Recently I made the 4th purchase for the 10foot portfolio, Probiotec Limited (ASX: PBP), a micro-cap contract pharmaceutical manufacturer with some interesting intellectual property. Again I have tried, with mixed success, to avoid putting up a wall of text. Here are my thoughts.
Some key stats:
Market capitalisation: $20.6m at $0.39 per share
Enterprise Value: $29.4m ($8.8m debt, virtually $0 cash)
Net tangible assets: $0.46 per share, predominantly inventories, receivables, and property. Past divestments suggest a big discount will be necessary in event of a stressed sale so I have not put too much weight on this.
Price to Earnings: 38x first half profit, albeit earnings are typically weighted heavily to 2nd half
EV/EBITDA: 13x first half (ditto)
Dividends: Nominal, 0.5c (1.1% yield) at most recent half.
Why does the 10foot investor want to own a capital intensive, low-margin manufacturer of pharmaceutical goods? Good question.
Probiotec is cheap given estimated full year earnings. It has good visibility of revenue due to production contracts, reliable customers, a small but significant stable of own-brand products, and spare capacity which it can draw on to support growth of its own products if necessary. With the recent divestment of assets and restructuring of the business including the combination of manufacturing efforts into one facility, the company should have less capital expenditure in the future and should be able to grow margins and generate much more free cash flow to pay down debt.
Additionally, I expect Probiotec to begin growing via new manufacturing contracts, as well as growth in its weight loss product lines. The company is small enough and cheap enough that relatively modest improvement in revenue and earnings, especially in the non-manufacturing business, could deliver respectable outcomes for shareholders.
- Contract manufacturing; management have reported several new contracts including one worth $10m in revenue (March 2016) with the first orders being delivered in Dec. There should be a big second half and several more contracts are reportedly close to finalisation (will come online in FY18).
- Weight management; the Impromy and Celebrity slim brands are releasing new products and Impromy in particular is chasing improved distribution. With reasonable supporting evidence behind it, I think Impromy has a good shot at growing distribution. Currently in ‘over 430’ pharmacies when there are ~5000 pharmacies Austwide.
- Intellectual property; the company recently had positive results for a clinical trial of an eczema treatment which reported clinically significant relief to patients, which the company is aiming to find a partner to commercialise. This is ideal as it does not seem to be too expensive, provides relief but not cure (ideal for a company selling medication) and has minimal downside but possible meaningful upside. Not a part of my core thesis.
- Europe; again not a part of my core thesis, but also minimal downside (except in event of closure + writedowns on property/segment valuation). Possible upside if some products eg Impromy or eczema one can be expanded here.
- Gold Cross brand refresh; with distribution Australia-wide I’m not expecting much growth from the Gold Cross brand. However, it is overdue for a refresh and some marketing and this could see recent modest growth continue.
- The usual product and sale-specific risks; production costs rising, competition (products/services are undifferentiated except for brand), product scandals or brand damage (failing quality control etc), price pressures from major customers, loss of distributors
- Finance-specific risks; inventory/ working capital blowout, operating leverage (high fixed costs), no cash on hand and minimal free cash flow (FCF) recently, all 3 issues magnified due to debt load
- Major partner iNova is owned by Valeant (yes, that Valeant)
- Big blowout in receivables with $1.6m past due as of annual report last year (no figure given at HY17). A big risk is that customers go broke/ don’t pay and Probiotec effectively works for free, wearing the cost of raw materials and manufacture.
OK so if you’ve been around a little while you know that Valeant is a very smelly company that some people think will go to zero. But, it also has very successful pharmacy businesses that are profitable and valuable. Probiotec has been partnered with iNova for quite a while so I think the risk of fraud or some such affecting Probiotec is quite low. It is possible that Valeant goes bankrupt and iNova collapses, but I also find that unlikely as the business is very well established and likely worth a fair amount of money. If iNova or other major customers collapsed it would be bad news for Probiotec, which has $9m in receivables.
The most likely risk I see here is that iNova gets sold off (reportedly Valeant is already looking for buyers) and there could be some sort of ‘change of control’ clause in the manufacturing contracts that could see iNova potentially exit its agreements with Probiotec. Alternatively iNova could look to bring manufacturing in-house, acquire a manufacturer, or lean on Probiotec to squeeze margins etc. I don’t think it too likely as iNova is expanding its contracts with PBP, but is something to keep an eye on.
I feel this brand has some promise, particularly due to the strong results from the clinical trials. While it is effectively just a diet shake and meal plan (and thus undifferentiated) the harnessing of the pharmacy for measuring blood sugar levels etc should help lift customer engagement and success, and results so far (the best among a variety of competing programs) support this idea.
Probiotec appears to be family-operated, with the Stringer family Messrs Wesley and Jared being the Managing Director and CFO respectively. Wes has 870,000 shares and Jared held 315,000 as of the annual report last year. CEO Wes is a former investment banker who was with Probiotec for 14 years as COO. CFO Jared is an accountant (CPA) and has been with Probiotec since 2002, but I couldn’t find much more about him.
New Chairman Geoffrey Pearce is formerly of BWX Ltd (ASX: BWX). Recently appointed director Greg Lan (who has been buying shares aggressively) comes to Probiotec after 15 years at Aspen Pharmacare. Major shareholder and director Robyn Tedder resigned last year and I couldn’t really determine why (there was a bit of board infighting which may explain it).
Other than shareholdings which seemed a bit small (unusual for family-operated biz) and salaries which seemed a bit high (not unusual for same) I’m happy with the quality and alignment of management. I do take into account though the previously much higher price of Probiotec shares over the past 15 years so it’s quite possible their dollar value investments are much larger than the # of shares would suggest.
I’d still be looking to see execs purchasing more shares in near future. I do prefer owner/founder types when it comes to management though, and the Stringers (and previous CEO, also a Stringer) tick a lot of boxes for me.
The bottom line
In a nutshell; Probiotec is cheaper than the market realises. With visible revenue due to manufacturing contracts and own-brand sales, debt appears manageable, while good management, lower capital expenditure and revenue growth in own-brand products could potentially make it quite a strong performer. It is a higher risk investment.
On the 16th of June 2017, I purchased 1200 shares at $0.425 each, for an average price of $0.4374 after brokerage.
I’ll soon begin a quarterly review of the 10foot portfolio for the 3 months to 30 June 2017, you can enter your email in the subscription box to receive an update when it’s out.
I own shares in Probiotec Limited (ASX:PBP). This is a disclosure and not a recommendation.