United-Guardian Stock: Pristine Balance Sheet, But Fully Valued (NASDAQ:UG)

Peter Lynch and other legendary value investors made their fortunes in small-cap stocks. They focused on less well-known small-cap stocks with strong fundamentals that often have unlimited or significant upside potential relative to a limited downside potential. This is called “asymmetric upside” or “asymmetric opportunity.”

One of these undiscovered small-cap stocks is United-Guardian, Inc. (NASDAQ:UG). The most recent Seeking Alpha article about it was published one year ago.

But has UG significant upside potential from the current price of $23 per share? Does UG offer an asymmetric opportunity from today’s price levels?

United-Guardian Has Got Strong Balance Sheet

As expected, UG was impacted by the global pandemic in 2020. However, despite the lingering effects of the pandemic, it announced revenue and profit growth in 2021 compared to 2020. The company also maintained a pristine balance sheet with zero debt and $8.2 million in cash & cash equivalents and marketable securities.

Specifically, UG reported that revenue increased by 27% from $10.9 million in 2020 to $13.9 million in 2021, with net income for 2021 increasing by 41% over 2020. This resulted in one of the company’s most profitable years ever. The shareholders can’t complain.

Gross profit on sales was also high, although it has been largely flat over the last years. Specifically, gross profit was 59% in 2021 compared with 56% in 2020, 58% in 2019 and 60% in 2018. The small increase in gross profit in 2021 was due to two main factors.

First, increased sales of the company’s Lubrajel line of products in 2021, which carry a higher profit margin than the Company’s pharmaceutical products. Second, the significant reduction in sales allowances related to the company’s pharmaceutical products in 2021 helped to increase the gross profit on those products in 2021 compared with 2020.

However, when it comes to the company’s revenue, there are not only positives but also negatives. Let’s start with the positives:

1) Some of UG’s products are either uniquely without direct competitors or have some unique characteristics, as quoted below:

The Company has some products or processes that are either proprietary or have some unique characteristics. Its Lubrajel line of products is well known globally and has a long-standing reputation for high quality. The Company believes that these characteristics will be advantageous to the Company in its continuing efforts to compete effectively with other companies marketing similar products.

and:

While the Company does have competition in the marketplace for some of its products, particularly its cosmetic ingredients, some of its pharmaceutical and medical products have some unique characteristics, and do not have direct competitors. However, these products may have indirect competition from other products that are not marketed as direct competitors to the Company’s products but may have functionality or properties that are similar to the Company’s products.

2) UG’s business is not subject to seasonality, as quoted below:

Due to the nature of the Company’s business and the types of products it markets it is not subject to any significant seasonal fluctuations in sales.

3) Fortunately, there is ample supply from numerous sources for the principal raw materials, as quoted below:

The principal raw materials used by the Company consist of common industrial organic and inorganic chemicals. Most of these materials are available in ample supply from numerous sources. The Company has six major raw material vendors that together accounted for approximately 86% of the raw material purchases by the Company in 2019 and 80% in 2018.

On the negative side, it’s worth noting that:

1) Most of the revenue (approximately 50%) are coming from the cosmetic ingredients segment, as illustrated below:

		Years ended December 31,
		2021				2020
Cosmetic ingredients		$	6,872,714			$	4,274,586
Pharmaceuticals			4,735,324				4,519,052
Medical products			2,171,204				2,052,961
Industrial and other			150,387				139,482
Total Net Sales		$	13,929,629			$	10,986,081

2) UG is heavily reliant on two products, as quoted below (emphasis added):

Two major product lines, Lubrajel® and Renacidin® Irrigation Solution (“Renacidin”) together accounted for approximately 93% and 92% of the Company’s sales for the years ended December 31, 2021 and December 31, 2020, respectively. Lubrajel accounted for approximately 64% and 57% of the Company’s sales for the years ended December 31, 2021 and December 31, 2020, respectively, and Renacidin accounted for approximately 29% and 36% of the Company’s sales for the years ended December 31, 2021 and December 31, 2020, respectively.

3) Although the company’s products are currently marketed worldwide by five marketing partners, the vast majority of the revenue (approximately 80%) are coming from the U.S., as illustrated below.

		Years ended December 31,
		2021				2020
United States		$	11,159,341			$	8,796,221
Other countries			2,770,288				2,189,860
Net Sales		$	13,929,629			$	10,986,081

4) Despite the ample supply in principal raw materials, some of these materials have become more expensive lately, as quoted below (emphasis added):

The pandemic has not significantly affected the ability of the Company to obtain raw materials, but it has made some of those materials more expensive, which could impact the Company’s gross profit margins in the future. The Company has been able to maintain production throughout the pandemic.

Outlook

Although UG will continue to be impacted to some extent by the global pandemic, outlook is positive, based on the CEO’s recent statements below:

With the global economy gradually recovering from the damage caused by the coronavirus pandemic, we have experienced a significant increase in demand for our cosmetic ingredients, with sales of those products increasing by 61% during 2021. While much of the increase was the result of a resurgence of sales into China, we also experienced a significant sales increase in Europe, particularly in the United Kingdom, where sales increased by 42%. At the same time, sales of our pharmaceutical products remained strong, as they have throughout the pandemic, and sales of our medical products increased by 6%. We are hopeful that sales of all these products will continue to grow in 2022. There are several ongoing projects that we hope will enable us to continue to expand our “natural” cosmetic products line, and our R&D department is working closely with both new and existing medical products customers to develop new products for them, which should further increase sales of our water-based medical lubricants. There is general optimism that we are finally through the worst of the pandemic, and that the global economy and the markets for our products will continue to improve. The future seems much brighter than it has in a long time, and we intend to continue working closely with our marketing partners, as well as our customers, to continue to bring new and innovative products to the cosmetic and medical markets.

and:

While we expect to continue to be impacted to some extent by the global pandemic, we anticipate that the impact will relate primarily to supply chain and shipping issues, increasing some lead times and raw material costs. As the impact of the global pandemic continues to lessen, and as we continue to introduce new products into both the cosmetic and medical markets, we are hopeful that our sales will continue to increase into 2022. We are confident that despite the lingering effects of the pandemic, we will end the year with financial results that will be significantly better than in 2020.

UG Stock Valuation

Based on the outlook above, we estimate that revenue and adjusted EBITDA in 2022 will be about $15 million and $6 million, respectively.

Meanwhile, with zero debt and $8.2 million in cash & cash equivalents & marketable securities, UG’s Enterprise Value currently is about $97 million.

Therefore, EV-to-2022 Revenue and EV-to-2022 adj. EBITDA are about 6.4 times and 16 times, respectively, at the current price of $23 per share, so we believe that UG is fully valued. To us, UG currently is not a bargain.

Dividend Sustainability

UG has generated positive operating cash flow and positive free cash flow over the last twenty years. As a result, it has been paying dividends since 1999. UG has a long history of dividend payments largely thanks to the fact that it has a low CapEx business model with annual CapEx being well below $1 million. Low annual CapEx is a key factor when it comes to dividend payments and dividend sustainability.

On that front, UG has raised the semi-annual dividend twice since November 2020, when it was $0.36 per share due to the pandemic, as quoted below:

On November 16, 2021, the Company’s Board of Directors declared a semi-annual cash dividend of $0.65 per share which was paid on December 7, 2021 to all stockholders of record as of November 29, 2021.

On May 18, 2021, the Company’s Board of Directors declared a semi-annual cash dividend of $0.48 per share, which was paid on June 7, 2021 to all stockholders of record as of May 31, 2021.

On November 18, 2020, the Company’s Board of Directors declared a semi-annual cash dividend of $0.36 per share which was paid on December 8, 2020 to all stockholders of record as of December 1, 2020.

On May 20, 2020, the Company’s Board of Directors declared a semi-annual cash dividend of $0.42 per share, which was paid on June 17, 2020 to all stockholders of record as of June 3, 2020.

As quoted above, the dividend of $0.65 per share was an increase of 35% over the $0.48 per share dividend the company paid earlier this year, and an 81% increase over the $0.36 per share dividend the company paid in December 2020. This also was the largest dividend the company has ever paid. But is it sustainable?

Based on semi-annual dividend of $0.65 per share (or $1.30 per share annually), the dividend payment translates into about $6 million annually, which exceeded the free cash flow of approximately $5 million in 2021. Obviously, something has to change here. UG will have to generate more free cash flow annually if it wants to continue paying the semi-annually dividend of $0.65 per share twice per year.

Actually, we took into account a handful of company-specific (i.e., operating cash flow, free cash flow, CapEx, products etc.) and sector-related factors, and we project that UG will hardly maintain this dividend policy in the foreseeable future.

In other words, we project that UG will hardly be able to pay a semi-annual dividend of $0.65 per share twice per year (or $1.30 per share annually) in the foreseeable future. Basically, we forecast that the annual dividend will drop to about $1 per share or lower by the end of 2023, at the latest.

United-Guardian Stock – Insider Ownership

Insider ownership is high, which largely explains the company’s generous dividend policy. Specifically, insiders own 29.1% with the CEO being the biggest shareholder, so their interests are aligned with shareholders’, as illustrated below:

Name of Beneficial Owner	Amount and Nature of Beneficial Ownership		Percent of Class
Ken Globus	1,318,053		28.7%
Arthur M. Dresner	12,175		(*)
Lawrence F. Maietta	4,000		(*)
Peter A. Hiltunen	320		(*)
Andrew A. Boccone	0		(*)
S. Ari Papoulias	0		(*)
Andrea Young	0		(*)
Donna Vigilante	0		(*)
All Officers and directors as a group (8 persons)	1,334,548		29.1%

The Review Of Strategic Alternatives

A few weeks ago, UG announced a strategic alternatives review. The purpose of the review is to ensure that value is being maximized for shareholders and that UG has sufficient scale and financial resources to take advantage of the growth opportunities available to the organization. These alternatives could include, among others, possible joint ventures, strategic partnerships or alliances, an outright sale of the company, or other possible transactions.

As shown below, the company’s CEO and biggest shareholder is 70 years old:

Name and Position with the Company	Age	Principal Occupation, Qualifications, and other Boards	Year First Elected a Director
Ken Globus President Chief Executive Officer General Counsel Chairman of the Board	70	President and General Counsel of the Company since July 1988; Chief Financial Officer of the Company from November 1997 to December 2006; and Chairman of the Board since September 2009. He has leadership experience, legal experience from his prior years as an attorney in private practice, business experience, and knowledge of the Company’s operations from over 38 years as General Counsel, Vice President, and then President of the Company. He holds a bachelor’s degree in Psychology and English from the State University of New York at Albany, and a Juris Doctor degree from the George Washington University Law School.	1982

As such, a sale is likely. But UG at $23 per share is fully valued, so we forecast that a buyout offer with a significant premium is not likely and the upside potential from today’s price level is limited.

Risks

To us, these are the key risks for the potential buyers:

1) Two products: The two major product lines, the Lubrajel® line (cosmetic ingredients & medical lubricants) and Renacidin® Irrigation Solution (a pharmaceutical product),together accounted for approximately 93% and 92% of the company’s sales for the year ended December 31, 2021. Therefore, UG has to implement a carefully planned strategy and expand its product offerings in an effort to reduce the operational risk in its business.

2) Competition: UG admits that the competition will remain fierce, so it’s safe to assume that increased competition could result in slow top line YoY growth and/or lower profit margin in the next years:

The pharmaceutical, health care, and cosmetic industries are all highly competitive, and during 2019 the Company experienced a high level of competition for its cosmetic ingredients both in the U.S. and in foreign markets. In 2019 the U.S. dollar continued to strengthen against many foreign currencies, which made the Company’s products less competitive in those markets. The Company believes that there will continue to be increased competition in coming years, especially from Asian competitors, and is working with ASI, its primary marketing partner, to address the issue and determine how the Company can make its products more competitive in the marketplace. The Company is aware that there are other domestic and foreign companies that are engaged in the same or similar areas of research as those in which the Company is engaged, some of which have substantially greater financial, research, manpower, marketing and distribution resources than the Company. In addition, there are many large, integrated and established pharmaceutical, specialty chemical, personal care and health care companies that have greater capacity than the Company to develop and to commercialize types of products upon which the Company’s research and development programs are based.

3) Acquisitions: Thanks to its debt-free cash-rich balance sheet, UG can afford to focus on inorganic growth and acquire smaller players. However, an acquisition is not a slam dunk and a deal could end up being a failure. For instance, UG may not be able to successfully integrate the acquired business without substantial expense or delays. Additionally, the acquired business could fail to generate anticipated revenue or earnings.

Takeaway

We are going off the beaten path to find outperformers for the subscribers to our research. This is how we unearthed dividend-paying UG in July 2020, when we advised them to buy it at $14 per share for their income portfolio.

Since our buy recommendation, UG has performed very well while returning to growth mode and maintaining a fortress balance sheet. Moreover, the company recently announced a strategic alternatives review with a sale being one of the options.

But UG at $23 per share is fully valued while some key risks persist, so we forecast that a buyout offer with a significant premium is not likely. Given that we do not see enough margin of safety at today’s price levels, we will stay on the sidelines.