholders. This is very relevant because they will have, I am sure, much better access to internal Cellestis data than we have.
My projections used in this spreadsheet are also more conservative than those put forward by Shaw Stockbroking.
In my "heart of hearts" I truly believe that the reality will be better than my projections. However, in the interests of producing a valuation that everybody can see as being a realistic minimum, I am quite happy to run with these conservative figures.
Taxation. Over the last few years the Company has paid less than the corporate tax rate of 30% because it had accumulated tax credits earned in the development years. Whilst there are some tax credits remaining to be used in the coming years I have set the tax rate at a flat 30% for all years. Any tax credits that are used will increase the valuation marginally.
Okay, so now we have described the financial future of Cellestis, as we might see it. We are close to getting a valuation but we do need to chat about a couple of other things first.
Cash. If you recall, way back at the beginning of this post, I stated that we calculate the NPV by discounting the future Cash flows back to a current value. There are a couple of different ways of looking at the cash flows - the end result is not really different but we do need to understand what we are doing.
You may notice in my calculations that I have used Earnings (for Cellestis, Cash earnings and Earnings are not materially different), rather than Dividend flow as the basis for the NPV. In effect, I am simply calculating on the basis that all of the cash earned by the Company belongs to us, the shareholders. Now, you might prefer to do it slightly differently and calculate the NPV based upon a (say) 60% dividend payout. However, that raises some interesting situations. For a start it would mean that the Company would have a quarter of a billion dollars of cash in the bank by 2020. Clearly that is not acceptable. Obviously, during the period of calculation, either the Company would increase the dividend payout perentage or it would find a great way to invest some of that cash to earn more profits for us.
In the end, the approach that I have taken is to look at the valuation as it would be looked at by Qiagen. It is important to realize that if this Scheme goes ahead then Qiagen will own 100% of Cellestis and all of the Cash that Cellestis generates will flow immediately to Qiagen.
We can't really predict how Cellestis will utilize the cash in the future. All we can really say is that the cash belongs to us, whether it is used within the Company or paid out as dividends. Of course we have to presume that the Company will use the cash in a manner that is in our best interests.
Anyway, as I say, this Scheme gives Qiagen access to all of the cash flows so it makes sense to value our Company based upon Earnings. It is worthwhile pointing out that the legislation states that the Independent Expert Valuation must take into account the benefit that the bidder receives by owning 100% of the target when determining if the bid is "fair and reasonable". It is also well recognized that this is the appropriate approach to valuing an enterprise in the situation of a takeover.
One final point regarding the cash flows. Clearly our investment could continue effectively forever and we should discount all of the cash received off into infinity. Obviously that is simply not practical. Hence the use of what is known as a terminal value. That is a discounted value that we apply to all future cashflows off past the end of our projection timespan. There are a number of methods for calculating that terminal value. However, a commonly used method, and one that I prefer, is to set the terminal value to be the amount of cash that we would recieve if we terminate our investment at the end of the projection period. In the case of an equity (ie a share) we can take the simple path of working out what we would be able to sell the share for. I usually calculate this price at a PE of 12. That is, I anticipate that I should be able to sell the share for 12 times the current earnings. That approximates to an 8% annual return, forever. That is programmed into the spreadsheet but you can fiddle with it if you wish. The truth is, in 2020, the forecast still only projects QFT having achieved a 37% market penetration. In effect we are assuming zero growth after the ten year projection. We would, in truth, anticipate further growth and a consequent higher PE.
Now, we need to talk about the Discount Rate that we are going to use to calculate our NPV.
In effect, the Discount Rate defines the rate of return we would like to make on our investment. More correctly, it is the rate of the alternate investment that we are comparing this investment with. If we know (or estimate) the future cash flows and know the rate of return that we require then we can calculate the price we would be willing to pay for the investment to achieve our desired annual return. In other words, we can calculate the Value. The spreadsheet is going to do this for us once we have decided what the Discount Rate should be.
Now, you may recall that the most common use of a DCF/NPV valuation is to compare one investment with another. The comparison is normally made to a Bond Rate or perhaps an IBD rate. Therefore, it is quite common to use a comparative interest rate (say 6%) as the Discount Rate. You can pop that in and see what value it generates. On my figures it comes out at $11.53. In other words, if I was content to earn a 6% return on my investment in CST then I would be willing to pay $11.53 for a CST share.
It is interesting to note that Qiagen are currently reporting a Return on Equity (ROE) of about 6%. That means that all the equity currently invested in their business is earning a return of 6% p.a. They are now proposing to use about $350m of that equity to purchase CST. Therefore, to keep their ROE stable they should be willing to earn a return of 6% and therefore pay $11.53 per CST Share. Now, of course, they are not going to make this takeover just to earn 6% (and they most definitely aren't - they are proposing to pay only $3.55, not $11.53). We'll come back to this a little later.
Personally, I usually run my DCF valuations at 8%. My justification for this is that it is around the figure that I believe my overall sharemarket investing portfolio should return over the long term. At a Discount Rate of 8% my current value of Cellestis comes in at $9.79. I'm going to call that my value of my Cellestis shares. Again, in plain English, that is saying that if I paid $9.79 for a Cellestis share then I would receive an annual 8% return on that investment.
Now, allow me to digress a little.
We need to talk about risk. There will be many people who will tell you that you should run a much higher Discount Rate to allow for risk.
There are a number of problems with this approach.
Firstly this approach assumes that there is some way to assign a number to risk. There isn't. Have a look at your portfolio. You will find all sorts of information about the shares that you own but nowhere is there a number representing "Risk". It's just crazy to somehow adjust the Discount Rate for Risk. Do you set it at 8.9%, 11.34% or what?
Secondly, when Risk is mentioned, people always think about the negative. However, there is both downside and upside risk. I believe that the figures that I have used in my DCF valuation are, in fact, so conservative that there is a significant "upside risk". That is, there is a substantial possibility that the Company may achieve higher returns than I have estimated. There are indeed, many events (some less likely than others) that could impact the future in either direction. Again, this just makes it impossible to assign some sort of number to "risk".
A much more sensible approach to risk is as follows.
Step one is done before any of this valuation. If the observable risks of the Company appear to be at such a level that would make you uncomfortable then just move on. Find an investment where you feel comfortable. If you are interested in a high risk investment that has a limited chance of rewarding then buy a lottery ticket.
Step two is what we have done above. That is, when valuing the Company be overly conservative with your projections. All of the estimates that I have described above are honestly screwed down to the worst possible outlook that I can envisage for Cellestis. I actually expect Cellestis to perform substantially better than described but I am being careful and conservative.
Step three is "Buy with a margin of safety". Once you have valued the company, try to buy it for less than you have calculated it is worth.
No investment in the share market comes with an ironclad guarantee. However, having applied those three steps you have minimised your risk - which is the best you can do.
Having said all of that, Shaw Stockbroking have done a DCF valuation in which they have applied a risk metric to their Discount Rate to come up with a Discount Rate of 12.2% (You would need to ask them how they came up with this figure). If you use my conservative figures and apply a Discount Rate of 12.2% the valuation comes out at $7.07.
I hope the above has given you the tools and information to work out what your Cellestis shares are worth to you.
Now, let's look at the offer Qiagen are making for our shares. What was it again? $3.55. What Discount Rate would we need to apply to get the value of Cellestis down to $3.55? It is 22%! (do it and check).
This is really saying that Qiagen expect to buy Cellestis for around $350m and receive an annual return on that investment of at least 22%.
You do have to wonder how stupid they think we are.
Don't forget to look at it the other way round too. This says that if we buy (or hold) our CST shares at a price of $3.55 then my projections indicate that we can expect an annual return of 22% ourselves.
Alternatively, try this. Set the Discount Rate to 8%. Now, try to adjust the sales figures down to a point where the valuation comes out at $3.55. Very hard to do isn't it? You would just about have to presume that, tomorrow, aliens are going to land, wave their gamma beam around and cure the world of TB.
I could go on forever. However, I'll just leave you with a few things to think about.
As you would now clearly understand, there is no definitive number that anybody can attach to a valuation. At the best, all any of us can do is to understand very clearly what we are doing (I hope I have helped in that) and thereby understand whether an investment presents good value for ourselves.
In the end, one very clear thing stands out. The Qiagen offer of $3.55 comes nowhere near representing the true value of Cellestis. In fact, if one was to make the assumptions about Cellestis that would be required to bring the value down to $3.55 then the business would probably not be attractive to Qiagen at all.
If this Scheme is approved then Qiagen will have bought themselves a phenomenal bargain and you, I and Australia will have, once again, allowed ourselves to achieve less than we can.
We are nobodies fools. We just have to make sure that we let everybody know that. Vic BulaSpokespersonCellestis Shareholders Action Group (CSAG)
P.S. If you are new to this mailing list, you can catch up on all previous emails at www.csag-blog.com
CST Price at posting:
$3.42 Sentiment: Hold Disclosure: Held
