Pharmex Industries: Acquisition of Formulex Group of Companies

Case Summary
The case talks about the acquisition of Formulex Group of Companies by Pharmex Industries, a pharmaceutical manufacturing company. Sean Cleary, the chief financial officer for Pharmex Industries is evaluating the acquisition opportunity and has to decide whether Formulex is a strategically and financially attractive target, what its value is and how to finance the acquisition. Formulex is a manufacturer and distributor of over 85 prescription and OTC pharmaceutical, vitamin and herbal products. The Formulex manufacturing facility is a Health Products and Food Branch of Health Canada-approved, 87,000-square-foot plant located in Montreal, Quebec. Formulex is owned privately by Rousseau (69%) and three venture capitalists (10.33% each). The company has an invested capital of $3.2 million. The VCs invested through convertible debentures two years ago, each contributing $200,000. Pharmex Industries is a high-growth pharmaceutical company that has aggressively expanded through acquisitions of financially sound firms. Pharmex has not yet profitable but expected to be within the year. It follows a focused strategy, offering a limited product line consisting of acetaminophen and other over-the-counter (OTC) analgesic products, at significantly lower costs to retail pharmaceutical drug stores.

Problems in the Case

Cleary has to arrive at a fair value for Formulex, the obstacle being that Formulex is a private company with forecasts not available beyond 5 years. The price-to-earnings multiple and total enterprise value/EBITDA multiple used to value similar companies varied significantly across the sector. Another decision point for Cleary is how to finance the deal.

How much cash will be required and how much can he manage through the debt capacity of combined entity after the acquisition will play an important role in the success of the acquisition.

Reasons for acquisition of Formulex

The decision to acquire Formulex fits in strategically with Pharmex. It would allow Pharmex to expand into the contract pharmaceutical manufacturing business. Pharmex would be able to expand further into international markets. Pharmex would be able to develop expertise in research and development and formulation to attract new clients and grow sales. The sales of Formulex are three times those of Pharmex and were expected to grow at an annual rate of 15 per cent over the next 5 years. Formulex also had a history of growth and earnings, and had a greater debt capacity than Pharmex.

The largest potential synergy would be from the increased buying power which would allow volume discounts since raw materials accounted for a major portion of the cost of goods sold. The Formulex facility was a higher quality facility which would lead to Pharmex saving $100,000 on capital expenditures to improve its existing facilities Weighted average cost of capital would decrease after the acquisition

Analysis
The value of Formulex may be calculated using the discounted cash flow method or relative valuation. Cleary and greater bargaining power and wants to pay less than the value of Formulex calculated from a DCF analysis if the market value of the company was less and there were few rival offers to acquire the company. Using discounted cash flow valuation (DCF), we try to calculate a fair value for Formulex. We use Exhibits 3, 4 and 5 for this. The terminal growth rate is assumed to be the long term GDP rate plus the inflation, which is approximated by the rate on long term Govt. of Canada bonds 6.3%. Cleary believes the cost of capital of Formulex to be 10%. We get an enterprise value of approximately $20.5 million. Exhibit 6 states that 10.33% ownership equates to $200, 000 at $3.66 per share. Given that the assumed value of debt (Exhibit 5) is $203,000, we get the share price to be $ 38.30. WACC EV Debt Equity No. of shares Share Price DCF calculations shown in Annexure I. 10% $20,458,882 $203,000 $20,255,882 528821 $38.30

Using relative valuation, it is given that the PE multiple of comparable firms in the industry varies between 10 and 20 while EV/EBITDA varies between 6 and 8.

Max
P/E Share Price EV/EBITDA Share Price Relative Value calculations in Annexure II. 20 31.47 8 31.09

Min
10 15.74 6 23.23

Since Cleary will pay less that the value as per DCF calculations, he should negotiate the deal in the range of $15.74 to $31.47 per share. It is likely that he is overestimating the value of Formulex. Looking at it from the perspective of Formulex, the VCs require compounded annual returns in the range of 40 per cent to 60 per cent. Even at a return of 50 per cent, the VCs would sell their stake of Formulex at $8.24 per share. This is well above the stipulated range of prices and hence, even a purchase price of $15.74 should be accepted by them.

If there were to be an acquisition, Pharmex prefers to raise as little cash as possible to finance the transaction. However, Rousseau would require $2 million in cash upon requirement and the rest in common shares of Pharmex. Each of the venture capitalists also wants to receive at least the cash amount of their original investment, i. e. $200,000 each and would consider receiving the rest of the proceeds in shares. Assuming Cleary is able to negotiate the price per share to be $15.74, we can calculate the number of shares of Pharmex that will be issued to Rousseau and the three VCs. % ownership 69% 10.33% 10.33% 10.33% No. of shares 364886 54645 54645 54645 Min cash payment $2,000,000 $200,000 $200,000 $200,000 $2,600,000 Pharmex Share Price No. of shares Amt paid in shares $3,743,310 $660,109 $660,109 $660,109 $5,723,638 2.35 2,435,591

Rousseau VC 1 VC 2 VC 3 Total

Pharmex can use the line of credit available to Formulex if it wants to avoid raising cash. Formulex has a line credit of $4.534 million at its disposal (Annexure III). At a purchase price of $15.74 per share, the goodwill generated will be equal to $4.104 million. The excess cash that Pharmex will have to raise is calculated below: Balance Sheet of Pharmex + Formulex as on Jan 31, 2000 $17,922,673 Equity $4,104,631 Liability (ex-Line of credit) Line of credit available New Debt/Equity $22,027,304 Total

Assets Goodwill

$518,954 $12,584,712 $4,534,411 $4,389,227 $22,027,304

Total

This shows that Pharmex will need to issue either new debt or equity to finance this acquisition. If it issues new equity, it will have to issue at least 2,435,591 shares. Since, debt is quite high as it is, Pharmex should ideally issue more shares. This will also keep the quite high debt-to-equity ratio in check.

Conclusions
The value of Formulex lies between $ 15.74 and $31.74 per share as per price multiples, while DCF valuation gives the value of Formulex as $38.30 per share. At a hurdle rate of 50 per cent for the three venture capitalists, the price per share comes out to be $8.24. Since the value as per discounted cash flow method gives the price per share at $38.30, it is most likely that the forecasts for the next five years are not accurate and are too aggressive. Pharmex wants to raise as little cash as possible. Hence, it can utilize the line of credit facility worth approx. $4.5 million available to Formulex. As the agreed upon purchase price increases, the amount of goodwill increases, thereby increasing the amount of cash that needs to be raised.

Annexures
Annexure I
Discounted Cash Flow valuation (Values in $ mil) Sales EBIT Earnings before interest after tax Dep and Amrt CapEx Increase in WC Net Investment OIC ROIC 12.937 13.019 7.4% 13.067 8.5% 13.123 9.7% 13.187 11.1% 13.260 12.7% 2.744 FCF 0.884 1.063 1.222 1.406 27.214 24.471 0.905 0.962 1999 2000 16.106 1.611 0.966 0.470 0.470 0.082 2001 18.522 1.852 1.111 0.470 0.470 0.048 2002 21.300 2.130 1.278 0.470 0.470 0.056 2003 24.496 2.450 1.470 0.470 0.470 0.064 2004 28.17 2.817 1.690 0.470 0.470 0.073 0.891 14.151 0.947 0.947 Terminal 2005 29.945 2.994 1.797 2006 31.831 3.183 1.910

Annexure II
Valuation using Price Multiples Max 20 1,610,626 223,777.5 832,109 16,642,182 528821 31.47 Min 10 1,610,626 223,777.5 832,109 8,321,091 528821 15.74 Max 8 2,080,814 16,646,512 203,000 16,443,512 528821 31.09 Min 6 2,080,814 12,484,884 203,000 12,281,884 528821 23.23

P/E EBIT Int (@ 10%) PAT Market Value No. of shares Share Price

EV/EBITDA EBITDA EV Debt Market Value No. of shares Share Price

Annexure III
Line of credit available to Formulex Term facility Rotating credit facility Already utilized Total cash available from line of credit $5,500,000 $2,750,000 $3,715,589 $4,534,411