Pharmex Industries Acquisition of Formulex Group of Companies

Discussion Question

Why does the acquisition appear to make a strategic sense?

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
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 companys access to capital markets

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
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 pharmacys brand that Pharmex could manufacture on the chains behalf
Generated higher sales volume Captured higher margins from proprietary product sales

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

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
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

What is the financial status of Pharmex?

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
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
In recent years..,
Sales: Cdn$14 mn EBITDA: Cdn$1.35 mn

Past 5 years companys 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
Proposed acquisition includes

Sales Assets Liabilities Intellectual properties

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)

Attractive because,

History of growth and earnings Had greater debt capacity than Pharmex

Formulexs 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
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

Expected lower WACC after acquisition because of..,
Growth in size of the company Formulexs existing access to low cost of debt Increased liquidity offered from Pharmexs imminent listing on the CDNX

Issues in finding Formulex WACC: its 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
Although the acquisition seemed to be very compelling, Pharmex would make an acquisition only if it did not dilute the companys EPS

Whats your opinion on this?

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
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
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

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

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

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
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

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

What the acquisition was worth to Pharmex and the minimum price that Formulexs stakeholders would accept?

NPV of Formulex Based on Proforma Numbers Growth rate in sales 15% Tax rate 40% Discount rate 10% EBIT (% of sales) 10% Increase in working capital 2% 2000 2001 2002 2003 2004 Terminal Value Sales 16106258 18522196.7 21300526.21 24495605.14 28169945.91 EBIT 1610625.8 1852219.67 2130052.621 2449560.514 2816994.591 Tax-adjusted EBIT 966375.48 1111331.8 1278031.572 1469736.308 1690196.754 Depreciation and amortization 470188 470188 470188 470188 470188 CapEx 470188 470188 470188 470188 470188 Increase in working capital 82125 48318.774 55566.5901 63901.57862 73486.81541 Free cashflows 884250.48 1063013.03 1222464.982 1405834.73 1616709.939 20613051.72 NPV $16,200,427.30 Value of debt 1637775 ($600000 convertible debt from VC investment considered coneverted into equity) Value of equity $14,562,652.30

Interest bearing debt 6803764 Equity 4219007 Percentage interest bearing debt 61.72% Perecentage equity 38.28% Cost of govt. debt 6.54% BBB spread 1.37% Cost of debt 7.91% Tax rate 40.00% After-tax cost of debt 4.75% Risk-free rate 6.32% Market risk premium 5% Levered beta (Patheon) 1 Total debt (Patheon) 81141 Interest bearing debt (Patheon) 39557 Total equity (Patheon) 79223 Percentage interest bearing debt (Patheon) 33.30% Perecentage equity (Patheon) 67% Unlevered beta 0.77 Relevered beta 1.51 Beta 1.51 Cost of equity 13.89% WACC 8.25%

Formulex 1 999 B/S Formulex 1 999 B/S Estimated Estimated Ex hibit 4 Ex hibit 4 Estimated Page 4 Estimated Ex hibit 4 Ex hibit 4 Ex hibit 4 (Beta for Patheon) Ex hibit 4 Ex hibit 4 Ex hibit 4 Estimated Estimated Estimated Estimated Estimated Estimated Estimated

Valuation from Different Methodologies Liquidation value (Equity) 2800000 Net book value (Equity) 4219007 DCF - standalone (Equity) 14562652.3 DCF - with synergies (Equity) 19201404.3 Comparables Trailing Earnings Implied Equity Value Forward Earnings Implied Equity Value Industry P/E (minimum): 10x 216748 2167480 293157 2931570 Industry P/E (maximum): 20x 216748 4334960 293157 5863140 Trailing Earnings Implied Equity Value Less Value of Debt Implied Equity Value Industry TEV/EBITDA (minimum): 4x 1347938 5391752 1637775 3753977 Industry TEV/EBITDA (maximum): 8x 1347938 10783504 1637775 9145729 Forward Earnings Implied Equity Value Less Value of Debt Implied Equity Value Industry TEV/EBITDA (minimum): 4x 2080814 8323256 1637775 6685481 Industry TEV/EBITDA (maximum): 8x 2080814 16646512 1637775 15008737 Implied equity value for VC (2 years, 55% IRR) $4,397,000.00

IRR Requirement for Venture Capitalists Issue date Issuer Instrument Principal Interest Term Repayment Date Conversion No. of shares Formulex outsatnding shares Percentage equity ownership Years invested to Jan 31, 2000 IRR (55%) PV of interest Required exit value Implied firm value 31-Jan-98 Formulex group of companies Convertible debt 200000 8% 4 years 31-Jan-02 at rate of $3.66 per common share 54645 528821 10.33% 2 -200000 $16,982.31 -183017.6899 $439,700.00 $4,397,000.00

Venture capitalist (31% of firm value) Original investment Required exit value Less: Cash (original investment) Portion in shares Pharmex share price(Jan 31, 2000) No. of shares to be issued Owner investor Original investment Exit value Less: Cash (Retiremnet needs) Portion in shares Pharmex share price(Jan 31, 2000) No. of shares to be issued Pharmex shares outstanding New shares to be issued Cash paid Equity paid Financing the deal Line of credit - term Line of credit - rotating Total Less: drawn portion Undrawn amount

600000 $200000 x 3 VCs 1319100 Exit valuation calculated from IRR x 3 VCs -600000 $200000 x 3 VCs 719100 2.35 306000 2600000 Amount invested by owners 2936061 From IRR calculations -2000000 936061 2.35 398323.8 30847317 704323.8 2600000 1655161 4255161 5500000 2750000 8250000 Total facility available 3715589 Portion drawn already 4534411 credit available to fund cash

Pharmex + Formulex (Jan 2000) Assumption Purchase price Finance (equity) Finance (line of credit) Cash Account receivables Related party receivables Subscription receivables Inventories Other assets Prepaid expenses Teporal investments Deffered tax credit Contract deposits Total current assets Capital assets Intangibles Deffered development costs Deffered financing costs Investments Goodwill Total long term assets Total assets 4255161 from IRR calculation 1655161 2600000 . Bank indebtedness 5064800 Accounts payable and accrued laibilities . Loan payable 9150 Current portion of long term debt 4811731 Line of credit 27147 Deffered tax liability 139498 Total current liabilities . Long term debt 87866 Future income tax . Total long term liabilities 10140192 Share capital 5104142 Retained earnings 2248639 Shareholders equity 173966 82836 172898 36154 (Good will = TA - TL) 7818635 17958827 Total liabilities and shareholders equity 617552 3343455 . 1015962 6315589 Increase in line of credit 2600000 . 11292558 4277137 215017 4492154 7540391 Increase in equity 1655161 -5366276 2174115

17958827

Increase in interest expenses since combined entity has a negative EBT

2600000@ 6.50% (prime rate)+0.75% taxes assumed to be 0 19674454 14199527 5474927 4603253 871674 99244 76663 894255 932703 -38448 584474 347069 931543 -969991 . . -969991 -4184815 -5154806 -0.031444907 30847317 45286673

Sales Cost of sales Gross profit General and administartive expenses Income before other income, depreciation, amortization and interest Other income Other expenses EBITDA Depreciation and amortization Loss before interest Interest - long term debt Interest - other Loss before tax Cash taxes Reported taxes Net loss Retained earnings (deficit) - beginning Retained earnings (deficit) - ending Loss per common share Common shares outstanding (basic) Common shares outstanding (diluted)

Pharmex + Formulex (Jan 2000) (Ratio Analysis) Liquidity Current ratio 0.9 CA/CL Acid test ratio 0.48 (CA-Inv-Prepaids)/CL Days of AR 94.13 Avg. AR *(365/sales) Days of Inv 123.69 Avg. AR *(365/COGS) Days of AP Avg. AP *(365/purchases) Profitability Gross profit/sales 27.80% Gen. adminsiatrive expenses/sales 23.40% Depreciation & amortization/sales 4.70% EBITDA/sales 4.50% EBIT/sales -0.20% Other income/sales 0.10% Interest/sales 4.70% ROA -5.40% NI/TA ROE -44.60% NI/NW Capacity LT debt/equity 2.43 LTD/NW Interest bearing debt/assets 0.29 Total debt/assets 0.68 EBIT/interest -0.04 EBITDA/interest 0.96 Total debt/ EBITDA 13.67 Funded debt/EBITDA 5.92 (LTD+current maturities+loan payable)/EBITDA

Discounted Cash Flow Valuation

t = n CF t Value = t t =1 (1 + r)

Cash Flows
Cash Flows

To Equity

To Firm

The Strict View Divide nds + Stock Buybacks

The Broader View Net Income - Net Cap Ex (1-Deb t Ra tio) - Chg WC (1 - Deb t Ra tio) = Free Cashflow to Equity

EBIT (1-t) - ( Cap Ex - Depreciation) - Change in Working Capital = Free Cashflow to Firm

Value of Equity

CF to Equity Value of Equity = (1+ k e )t t=1

t=n

DISCOUNTED CASHFLOW VALUATION

Cash flows Firm: Pre-debt cash flow Equity: After debt cash flows

Expected Growth Firm: Growth in Operating Earnings Equity: Growth in Net Income/EPS

Firm is in stable growth: Grows at constant rate forever

Terminal Value

Value Firm: Value of Firm Equity: Value of Equity

CF1

CF2

CF3

CF4

CF5

CFn ......... Forever

Length of Period of High Growth

Discount Rate Firm:Cost of Capital Equity: Cost of Equity

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

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
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 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
Cost of b orro wing should be b ased upon (1 ) synthetic or actual bond rating (2 ) default spread Cost of Bo rrowing = Riskfree rate + Default spread
Cost of Capital = Cost of Eq uity (Equity/(Deb t + Equity)) + Cost of Bo rrowing (1 -t)

Marginal tax rate, reflecting tax benefits of debt

(Debt/(Debt + Equity))

Cost of e quity based upon bottom-up beta

Weights should be market value weigh ts

Cost of Equity
Preferably, a bo ttom-up beta, based upon other firms in the business, and firms own financial levera ge Cost of Equ ity = Riskfree Ra te + Beta * (Risk Premium)

Has to be in the sa me currency as cash flo ws, and defined in same terms (real or nominal) as the cash flows

Historical Premium 1. Mature Equity Market Premium: Average premium earned by stocks over T.Bonds in U.S. 2. Country risk premium = Country Defau lt Spread* ( Equity/Country bond )

or

Implied Premium Based on how e quity marke t is price d today and a simple valua tion model

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 = EBITn+1 X(1-t) / cost of capitaln

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
Expected Growth
Net Income Operating Income

Rete ntion Ra tio= 1 - Dividends/Net Income

Retu rn on Equity Net Income/Book Value of Equity

Reinvestment Rate = (Net Ca p Ex + Chg in WC/EBIT(1-t)

Retu rn on Capital = EBIT(1-t)/Book Value of Capital

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

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

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
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
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
Determining Variables P/E P / BV P/S V / EBIT Growth, Payout, Risk Growth, Payout, Risk, ROE Growth, Payout, Risk, Net Margin Growth, CE needs, Leverage, Risk (P/E) / G (P/BV) / ROE (P/S) / Net Margin

V / EBIT (1-t)
V / EBITDA V/S V / Book Capital

Growth, CE needs, Leverage, Risk

Growth, CE needs, Leverage, Risk Growth, CE needs, Leverage, Risk, Operating Margin Growth, Leverage, Risk, ROC

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