Independent Expert Valuation - Critique Part Two.

The Independent Expert (IE) has been employed by Cellestis and paid for with our money for the worthwhile purpose of independently protecting us (the shareholders) from a takeover that is unfair to us or not in our best interests. For that reason it is absolutely essential that we examine the IE Valuation in great depth to ensure that he has, in fact, produced a Valuation that we can rely upon in making our decisions.

I suggest that he has not.

The Valuation Method.


I wrote about this yesterday and just wish to touch on it again in summary.

The IE believes that a FME valuation is more appropriate in valuing Cellestis than a DCF valuation. His rationale for that decision is essentially that "it may be difficult to estimate future cash flows". This is absolutely true. None of us have a crystal ball that will project the future with a 100% accuracy. However, given that valuing an operating business is always about projecting the future, this difficulty applies to any valid valuation method, including the FME valuation method chosen by the IE. Furthermore, the FME valuation method suffers further because it does not provide any meaningful representation of the future. What does a FME multiple of 19 really tell you about the projection of the future? On the other hand, a DCF valuation uses and displays a projection of the future that can be critically examined.

Anyway, having rejected the DCF valuation, the IE has produced a DCF valuation to "confirm" the FME valuation. Let's have a look at his DCF valuation.

The Independent Expert DCF Valuation.

The IE has not provided the year by year detail of his DCF valuation. This is somewhat surprising, given that he has presented the detailed CSAG DCF valuation.

He has, instead, provided a scant set of assumptions, percentages and numbers. Fortunately, we can use that information to "reverse engineer" his DCF valuation.

In doing so we rely upon his assumptions which include:

the overall market size of latent tuberculosis tests by number of tests conducted per annum in the developed world (45 million as at 31 December 2010)

future gross profit margins are assumed to remain relatively stable

Given that he has assumed that Gross Profit margins are projected to remain stable and we have previously been informed that we cannot expect any decrease in manufacturing costs as volume increases then he has assumed that the selling price of the product will remain stable. This means that the revenue growth profiles that he has provided will largely equate to sales volume growth profiles.

The IE provides three scenarios for his DCF valuation.

Scenario 1: revenue growth of 30% p.a. during the initial years, reducing progressively to 8% p.a. over the Projection Period. Under this scenario, Cellestis is projected to reach a market share of 10% in four years i.e. by FY 2015. Cellestis’ market share by the end of the Projection Period is assumed to be approximately 20%

 Scenario 2: revenue growth of 30% p.a. during the initial years, reducing progressively to 5% p.a. over the Projection Period. Under this scenario, Cellestis is projected to reach a market share of 10% in five years i.e. by FY 2016. Cellestis’ market share by the end of the Projection Period is assumed to be approximately 14%

Scenario 3: revenue growth of 30% p.a. during the initial years, reducing to 3% over the Projection Period. Under this scenario, Cellestis is projected to reach a market share of 10% in six years i.e. by FY 2017. Cellestis’ market share by the end of the Projection Period is assumed to be approximately 11%

Using the above assumptions we can firstly "fill in the gaps" to provide year by year growth detail that matches these assumptions.

Here is the result. (click on the image for full size)

The first comment is that Scenario 3 is a mathematical impossibility. Given that the growth in 2023 is assumed by the IE to be 3% it is actually impossible to get the market share down to the 11% (4.95m tests) unless you were to assume that in the years 2018 to 2022 the growth dips significantly below 3% and then jumps back up to 3% in 2023.

It is up to us to look at these growth scenarios to decide if we believe that they are, in fact, realistic. Personally, I think not.

It certainly doesn't seem realistic to see two years of 30% revenue growth to suddenly fall off a cliff to a growth of 13%, 11% or 9%.

Our lead product, QuantiFERON-TB Gold In-Tube only received FDA approval in 2007 and CDC guidelines in 2010. Even so, we have already achieved a 5% market penetration. USA volume sales have been growing at 50% p.a.. Remember that if the A$ stops climbing (it doesn't even need to fall) then the growth in foreign markets will flow directly through to revenue denominated in $A. Does it really seem realistic to expect that over the next 12 years we will only increase our market penetration to 11%, 14% or 20%? It is important to understand that the 45m potential market is purely our target (developed world) market. It does not include the underdeveloped and developing world. Neither the Company or us have ever built those markets into our projections. There is no reason whatsoever that the superior diagnostic QFT-TB should not ultimately largely replace the much detested TST test in the developed world.

Bear in mind also that none of the IE valuation models have factored in any revenue from additional products developed on the QFT platform. As recently as the last AGM, the Directors provided details of several potential diagnostics being developed on the QFT Platform. It is not unreasonable to assume that at least a proportion of these potential diagnostics have real commercial potential - otherwise our Company would not have spent the time and effort in developing them. That potential has value.

Having now derived the IE revenue projections from his own assumptions, we could produce full DCF valuations for the 3 scenarios. However, to save myself a lot of work, I am going to assume that the IE has used his growth projections correctly to perform the mechanics of the DCF. His outcome is summarised in the following table.

Note that to get the DCF valuation down to something approaching the $3.55 that he is assuring us is fair and reasonable and in our best interests, he has to assume his scenario 2 (sales in 12 years time of 14% of the market) and a Discount Rate of between 14% and 15%.

I will deal with his selection of Discount Rate in a later post.

For the moment let's just try to understand what his DCF valuation is saying.

"If Qiagen buy Cellestis at $3.55 per share then, even if sales were to only ever achieve those outlined in Scenario 2 then they would achieve an effective annual return on their investment of more than 14%."

Of course we know and Qiagen know that Cellestis has the potential to achieve much much more than the revenue outcome described in Scenario 2.

If, on the other hand, were we to believe the still pessimistic Scenario 1 view of the future of Cellestis and a Discount rate of 13% then the value of a Cellestis share is $5.55 (56% above the offer price).

In his conclusion of the DCF valuation the IE states:

"The estimated value of a share in Cellestis on a control basis under each of the three cash flow scenarios discussed above and a range of higher and lower discount rate assumptions, as set out in the table below."

Note that he has suddenly decided that his DCF valuation that has not mentioned anything about a control premium is now a representation of the value of Cellestis on a control basis. Even if we were to assume that all of his projections and his discount rate are applicable then this is a sharemarket valuation. It is not a "takeover valuation". It includes no premium for control.

Vic
Spokesperson
CSAG

Disclaimer. Nothing in this document should be construed as personal financial or legal advice. All information is provided on the understanding that you will take whatever steps are necessary to ensure that any actions that you take are the most approriate for your own personal circumstances. The author accepts no responsibility for the impact of any consequent outcomes.