FM - PHARMEX

Pharmex Industries – Acquisition of Formulex Group of Companies: 

Pharmex Industries – Acquisition of Formulex Group of Companies

Discussion Question: 

Discussion Question Why does the acquisition appear to make a strategic sense?

Key Points: 

Key Points Dated: Jan 2000 By: Sean Clearly, CFO Key issue… Considering acquiring the Formulex group of companies and to know whether its strategically and financially attractive target How much Formulex was worth How to finance the acquisition

Pharmex Industries: 

Pharmex Industries Contract pharmaceutical manufacturing company Focusing in expansion Objectives… To achieve rapid growth Diversifying business risk from over dependence on a single market To grow in size significantly Challenged by finding an acquisition which could increase the company’s access to capital markets

Pharmex Industries: 

Pharmex Industries Founded in: April 1996 Founded by: Ahmad Doroudin + George James Based on: Ph.D thesis Initial investment: Cdn$250 Large scale manufacturing of Acetaminophen Focus: change the purchasing patterns of the retail pharmacy industry

Business Strategy: 

Business Strategy Offering only a few high-volume, low-margin products to retail pharmaceutical drug stores to capture economies of scale Offering only limited products at lower costs.. Acetaminophen OTC analgesic products Pharmacy chains benefited from lower costs by selling private label products under the pharmacy’s brand that Pharmex could manufacture on the chain’s behalf Generated higher sales volume Captured higher margins from proprietary product sales

Business Strategy: 

Business Strategy Analgesics formed a high volume of OTC sales Private label products benefited from pharmacists and sales staff recommendations Expanding product line by acquiring Whampole Canada Inc., a branded product line of vitamins and herbals, giving access to North American and international market

Products Produced and Marketed: 

Products Produced and Marketed Analgesics Narcotic analgesics OTC products in finished-dosage and bulk formats for US and Canadian markets OTC products in Eastern Europe in own brand

Future: 

Future Tremendous growth in contract manufacturing as expected increase in outsourcing form large Pharma companies As part of Wampole transactions would also acquire Novopharm Quebec Novopharm Quebec had…, FDA approved premium quality manufacturing facility Skilled and trained staff Post merger result Sales in 1999: Cdn$54 Employees: 220 in Canada (165 in province of Quebec) Distribute and manufacture: more than 228 products Facilities: 4 over 265000 sq. feet manufacturing, lab and distribution capacity Synergy would improve company performance

Discussion Question: 

Discussion Question What is the financial status of Pharmex?

Financial Performance: 

Financial Performance Not yet profitable but expected to be within the next year Sales in the most recent fiscal year were Cdn$5.7 million Management wanted to grow company significantly Stocks to be listed in March 2000 Had met investor expectations Had established greater access to capital Recently raised approx. Cdn$600,000 through a special warrant financing in Nov.1999

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Formulex : 

Formulex Founded in: 1979 Manufacture and distribute…, 85 prescriptions and OTC products Vitamin Herbal products Key asset: Health products and food branch of health Canada approved 87000 sq ft Manufacturing facility located in Quebec Owned DINs and trademarks for no. of branded products

Formulex: 

Formulex In recent years.., Sales: Cdn$14 mn EBITDA: Cdn$1.35 mn Past 5 years company’s compounded annual revenue growth rate: exceeded 80% Four divisions… Formulex Canada Inc., Laboratories International O.H. Inc., Medprodex Inc., Pro-Pharmalab Inc.

Acquisition of Formulex: 

Acquisition of Formulex Proposed acquisition includes… Sales Assets Liabilities Intellectual properties Attractive because…, Expand into contract manufacturing Low-cost manufacturing facility Broad and diversified product line on contract Strong export business Expansion into international markets R&D and formulation expertise Attract new clients and grow sales (Fomulex sales is three times of Pharmex) History of growth and earnings Had greater debt capacity than Pharmex

Formulex’s Financial Performance: 

Formulex’s Financial Performance Expected annual sales growth (next 5 years): 15%, growth there after not predictable EBIT: 10% of sales Depreciation and amortization: expected to remain the same as recent years Capital expenditure = depreciation for next 5 years Incremental working capital: 2% of incremental sales Effective tax rate: 40% Closest comparable public contract manufacturer: Patheon Appropriate discount rate: 10% (cost of capital fo Formulex)

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Benefits of Acquisition: 

Benefits of Acquisition Largest potential synergy from increased buying power and allow volume discounts Pharmex expected to save Cdn$100,000 on capital expenditures to improve its existing facilities At Formulex… Procure raw materials for analgesics products at three-quarter of Formulex usual costs Analgesics formed 20% of sales Cost of raw material: 50% of sales price

Benefits of Acquisition to Pharmex: 

Benefits of Acquisition to Pharmex Expected lower WACC after acquisition because of.., Growth in size of the company Formulex’s existing access to low cost of debt Increased liquidity offered from Pharmex’s imminent listing on the CDNX Issues in finding Formulex WACC: it’s a private company Rousseau.., Owned 69% of the company while the three remaining venture capital investors owned 10.33% (Cdn$200,000 each) each Is to retire and decided to sell the business by the summer

Discussion Question: 

Discussion Question Although the acquisition seemed to be very compelling, Pharmex would make an acquisition only if it did not dilute the company’s EPS What’s your opinion on this?

Discussion Question: 

Discussion Question Although Formulex had mentioned that it had interest from another acquirer, clearly felt that this was a negotiating tactic Do you agree?

Structuring a Deal: 

Structuring a Deal Formulex provided pro forma financial statements Pharmex announced its discussion to acquire much larger companies.., Novopharm Quebec Has FDA approved facility Wampole Canada These two pending deal has improved the bargaining power of Pharmex and reduced the negotiating ability of Formulex

Structuring a Deal: 

Structuring a Deal Book value of the company: Cdn$4.2 mn Appraiser had assessed the liquidation value of the company: Cdn$2.8 mn Comparable firms were trading at… P/E: 10 to 20 times Total enterprise value / EBITDA: 6 to 8 times Formulex investors.., Company stakeholders: Cdn$3.2 mn Rousseau: Cdn$2.6 million Three venture capital groups (invested in convertible debenture) Venture capital investors expect a annual return of 40% to 60% depending on risk of the investment

Discussion Question: 

Discussion Question What is the future economic value of the company through a discounted cash flow analysis?

Financing the Deal: 

Financing the Deal Raise as little cash as possible to finance a deal Flexibility in payments… cash + shares Recently Pharmex stock closed at Cdn$2.35 on Jan 31, 2000 Additional cash possible through debt Formulex already had Term credit: Cdn$5.5 mn @ prime+0.75% Rotating line of credit for working capital: Cdn$2.75 mn, only Cdn$3,715,589 was drawn under this credit facility and noted that undrawn portion could be helpful in financing the transaction

Negotiations with Investors: 

Negotiations with Investors To Rousseau Immediate need for Cdn$2 million in cash upon retirement He was advised that there were tax defferal advantages from receiving the balance of his proceeds in common shares of Pharmex He did not have any foreseeable need for funds Venture capitalists Cash amount of original investments at a minimum Remaining proceeds in shares

To be Done: 

To be Done Assessing debt capacity Making adjustments for goodwill Adding appropriate amount of debt and equity Determine interest expenses for income statement Negotiating a favorable agreement within the next three months

Discussion Question: 

Discussion Question How to structure a deal that would allow Pharmex to capture the most value from the acquisition, while meeting the interests of Formulex stakeholders?

Discussion Question: 

Discussion Question What the acquisition was worth to Pharmex and the minimum price that Formulex’s stakeholders would accept?

Discounted Cash Flow Valuation: 

Discounted Cash Flow Valuation

Cash Flows: 

Cash Flows

Value of Equity: 

Value of Equity

Value of Firm: 

Value of Firm FCFF = EBIT (1-t) – (CE – Dep.) -  Non cash working capital …1 FCFF = EBIT (1-t) – (1 – Reinvestment Rate) …………………..2 Cash flow to the firm is often termed as an unlevered cash flow

Adjustment to EBIT: 

Adjustment to EBIT Financing expenses – operating leases Treatment of capital expenditure as operating expenses – R&D Incidence of one time or irregular income and expenses

Tax Rate: 

Tax Rate Effective tax rate = Taxes due / Taxable income Marginal tax rate – tax on last $ of income Reasons for difference in effective tax rate and marginal tax rate… Different accounting standards for tax and reporting purposes Using tax credits to reduce taxes paid Deferring taxes on income to future periods Use different at tax rates at different period… Early years Years with carry forward losses

Reinvestment: 

Reinvestment Net capital expenditure = Capital expenditure – Depreciation Adjustments… Seldom have smooth capital expenditures - normalize by average or industry norms Amortizing R&D Acquisitions – can be normalized WC needs = %  revenues

Expected Growth: 

Expected Growth Expected growth rate in operating income = Reinvestment Rate x ROC Reinvestment Rate = (CE – Dep. +  Non cash WC) / (EBITx(1-t)) ROC = (EBITx(1-t)) / Capital Invested RR and ROC should be forward looking – may use industry average

Discount Rate: 

Discount Rate

Cost of Equity: 

Cost of Equity

Terminal Value: 

Terminal Value Assets having infinite life Reflects all cash flows beyond that point Grows at constant rate = growth of economy Cost of capital and growth used are sustainable forever = EBIT n+1 X(1-t) / cost of capital n

Growth Period: 

Growth Period Length of high growth period depends on… Size of the firm Existing growth rate and excess returns Magnitude and sustainability of competitive advantage

Growth: 

Growth

Growth Firm: 

Growth Firm Variable High Growth Firms tend to Stable Growth Firms tend to Risk be above-average risk be average risk Dividend Payout pay little or no dividends pay high dividends Net Cap Ex have high net cap ex have low net cap ex Return on Capital earn high ROC (excess return) earn ROC closer to WACC Leverage have little or no debt higher leverage

Cash and Nonoperating Assets: 

Cash and Nonoperating Assets Operating income = income form operating assets Cost of capital = cost of financing operating assets Operating assets value = present value of operating cash flows Assets value = value of operating assets + value of nonoperating assets Nonoperating assets include… Cash and marketable securities Minority holdings in other firms

Warrants, Management Options, and Convertibles: 

Warrants, Management Options, and Convertibles Value per share = (operating assets value + nonoperating assets value – outstanding debt – value of options – convertible bonds ) / no. of shares outstanding …. Or…. Value per share = value of equity + cash proceeds from option exercise / fully diluted shares

Others…: 

Others… Value of Control Include premium for stocks with higher voting rights Value of liquidity Depends on… Size of business Types of assets owned by firm Health and cash flows of the business Measured in terms of bid-ask spread Bid-ask spread will be larger for smaller, more volatile, and lower-priced stocks

Valuing Equity: 

Valuing Equity FCFE Model… FCFE = NI – (CE-Dep.)(1-D/TA)- NWC (1-D/TA) Expected growth rate = retention rate x ROE DD Model… Holds good of… Entire cash flow is paid out as dividends Difficulty in estimating cash flows from statements

Relative Valuation: 

Relative Valuation Determining Variables P / E Growth, Payout, Risk (P/E) / G P / BV Growth, Payout, Risk, ROE (P/BV) / ROE P / S Growth, Payout, Risk, Net Margin (P/S) / Net Margin V / EBIT Growth, CE needs, Leverage, Risk V / EBIT (1-t) Growth, CE needs, Leverage, Risk V / EBITDA Growth, CE needs, Leverage, Risk V / S Growth, CE needs, Leverage, Risk, Operating Margin V / Book Capital Growth, Leverage, Risk, ROC

The Paths to Value Creation: 

The Paths to Value Creation Using the DCF framework, there are four basic ways in which the value of a firm can be enhanced: The cash flows from existing assets to the firm can be increased, by either increasing after-tax earnings from assets in place or reducing reinvestment needs (net capital expenditures or working capital) The expected growth rate in these cash flows can be increased by either Increasing the rate of reinvestment in the firm Improving the return on capital on those reinvestments The length of the high growth period can be extended to allow for more years of high growth. The cost of capital can be reduced by Reducing the operating risk in investments/assets Changing the financial mix Changing the financing composition