A curious set of incentives at Probiotec

My position in Probiotec Limited (ASX: PBP) has ripped higher over the past few months, up over 100% since I bought it in June. This has given me a problem and funnily enough I’m more concerned about being up 100% on Probiotec than I was being down 70% on RNY Property Trust (ASX:RNY), my first loser.

The problem is that Probiotec has moved pretty close to IV long before the business performance has occurred that should propel it there.

Probiotec also released an announcement the other day that refers to some sort of approach or opportunity that has become apparent to management. In return for working on this approach, which will ‘release capital, improve returns, and unlock value for shareholders’, management is awarding themselves options with an exercise price of $1.20 (subject to shareholder vote), well above the then-closing price of $0.74.  In return management will forego cash short-term incentives.

They also announced that the initiatives would free up cash and as a result it was considered prudent to establish a share buyback capability. Oh and first half profits are expected to be somewhere between 40% and 100% higher YoY.

Follow the money?

I’ve never seen a management team willing to forego a cash bonus in return for options set so far above the market (~60% above last traded price before the announcement). That suggested to me that there was something real here, and in the three days following the announcement, around 300k shares changed hands, with the CEO buying a quarter of those (approx ~20% of his base salary).

Although I was in unknown territory, I elected to follow the incentives and I bought more shares within 10% of the CEO’s buy price. Probiotec is currently around 15% of the 10foot portfolio, although I will be increasing the portfolio size soon (more on that in the upcoming quarterly) which should take it to about a 7% position or less.

(If you’ve ever seen this type of incentive change in the past,  let me know so I can see how it turned out.)

Given the forecast lift in profit I expect the PBP CEO would be in for a sizeable STI cash bonus this year. He earned $68,000 STI last year on a base salary of ~$300k.

I reasoned that anybody that is willing to give up a seemingly guaranteed (given profit growth) ~$100k cash in return for options set 60% above the last market price must really believe in the value of the options, be very certain of achieving the deal, or be so rich that neither is meaningful to them. The number of options being issued was not disclosed (presumably will be disclosed after the EGM vote in January) but Probiotec either needs to issue a lot of options, or the company has to be ‘worth’ a lot more than $1.20 a share (or pay out a lot of capital returns) in order to make up the guestimated $100k in STI cash that will be foregone. That’s something to look at after the EGM.

A value-adding buyback? 

If the company is doing a deal that will see shares head above $1.20 (see management’s option issue), I have to question why they set up a buyback facility, and whether buying back shares would be a good idea at that price. I have no idea what kind of ‘unlocking’ they’re doing, but at $1.30 /share (assuming management gets in the money on the options),  Probiotec has a market capitalisation of $80m and an EV of $87m.

Guidance was for a +40% to +100% improvement in first half NPAT; assuming that’s carried over to the full year, full year profit could be between $3.5m and $5m. A buyback at $1.30 ($80m mcap) would be buying back shares at between 16x and 23x NPAT, which is pretty lofty for a cyclical manufacturer with a reasonable amount of debt. That excludes the South Pack acquisition but even approximating South Pack’s results, the buyback could be at around 12x-14x (??) earnings. This is just a rough estimate but I wouldn’t think that a buyback at that price would be value accretive.

Probiotec could justify a price above $1 if it can improve its margins enough (I am optimistic that it can), but the risks are considerable – PBP is historically a poor capital allocator, has a new acquisition, is a manufacturer, and has debt. Risks of poor capital allocation are heightened by this possible buyback.

One possibility is that Probiotec will be buying back its shares from the vendor of South Pack and significant PBP shareholder, CVC Limited (ASX: CVC).  CVC has a long history with Probiotec; they even sponsored the company’s listing back in 1998. Given how tightly traded shares are, CVC may sell its shares back to Probiotec at a discount (is this what the buyback facility is for?). That could add value though I’m not sure why CVC would sell its shares below market pricea.

With CVC being a private equity firm, I imagine that there are some dealmaking cogs turning in the background at the moment. I speculate, but I guess that the Probiotec deal may be some sort of sale of the company’s IP or businesses, perhaps followed by a capital return to shareholders.

My intention, pre- this announcement, was to hold until Feb / August 2018 to see if obesity product sales and margin improvement initiatives were picking up as expected. If so, then I’d re-evaluate at the time. However, the recent update was a real wild card.

I think the willingness to forego a cash incentive in return for options set so far above the market is indicative that management could be onto something (follow the $$$). It’s a risky approach, and predicated on the uncertain belief that management is trustworthy and not trying to pump their shares (e.g. to let CVC sell out) or anything like that.

I recently increased my stake and intend to continue holding Probiotec while I see what shakes out. Will have more details on my average cost etc in the 10foot quarterly review in the next few weeks.

Of the companies mentioned, I own shares in Probiotec Limited. This is a disclosure and not a recommendation.

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