PBP; Xiang Yang

0

7240AFE Advanced Corporate Finance [This report represents the results,

findings and recommendations of the analysis conducted using historical

data and annual reports of Probiotec Ltd from year 2009 to 2013]

Consultant Project

Probiotec Limited

Xiang Yang S2873075

EXECUTIVE SUMMERY

In this consultant project, Probiotec Limited (PBP.AX)’s historical data and annual reports (from

2009 to 2013) will be analysed to provide shareholders and company’s governing body an insight of

Probiotec Limited’s corporate governance, operating performance, and business practises. Also,

recommendations will be presented at the end of this report, in order to improve company’s

performances in different aspects under current financial and market situation.

This report is separated into 3 parts. In the first part, Probiotec’s corporate governance will be

reviewed to ensure that management’s decision making and business practices are acted in the

shareholders’ best interest and within the code of conduct. Further, the Probiotec’s operating

performance will be analysed through company’s accounting performance, market performance,

investment decision, financial decision and dividend decision. The valuation and risk management for

Probiotec will be precisely performed in this part as well. In the last part of this report, appropriate

recommendations will be provided based on the calculation and analysis above.

As the summary provided below, it briefly presents the major issues of Probiotec, which will be

analysed in this report:

1. Corporate governance review, mainly focus on the changes of director’s remuneration related

to the changes of company’s return on equity (ROE);

2. Over expansion of its business into multiple offshore destination simultaneously;

3. Sluggish international retail economy and slow domestic retail environment;

4. Lack of risk management (hedging policy) regarding to the rapid increase in the value of

Australian dollar;

5. Significant decreases in Company’s liquidity.

Depend on the issues above, several recommendations for the purpose of improving Probiotec’s

business practices are summarised as below:

1. Decrease its debt to equity ratio from 61.93% to 40%;

2. Restructure the company by selling some parts of its oversea assets (non-profitable Plants and

Sales Companies), and some brands (bearing losses) as well;

3. Improve the performances in Nutritional products segment, or abandon it;

4. Introduce hedging policy to company to avoid the risks of the increases in interest rates and

dramatic changes in currency exchange rates.

7240AFE Consultant Project – Probiotec Limited

As consequence of following above suggestions, it is reasonable to expect that Probiotec Limited may

still be able to turn its business loss to profit, and return its profitability to previous level in 2009.


Content

INTRODUCTION....................................................................................................................1

CORPORATE GOVERNANCE............................................................................................2

Organizational Structure..................................................................................................................2

Mission Statement............................................................................................................................2

New Share Issues.............................................................................................................................2

Directors’ Remuneration..................................................................................................................3

ACCOUNTING PERFORMANCE........................................................................................4

Du-Pont Model Analysis..................................................................................................................4

Major Financial Ratio Analysis........................................................................................................5

Segment Report........................................................................................................................6

Geographic Segment........................................................................................................................6

Business Product Segment...............................................................................................................6

MARKET PERFORMANCE.................................................................................................8

INVESTMENT DECISION..................................................................................................11

FINANCING DECISION......................................................................................................12

DIVIDEND DECISION.........................................................................................................13

Free Cash Flow Analysis................................................................................................................13

Operating activities........................................................................................................................13

Investing activities..........................................................................................................................14

VALUATION.........................................................................................................................15

Discounted cash flow approach (DCF)..........................................................................................15

P/E ratio approach..........................................................................................................................16

MERGERS AND ACQUISITIONS.....................................................................................17

RISK MANAGEMENT.........................................................................................................18

Market risk (Foreign exchange risk)..............................................................................................18

Market risk (Interest risk)...............................................................................................................18

Liquidity risk..................................................................................................................................19

Credit risk.......................................................................................................................................20

RECOMMENDATION.........................................................................................................21

REFERENCE.........................................................................................................................22


INTRODUCTION

Probiotec Limited (PBP.AX) is a leading emerging pharmaceutical company listed on Australian

Stock Exchange (ASX). It mainly focuses on developing, manufacturing, and selling pharmaceuticals,

foods, and nutraceutical products in Australia and other countries, such as New Zealand, Europe, and

China. There are five segments in Probiotec Limited, include Branded Pharmaceuticals, Contract

Manufacture, Weight Loss and Sports Nutrition, Europe, and Specialty Products. It provides owned

and licensed branded prescription and over-the-counter pharmaceutical products,

complementary medicines, and specialty ingredients (Yahoo Finance, 2014). The company is

also involved in the contract manufacturing of pharmaceutical, food, and animal nutrition

products for pharmaceutical and food companies; manufacture and sale of a range of weight

loss and sports nutrition products in various channels, including FMCG, pharmacy, health

food stores, and online; and provision of Celebrity Slim and Impromy weight loss programs.

In addition, it sells human and animal nutrition products, incorporating the sale of ingredients

and additives for use in the pharmaceutical and food industries (Probiotec Limited, 2013).

In this report, the Probiotec Limited’s corporate governance, accounting performance, market

performance will be analysed in details. Further, the decisions made in investments, finances, and

dividends will be discussed as well. Finally, based on the analyses of company’s valuation, mergers

and acquisitions, and risk management, several appropriate recommendations will be provided at the

end of this report.


CORPORATE GOVERNANCE

Organizational Structure

As the main governing body of Probiotec, board of directors has responsibilities to monitor, review

and improve company’s corporate governance in a high standard. Relied on Commonwealth

Government’s CLERP 9 legislation and the Australian Standard AS8000 Good Governance

Principles, board of directors in Probiotec Limited is responsible for the best interests of stakeholders,

and must fully comply with the principles, practices and legal requirements (Probiotec Limited,

2013).

According to Probiotec Limited’s annual report in 2013, the board’s responsibilities are summarised

as:

• “providing strategic direction and approving corporate strategic initiatives;

• selecting and evaluating future Directors, the Chief Executive Officer (‘CEO’) and the Chief

Financial Officer (‘CFO’);

• planning for Board and executive succession;

• setting CEO and Directors’ remuneration within shareholder approved limits;

• approving Probiotec’s budget and monitoring management and financial performance;

• considering and approving Probiotec’s Annual Financial Report and the interim and final financial

statements;

• approving Probiotec’s risk management strategy, monitoring its effectiveness and maintaining a

direct and ongoing dialogue with Probiotec’s auditors and regulators; and

• considering and reviewing the social and ethical impact of Probiotec’s activities, setting standards

for social and ethical practices and monitoring compliance with Probiotec’s social responsibility

policies and practices” (Probiotec Limited, 2013)

Mission Statement

Probiotec’s mission stated in annual reports is to create long-term shareholder value by:

• “leading in the innovative development of consumer health products;

• growing revenues while improving margins; and

• increasing distribution levels in both domestic and international markets” (Probiotec Limited, 2009).

New Share Issues

Probiotec issued 4,533,403 new shares in 2010. Then, 1,587,272 and 37,866 new shares were issued

over the next two years, respectively. Compared with its most similar peer company - Vita Life

Sciences Ltd (VSC.AX), Probiotec issued much more shares in 2010 than Vita Life Sciences did.


Even though Vita Life Sciences issues 3,559,753 shares in 2011, which are more than double of

shares issued by Probiotec, VSC repurchased almost half of the shares issued in 2011, during the next

two years. However, based on the great performance in 2009, Probiotec planned to expand its

business in offshore markets rapidly in 2010. Thus, Probiotec issued a large number of shares

(4,533,403 in 2011) to raise more than 11 million and did not buyback any shares during the next 3

years, in order to support its expansions in Europe and Asia markets.

Share outstanding 2013 2012 2011 2010

PBP.AX 0 37,866 1,587,272 4,533,403

VSC.AX -223,988 -1,370,422 3,559,753 0

Directors’ Remuneration

2013 2012 2011 2010 2009 VSC (2013)

Total Directors

Remunerations 1,475,514 1,487,875 1,424,003 1,491,338 875,970 215,627

Sales 67,342,884 66,046,188 71,770,144 74,842,141 87,133,035 35,411,000

Directors

Remuneration /

Sales (%) 2.19% 2.25% 1.98% 1.99% 1.01% 0.61%

Directors

Remuneration /

Total assets

(%) 1.34% 1.47% 1.34% 1.18% 0.86% 0.98%

ROE 1.70% 2.51% -1.98% 10.69% 16.13% 23.73%

As clearly showed in the table above, Probiotec Limited’s percentage of directors remuneration over

sales was almost doubled to 1.99% in 2010 (1.01% in 2009). Then, this percentage further grew to

peak at 2.25% in 2012 while its return on equity (ROE) kept dropping continuously from 16.13% in

2009 to -1.98% in 2011, 2.51% in 2012, and 1.70% in 2013. Although the annual reports of Probiotec

Limited clearly states that “The Remuneration and Nominations Committee has structured the

Group’s executive remuneration policies to ensure:

• the policy motivates executives to pursue the long term growth and success of Probiotec within an

appropriate control framework;

• the policy demonstrates a clear relationship between individual performance and remuneration; and

• the policy involves an appropriate balance between fixed and variable remuneration, reflecting the

short and long term performance objectives appropriate to Probiotec’s circumstances and goals”


(Probiotec Limited, 2011), the directors’ remunerations still unreasonably rose while Probiotec

Limited made a loss of $11,303,166 in 2011. Compared to its competitor (VSC), the percentage of

directors remuneration over sales in Probiotec Limited (2.19%) in 2013 is more than triple of the

percentage in VSC (0.61%). Consequently, the increases in the director remuneration indicate that the

management of Probiotec did not act in accordance with the guidelines stated in the annual reports. A

potential agency cost was created against its shareholders’ interests.


ACCOUNTING PERFORMANCE

On the perspective of accounting performance, both of company’s return on equity (ROE) and return

on asset (ROA) decreased dramatically during last 5 years and reached the bottom at -1.98% and

0.36% respectively in 2011. Compared to its peer company, the ROE (1.70%) and ROA (2.00%) of

Probiotec are much lower than the percentages in VSC (23.73% and 17.53%, respectively). It clearly

indicates that Probiotec Limited’s resources were failed to be allocated during these periods, which

leaded to a lower income generated from its investments.

Du-Pont Model Analysis

Year ROE ROA PM AT EM

2009 16.13% 9.67% 9.68% 0.85 1.96

2010 10.69% 7.21% 10.49% 0.59 1.92

2011 -1.98% 0.36% -1.69% 0.67 1.74

2012 2.51% 2.94% 2.37% 0.65 1.62

2013 1.70% 2.00% 1.61% 0.61 1.73

5-year Average 5.81% 4.43% 4.49% 0.67 1.79

VSC (2013) 23.73% 17.53% 10.90% 1.61 1.35

As illustrated in the table above, by using Du-Pont Model, ROE can be broken down into three

components: profit margin, asset turnover, and equity multiplier. Firstly, the profit margin (PM)

presents the profits generated by the company out of its revenue. Probiotec’s profit margin after a

slight increase in 2010, this figure jumped from 10.49% to -1.69% in 2011. Then, it returned to

positive at 2.37% in 2012 and 1.61% in 2013. Compared to VSC’s profit margin (10.90%) in 2013, it

indicates that the worse profitability of Probiotec after 2010. Company can only generate very limited

return related to its sales due to the dramatic strengthening in Australian dollar.

Further, asset turnover represents (AT) whether the company effectively uses its assets or not. As can

be seen from the table, Probiotec’s asset turnover dropped from 0.85 in 2009 to 0.61 in 2013 (0.67 for

5-year average), which is much lower than the figure in VSC (1.61 in 2013). It is obviously that

Probiotec Limited’s performance on sales for every unit of assets owned was much poorer than its

peer company, under a sluggish domestic and global retail environment.


In the equity multiplier (EM), it is used to measure the level of leverage used by the company.

Probiotec reduced its leverage from 1.96 in 2009 to 1.62 in 2012. However, its equity multiplier

(1.79) is still much higher than VSC’s (1.35) in 2013. The higher leverage indicates that the company

is more risky and less future financial flexibility than its competitor, and also brought more pressure

to company and its management while the more expensive interest payments and greater returns were

requested by shareholders for bearing extra risks.

Major Financial Ratio Analysis

Year Current

Ratio

Days A/R Days Inventory Days A/P Required

Financing

Period

2011 0.67 56.62 179.88 110.34 126.16

2012 0.71 51.66 144.18 107.57 88.28

2013 0.64 53.32 131.35 114.67 99.21

In order to maintain adequate cash flows for company’s normal operations, company had better

shorten the days for collecting account receivables and delay the account payables. In the table above,

Probiotec’s days account receivable slightly decreased from to 56.62 days in 2011 to 51.66 days in

2012 based on the recovery of global economy after the influences of global financial crisis. With the

same reason, the days inventory dropped from 179.88 days in 2011 to 144.18 days in 2012 and further

reduced to 131.35 days in 2013. As stated in Probiotec’s annual report 2013, under the unexpectedly

difficult economic situations, the days account receivable rose again, to 53.32 days. However,

fortunately, most of the suppliers extended the due dates, in order to avoid bad debts being written off

from books, the days account payable increased to 114.67 days, which gave Probiotec more days to

maintain adequate cash flows for its business operations. Consequently, Probiotec’s required

financing period reduced from 126.16 days in 2011 to 99.21 days in 2013, which implies that

company’s cash management is essential especially with the global economic downturn.


Segment Report

Geographic Segment

Geographic

Segment

Australia New Zealand Europe America Others

Sales 61,634,728 1,396,592 5,696,227 68,454 785,960

Sales

percentage 88.58% 2.01% 8.19% 0.10% 1.13%

As illustrated in the table above, due to the dramatic increases in the value of Australian dollar against

the other currencies, Probiotec restructured its export activities by selling some non-profitable entities

in Asia, America, and other countries, all the sales in these countries reduced or eliminated during the

fiscal year 2013. After the disposals in offshore markets, Probiotec’s sales now mainly depended on

the performances in domestic markets, which contributed 88.58% of the company’s total sales in

2013. Moreover, the Probiotec also continuously focused on the manufacturing and distribution

business in the United Kingdom and Ireland (8.19% of total sales). These retreats from offshore

markets reduced the risks of rapid changes in currency exchange rates by compromising Probiotec’s

capabilities of diversifying the risks of the recession in domestic market and retail environment.

Business Product Segment

Business segment Pharmaceuticals

and consumer

health

Contract

manufacturing

Nutritional

products

Export sales

Sales 35,445,162 23,729,543 3,275,289 7,131,966

Sales Percentage

50.94% 34.10% 4.71% 10.25%

EBIT, operating

P/L 6,067,092 2,977,244 -455,756 202,711

Profit Margin, PM

11.98% 8.78% -9.74% 1.99%


Probiotec’s business can be separate into 4 segments: pharmaceuticals and consumer health, contract

manufacturing, nutritional products, and export sales. As the highest profit margin segment (11.98%),

pharmaceuticals and consumer health products contributed more than half of Probiotec’s sales and

EBIT in 2013, around $35,445,162 and $6,067,092, respectively. However, due to the recession of

economic conditions in the domestic retail environment, and poor performance in the cost control of

weight management products, the profit margin in this segment dropped more than 7%, from 19.02%

in 2012 to 11.98% in 2013. On the contrary, the revenue from contract manufacturing segment

increased from $17,514,134 in 2012 to $23,729,543 in 2013. The profit from this segment rose almost

1 million while the profit margin reduced around 3% over the fiscal year 2013. It is the result of

transferring group’s Biosource brand from Pharmaceuticals to contract manufacturing segment during

the year. Moreover, due to the selling of some non-profitable brands, Nutritional products segment

experienced a loss from discontinued operations, around $455,756. In the export sales segment, as a

result of restructuring its export activities, such as the closure of loss making entities in offshore

market, both the profit and profit margin recovered while the sales decreased slightly in 2013. In

addition, the profitability of all segments mentioned above was also largely influenced by the strength

of the Australian dollar against both the Euro and Great Britain pound (Probiotec Limited, 2013).


MARKET PERFORMANCE

In the market performance, in 2009, based on the great performance in sales, Probiotec’s annual

revenue grew 31.9% to $87.13 million while the profit before tax rose 41.8% to $12.05 million.

Probiotec Limited’s stock price increased significantly from around $1.50 per share to more than

$2.70 per share.

Afterwards, Probiotec Limited brought out its aggressive worldwide expanding plans in fiscal year

2010. It started to increase distribution and sales through Europe and Asia, and leverage its

manufacturing capabilities. Probiotec raised 3 million from debts and more than 21 million from new

shares to acquire brands, manufacturing plants and sales companies globally. After the new company

strategies announced, the share price of Probiotec Limited jumped significantly to $1.60 per share in

April 2010. Then, this figure further dropped around $1 per share to $0.6 per share after the annual

report for fiscal year 2010 published.

As can be seen from the graph below, the historical share price of its peer company - Vita Life

Science (yellow line) will be used to compare with the share price of Probiotec (blue line) while the

SP & ASX 200 (red line) is set as the benchmark.


In fiscal year 2011, the Probiotec’s share price experienced a great decrease. This drop can be

attributed to three reasons:

1. “Probiotec Limited’s expansion of its business into multiple offshore markets simultaneously;

2. Those expansion made at the time of a rapid increase in the value of Australian dollar against

the other currencies;

3. The international retail economy was sluggish at that moment” (Probiotec Limited, 2011).

With the rapid increase in Australian dollar, Probiotec’s export costs increased as well. At the same

time, the sluggish international retail economy further brought Probiotec’s profits down in 2011.


INVESTMENT DECISION

During these 5 year period, Probiotec’s beta (β) can be calculated at 0.57, which indicates that

Probiotec’s share price is not sensitive to fluctuations in the market. The correlation between

Probiotec and ASX 200 is low.

Jenson’s Alpha (α) = -0.06

At the given level of risk, the Jensen Alpha (α) of Probiotec can be computed at -0.06, which indicates

the market performance of Probiotec is worse than the expectations. The actual performance of

Probiotec’s stock over the past five years was 6%, well below the expected market return.

CAPM (Ke) = Rf + β [Rf + E(Rm)] = 8.80% (based on the data of the last 5 years)

Applying the Capital Asset Pricing Model (CAPM), the expected annual returns (Ke) of Probiotec can

be calculated at 8.80%. However, the actual 5 year average annual return was -0.3%, which was much

lower than the expected return. The R-Squared (R²) of Probiotec was 0.026, which indicates only

2.6% of the risk in Probiotec was from market sources.

In the economic value added (EVA), after the great performance in 2009, Probiotec’s profits declined

materially and slightly recovered during the past 5 years. As showed in the table below, the economic

value added decreased significantly in 2010. Then, it further dropped to a negative $4,027,909 in

2011, which presents both the company and shareholders suffered a loss during that year. After the

disposals of non-profitable offshore entities, the economic value added recovered around 2.5 million,

but remained negative $1,509,729 in 2012. However, the figure went down again to $-2,495,060 in

2013, due to the losses from disposals, and the worse domestic and global retail environment which

brought the profits down during those periods.


EVA (Economic Value Added)

30/06/2009 30/06/2010 30/06/2011 30/06/2012 30/06/2013

4,564,457 2,528,655 -4,027,909 -1,509,729 -2,495,060

FINANCING DECISION

Probiotec

Limited

Interest Coverage Rating Interest rate

Low High

1.94 1.75 1.999999 B+ 7.00%

Based on the great performance in 2009, Probiotec raised large amount of money from new debts and

issuing new shares in 2010, in order to expand in offshore markets. According to the credit rating

issued by Standard & Poor’s, the increases in Probiotec’s leverage lifted its cost of debt as showed

above. The interest coverage ratio of Probiotec was 1.94, which indicates the credit rating should be

B+. According to the coverage ratio, the current credit rating was the same as the current official

rating. Therefore, its debt financing costs exactly equal to the amounts stated.

Current Optimal Change

D/(D+E) Ratio 61.93% 40.00% -21.93%

Beta for the Stock 0.57 0.39 -0.18

Cost of Equity 8.80% 7.45% -1.35%

AT Interest Rate on Debt 4.90% 4.03% -0.88%

WACC 6.39% 6.08% -0.31%

Implied Growth Rate 4.50%

Market Value of Firm (C) $43,098,115 $45,262,967 $2,164,851

Market Price/share (C) $0.31 $0.35 $0.04

*Firm Value (C): No growth in savings. New Firm Value=Current Firm value +{(WACC(current)-New

WACC)*Current firm value/New WACC}


As the results of calculation above, the current capital structure of Probiotec maximises neither the

value of the firm nor the share price. Also, it did not minimise the cost of equity and interest rate on

debt. In order to achieve the optimal financial mix, Probiotec should pay off the debt raised in 2010

for the purposes of acquisition and expansion in offshore market. This movement will decrease its

debt ratio from 61.93% to 40%, and also increase the firm’s value by $2,164,851 and share price by

$0.04 per share. With the lower debt ratio, the beta of Probiotec will be improved by 0.18 to 0.39.

Consequently, both the cost of equity and interest rate on debt will go down by 1.35% and 0.88%,

respectively. After this restructure, the interest expense will be reduced, which leads to a potential

greater profitability of Probiotec. In addition, more financial flexibilities will be gained from this

restructure for Probiotec’s future investments.

DIVIDEND DECISION

Free Cash Flow Analysis

Free Cash Flow

Analysis

2013 2012 2011 2010 2009

EBIT 3,143,002 4,249,601 540,510 12,995,677 14,126,398

NOPAT 2,200,101 2,974,721 378,357 9,096,974 9,888,479

%CH-NOPAT -26.04% 686.22% -95.84% -8.00% -

Operating capital

(OC) 71,407,706 68,203,044 67,013,964 99,896,162 80,971,909

%CH-OC 4.70% 1.77% -32.92% 23.37% -

NOWC -13,701,395 -9,578,658 -13,130,814 11,355,053 13,613,167

Non-cash working

capital -13,747,512 -9,772,046 -14,068,921 8,538,638 11,939,771

Change in Non-

cash Working

Capital (DNWC) -3,975,466 4,296,875 -22,607,559 -3,401,133 -

Net fixed assets 85,109,101 77,781,702 80,144,778 88,541,109 67,358,742

FCFE 2,441,235 -7,863,642 20,887,903 14,217,831 -

FCFF -1,004,561 1,785,641 33,260,555 -9,827,279 -

Current Ratio 0.64 0.71 0.67 1.43 1.64

As we can see from above table, due to the large capital expenditures in acquiring offshore assets, the

free cash flow to firm (FCFF) turned to be a negative $9,827,279 in 2010. Afterwards, as a result of

the increase in current liability in 2011, Probiotec experienced a great change in non-cash working


capital (DNWC), which decreased dramatically by $22,607,559. With the change in non-cash

working capital, the FCFF rose largely from a negative $9,827,279in 2010 to a positive $33,260,555

in 2011. In 2012, due to the disposals of non-profitable entities, the non-cash working capital

increased by $4,296,875, which led to another drop in FCFF. Further, in terms of the strong

Australian dollar against the other currencies and the new acquisitions in Europe, the EBIT declined

around 1 million while net fixed assets increased again, to $85,109,101 in 2013. In addition, the

current ratio kept dropping continuously from 1.64 in 2009 to 0.64 in 2013. It clearly indicates that

Probiotec faced serious liquidity problems after the aggressive expansions.

Operating activities

From the table in the next page, as explained in accounting performance part, it is easily found that

Probiotec improved its cash to cash cycle during the past three years. Even though the days used to

collate account receivable slight increased by almost 2 days, the days used in selling inventories

decreased by 3 days. Also, the suppliers extended the days for account payables to 114.67 days.

Year Days A/R Days Inventory Days A/P Required

Financing Period

2013 53.32 131.35 114.67 70.01

2012 51.66 144.18 107.57 88.28

2011 56.62 179.88 110.34 126.16

Therefore, the days required for financing reduced by 18 days, which indicates Probiotec’s cash to

cash cycle getting more efficient and less working capital was required.

Investing activities

Cash Flows From Investing Activities 2013 2012

Payment for property, plant and equipment (8,034,247) (3,532,926)

Proceeds from sale of property, plant and equipment 32,094 1,048,125

Proceeds from sale of intangible assets 900,000 6,000,000

Cash payments for investments - (322,046)

Receipts relating to loans receivable 511,496 590,001

Purchase of intangible assets (1,309,880) (2,596,575)

Net cash used in investing activities (7,900,537) 1,186,579


From Probiotec’s cash flows statement in 2013, due to a large amount of funds used in the

investments (purchasing property, plant and equipment), and less income received from the disposals

of property, plant, equipment, and intangible assets, Probiotec’s net cash used in investing activities

dropped significantly from a positive $1,186,579 in 2012 to a negative $7,900,537 in 2013. It

indicates that Probiotec spent lots of funds into the fixed assets again for the purposes of expansion in

oversea markets. Based on the poor sales performance in 2013 and current sluggish retail conditions,

it is reasonable to assume that Probiotec may experience another recession after this aggressive

expansion (similar to the expansion in 2009).

In terms of the significant decrease in profit in 2011 and aggressive expansion in 2013, it is

reasonable for Probiotec to stop paying dividends from 2011.

VALUATION

The difference between the Probiotec’s intrinsic value and market value can be another important

factor used by shareholders to make investment decision. In the valuation part, there are three main

models normally used to calculate the intrinsic value, including discounted cash flow approach

(DCF), dividend discount model (DDM), and P/E ratio approach. In this report, only DCF and P/E

ratio approaches will be applied, due to the ceases of Probiotec’s dividend payment after 2010. Then,

the calculated intrinsic values will be used to compare with the market value and measure whether its

stock is overpriced or underpriced.

Discounted cash flow model

Estimate Free Cash Flow to Firm (FCFF)

Year 0 1 2 3 4 5 6EBIT'(1-t) 3,184,681 3,212,788 3,241,14

43,269,750 3,298,60

83,327,721 3,477,468

Net Capex = Capex-Depr

5,073,823

∆W (3,975,466)

Estimate Free Cash Flow to Firm (FCFF)Year 0 1 2 3 4 5 6EBIT'(1-t) 3,184,681 3,212,788 3,241,14

43,269,750 3,298,60

83,327,721 3,477,468

FCFF=EBIT(1-t)(1-d) 2,086,324 2,409,591 2,430,858

2,452,312 2,473,956

2,495,791 1,419,274

Present Value (PV) 2,260,932 2,140,167

2,025,853 1,917,645

1,815,217

Terminal Value (TV) 31,706,649


Compute Intrinsic Value per Share

Sum(PV(FCFF),..,TV)

41,866,462

+ cash 46,117- Debt 26,690,015 = Equity 15,222,564Shares Outstanding 52,929,356

Intrinsic Value per share =

$0.2876 Market share price = $0.31

By using the discounted cash flow approach (DCF), the intrinsic value of Probiotec can be calculated

at $0.2876 per share. Compared to the market value of Probiotec ($0.31), Probiotec’s stock is slightly

overpriced by $0.02 per share.

P/E ratio approach

Intrinsic value per share = Industry P/E × EPS

= 12.27 × $0.011

= $0.135

As the formula above, the industry average P/E ratio in Pharmaceuticals industry (12.27) will be

applied. By using P/E ratio approach, the intrinsic value of Probiotec can be computed at $0.135 per

share, which is much lower than the market share price ($0.31 per share). Therefore, based on the

results calculated above, Probiotec’s stock is well overvalued.


MERGERS AND ACQUISITIONS

Based on the great performance in offshore markets during previous year (2009), Probiotec started its

aggressive expanding plans in oversea market in 2010. It acquired a large number of entities (plant,

brands and sales company), such as a manufacturing facility in Dundalk, the 50% shares in Celebrity

Slim brands (fully own), four sports nutrition brands, the 50% of the Australian Dairy Proteins JV

(fully own), and a China-based sales company in Hong Kong. However, due to the lack of hedging

policy, Probiotec cannot offset the higher expenses from a rapid increase in Australian dollar against

the other currencies. Under the worse global retail environment, Probiotec experienced a great loss

after the aggressive expansion.


RISK MANAGEMENT

The major risks faced by Probiotec include market risk, liquidity risk, and credit risk.

Market risk (Foreign exchange risk)

As mentioned above, Probiotec did not introduce any hedging policies to protect the firm’s profits

from the foreign exchange risk. Company is still exposed to the risk of the rapid changes in the

exchanges rate of foreign currencies. Probiotec only explained and predicted the sensitivity of firm’s

profit to the changes of currencies exchange rates based on the historical data. As stated in Probiotec’s

2013 annual report, the results of 10% strengthening of Australian dollar against Great British pound

(GBP), 15% strengthening of Australian dollar against the New Zealand dollar (NZD), 10%

strengthening of Australian dollar against US dollar (USD) and a 10% strengthening of Australian

Dollar against EUR, are simply presented as below:

2013 ProfitGBP $(72,160)NZD $(12,139)USD $33,104EUR $719

Regarding to the ambition of the directors of Probiotec in offshore expansions in the near future, the

main risk faced by Probiotec should be the foreign exchange risk.

Market risk (Interest risk)


Probiotec’s financial assets and liabilities are also exposed to the variable interest rate risk. As

explained in its 2013 annual report (shown in the table below), a large amount of company’s assets

and liabilities were exposed to the risk of changes in variable interest rates.

2013 Weightedaverageinterest rate%

1 yearor less$

Over 1 to5 years$

More than5 years$

Total$

Financial assets: 2.90

Cash 46,117 - - 46,117

Total financial

assets 46,117 - - 46,117

Financial

Liabilities 5.80

Loans and

overdraft 22,288,610 50,000 - 22,338,610

Total financial

liabilities

22,288,610 50,000 - 22,338,610

Net exposure (20,242,493) (50,000) - (22,292,493)

In terms of the sensitivity analysis in Probiotec’s 2013 annual report, the impacts of an increase in

interest rates shown as follow:

2013 Profit $

1% (222,925)

2% (445,850)

Liquidity risk

Another major risk faced by Probiotec is the risks that the company may not be able to raise funds to

continuously maintain the its current operations. The insufficient liquidity in Probiotec may not be

able to meet its liabilities when due, and it also reduces its future financial flexibility. As can be seen

from the table below, there was a great decline in Probiotec’s current ratio after the fiscal year 2010,

from 1.64 in 2009 to 0.64 in 2013. The figure was much lower than its competitor’ (VSC), which

shows the worse liquidity in Probiotec in 2013.


30/06/2009 30/06/2010 30/06/2011 30/06/2012 30/06/2013 VSC(2013)

Current Ratio:

1.64 1.43 0.67 0.71 0.64 3.61

Furthermore, in Probiotec’s annual report (2013), the total carrying amount of its non-derivatives

financial liabilities increased around 6 million during fiscal year 2013. As illustrated in the table

below, a 3 million more non-derivatives financial liabilities got close to maturity date ( less than 6

months), which may further reduce Probiotec’s liquidity.

Carrying

amount

Total

contractual

cash flows

Less than 6

months

6 – 12 months 1 – 5 years

Non-derivatives financial liabilities (2013)

Trade and

other payables 13,767,584 13,767,584 13,446,584 321,000 -

Fixed

borrowings

(including

finance leases) 3,802,111 4,054,144 734,906 734,906 2,584,332

Variable

borrowings 22,338,610 22,338,610 675,000 675,000 20,988,610

Total 39,908,305 40,160,338 14,856,490 1,730,906 23,572,942

Non-derivatives financial liabilities (2012)

Trade and

other payables 10,213,722 10,213,722 9,892,722 321,000 -

Fixed

borrowings

(including

finance leases) 2,763,434 3,046,752 513,075 513,075 2,020,602


Variable

borrowings 21,065,968 22,619,870 1,650,343 4,931,543 16,037,984

Total 34,043,124 35,880,344 12,056,140 5,765,618 18,058,586

Although the company may gain a 4 million dollar financial flexibility in the next 6 to 12 months,

however, in the long-run (1 – 5 years), Probiotec’s liquidity problems are still noteworthy.

Credit risk

2013 2012

(Increase)/decrease in trade and other receivables (2,782,006) 1,803,391

As stated in the notes to the statement of cash flows, the trade and other receivables increased

significantly by $2,782,006 in 2013. It indicates that Probiotec may not be able to collect the

payments from customers and a raise in its bad debts. Even though Probiotec stated in its annual

reports that all the trades were made to the credit-worthy third parties and a credit insurance policy

was applied by the company, the dramatic increase in accounts receivable still worthy to be take into

concerns.

RECOMMENDATION

Based on the analyses performed in the previous parts of this report, some appropriate

recommendations can be provided to the shareholders and Probiotec’s management.

According to the optimal financial mix analysis, Probiotec should lower its leverage from 61.93% to

40%. After company’s financial structure achieve the optimal mix, Probiotec’s firm value will

increase by $2,164,851 while the market share price will rise 13% ($0.04 per share) to $0.35 per

share. Even more important, Probiotec will further decrease its beta from current 0.57 to optimal 0.39,

improve its liquidity and gain the extra financial flexibility for its future investment.

Moreover, for the potential incentives to open the offshore markets, management should employ the

hedging policies (interest rate swaps and forward exchange contracts) to company, which will reduce

the uncertainty of Probiotec’s future profitability and protect company from the risk of rapid increases

in the interest rates and the value of Australian dollar against the other foreign currencies. These

protections will also improve the investors’ confidence in investing Probiotec.

Further, company’s management should review the company’s policies for credit purchases and

reduce the amounts of its account receivables, which may decrease the amount of potential bad debts.


In addition, according to the historical sales data, Probiotec should further dispose some non-

profitable brands and sales companies. Nutritional products may need to be abandoned if the poor

performances in this segment remain disappointed in the near future.

REFERENCE

Probiotec Limited, (2009). Annual Report 2009





Yahoo Finance (2013), graphs retrieved from: http://finance.yahoo.com Accessed

01.09.2014.

Yahoo Finance (2014), retrieved from: https://au.finance.yahoo.com/q/pr?s=PBP.AX


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