To Adcock shareholders: Before vote, read this. Independent investment analyst report challenges CFR claims

Adcock Ingram shareholders who won’t get to Wednesday’s special general meeting need to hand over their proxies today to have a say in whether their company gets sold to Chilean group CFR. Independent investment analyst Mark Ingham has done an in-depth study of the terms being offered and the offeror itself. He challenges a number of the key claims made by the Chileans, critically those relating to the benefits which South Africa will gain from a successful transaction. This is the issue likely to count most for the “kingmaker”, the Public Investment Company, which holds 19% of the vote. – AH  

By Mark Ingham*

There is a deceptively similar comparison between Adcock Ingram and Aspen Pharmacare. Both in the same sector but taking wildly differing paths and coming up with astonishingly divergent outcomes. Six or seven years back there was little difference between the earnings of Aspen and Adcock Ingram. This year Aspen trading profits are more than five times that of Adcock Ingram and its enterprise value more than ten times that of Adcock Ingram, even with the CFR bid premium.

Share price divergence - Aspen (blue line) has massively outperformed Adcock
Share price divergence – Aspen (blue line) has massively outperformed Adcock (red line) since the latter was re-listed in 2008. Mark Ingham suggests why.

Adcock Ingram has a number of attributes, not least a good infrastructure and competitive manufacturing operations at Wadeville, Clayville and Aeroton. But Adcock Ingram remains overwhelmingly reliant on the domestic South African market and in that it is not entirely in command of its own destiny given the regulatory situation and influence of state tenders. One also struggles to get a clear sense of purpose for Adcock Ingram.

Adcock Ingram has become increasingly dependent on branded OTC, with household names such as Panado, Corenza and Bioplus to do the heavy lifting on group profitability. This segment generated R2 billion in sales for the year ended September 2013 or some 40% of Southern Africa revenue. The OTC consumer contribution before Southern Africa operating expenses and R&D is 60%, up from 51%.

Adcock Ingram has a long established prescription medicine business that generated R1.85 billion in F2013, 37% of the total Southern Africa revenue. The profit proportion is 27%, down from 35% in F2011 and with the contribution margin at 17% some thirteen percentage points less than in F2011.

Similarly, the Hospital segment has languished and the contribution margin this year of 12.5% compares with over 19% in F2011.

Adcock Ingram has been particularly vulnerable to both single exit pricing controls and exchange rate weakness. With raw materials and operating cost increasing margins are under downward pressure – contribution margins in Southern Africa have fallen by 8.5% between F2011 and F2013.

In South Africa Pharma, it is essential for efficiency and procurement savings to bolster margins in a price sensitive and regulated market. Rand weakness influences raw materials and with raw materials accounting for about 65% of cost of production manufacturing scale is essential to mitigate the price-down effects in this industry.

In the case of Aspen, with foreign currency accounting for about two-thirds of cost of materials and the South African rand the balance, greater foreign sales have a very important benefit in managing foreign exchange exposure. There is ample capacity to fill, notably in Port Elizabeth, as international accounts for one sixth of volumes and growing.

With local pricing, predictability is desirable and a revised SEP adjustment formula that takes into account local inflation and exchange rate movements may provide that even if it could mean prices move up and down.

Adcock Ingram tries to sell itself

On 21 March, Bidvest sent an unsolicited letter to the Board of Adcock Ingram proposing that Bidvest buy 60% of the issued share capital of Adcock Ingram. The offer was 50% cash at R65 per share and 50% in Bidvest shares. It was about R62 equivalent at the time.

The legalistic rebuttal to the friendly Bidvest approach was a case of protesting rather too much and the shareholders did not get a look in.

Time went by and a white knight conveniently emerged for Adcock Ingram in the form of CFR Pharmaceuticals a company listed on the Santiago Stock Exchange.

CFR submitted a non-binding offer to acquire 100% of the issued share capital of Adcock Ingram on 3 July 2013. The possible price at the time was about R73 per share in cash and new CFR stock. Adcock Ingram would get a secondary listing on the JSE.

A number of conditions were necessary, including waiver of the controlling shareholders pre-emptive rights, 75% approval by Adcock Ingram shareholders, successful placement of new CFR equity of up to $750m, raising of new debt and other regular approvals. Senior executives will be enriched by a deal.

As a result of the conditions of the scheme of arrangement, the board agreed not to pay a final dividend in respect of the year ended 30 September 2013 – a divergence from the dividend policy of two to three times cover. Adcock Ingram paid 201 cents in F2012 and for the first half of F2013 a dividend of 86 cents was paid.

Bidvest comes back with a clean cash offer

On 2 December, a consortium comprising Bidvest and CIH made a 100% cash offer to acquire up to 34.5% of Adcock Ingram issued ordinary shares from existing Adcock shareholders directly. On first come first served acceptance, there is immediate cash of R70 per Adcock Ingram ordinary share. This is below the 35% threshold for a mandatory. At last count, Bidvest held 7% of Adcock Ingram.

Bidvest thus underscores and in fact strengthens the existing BEE credentials, the primary listing is maintained, there is no financial risk to Adcock Ingram, and the R70 cash per share is about R23 better than CFR alternative on a cash/stock split of 64/46.

Ratings watch on CFR

When CFR made its approach, Fitch put CFR bonds on negative watch, mentioning risks such as pace of acquisitions, size of its targets, management distraction and a pay-down of debt to targeted levels of 2 to 2.5x EBITDA.

As recently as 20 November, Fitch reaffirmed its negative watch on CFR. The comments from Fitch is useful to note.

It states that “if the acquisition is successful, CFR’s business profile would improve as a result of broader geographic and product diversification” and the ratings agency estimated approximate sales of USD1.4 billion and EBITDA of USD280 million. It also stated that South Africa would become the company’s most important market, at 40% of CFR’s revenues followed by Colombia at 18%, Chile at 12%, Peru at 8% and Argentina at 7%. Debt would rise to at least USD1.1 billion from USD0.5 billion as at 30 September.

Fitch comments further that in combination with the new debt, the pro forma debt- to-EBITDA ratio of around 3.9x was “weak for the rating category.”

Fitch concludes that “the successful placement of $750m of equity is a key to avoiding ratings downgrades” and that a stable outlook is “dependent on management’s ability to quickly obtain synergies and return its capital structure to targeted leverage levels.”

Africa a deal attractor for CFR

On the 22 July, CFR held an extraordinary general meeting. The purpose of that meeting was to seek approval for an increase CFR’s paid-in capital to part-fund the acquisition of Adcock Ingram.

An important attraction for the Chilean audience was that South Africa was seen as “a new core market” and “an entry door to rest of Africa” with “operations in South Africa, Kenya, Ghana, Zimbabwe and India” and in fact having “a leading presence.” This squares with the Fitch observation that South Africa was the real attraction and would command the lion’s share of revenue.

The point about Africa for the Chilean audience has interest for the South African one too, not least given that CFR has no experience at all in Africa and seeks to diversify its own sources of income.

Foreign direct investment claim has little basis

In the circular to shareholders dated 18 November, “significant foreign direct investment” is cited as a rationale for the buy-out of Adcock Ingram. The figure of R12.6 billion that is quantified in fact is the approximate total value of Adcock Ingram as envisaged by the buy-out terms in cash and shares.

This “significant foreign direct investment” is not net new foreign direct investment in the conventional sense of the term. It is not adding to the capital stock of South Africa, it is not new money coming in to build a greenfields factory and create new jobs. This is a straightforward take-over of a JSE listed company.

A secondary listing of CFR on the JSE is said to “enhance South Africa’s profile as an investment destination.”

This claim needs examining. Following the leveraged transaction, holders of Adcock Ingram shares will own approximately 17% to 24% of CFR in a secondary listed entity. The Weinstein family will own approximately 55% and the primary listing will be Chile. Secondary listings carry minimal investment destination merit.

Funding mechanisms

Of this R12.6 billion, R6.4 billion to R8.1billion is payable in cash and R4.5 billion to R6.2 billion by way of CFR shares.

How this is funded is important for Adcock Ingram shareholders in making a decision and for the foreign exchange position of South Africa.

CFR is having to raise new equity and debt. The purchase is to be funded largely by bank debt of $600m and the issue of CFR shares valued at $620m or the issue of 2.65 billion new CFR shares. CFR has 8.42 billion shares in issue of which the Weinstein family hold 73%.

The debt being raised is a function of the carrying capacity of both the CFR and Adcock Ingram balance sheets. The new equity is issued by CFR as it currently is, independent of Adcock Ingram but contingent on CFR buying Adcock Ingram.

CFR shareholders have authorised the directors to set the final price of the offered shares between CLP$125 and CLP$134.5 and the issuance and placement begins within 180 days after 22 July.

The finalisation of the offer mix is subject to the outcome of a capital increase. And the amount of cash and the number of CFR shares on offer to Adcock Ingram shareholders via “mix-and-match” does not change because of the elections.

With an attributed value of R2.334 per CFR share, roughly equivalent to CLP$120, the settlement is a minimum of 51% and a maximum of 64.3% in cash and a minimum of 35.7% and a maximum of 49% in CFR stock.

If we take the above range, then at CLP134.5 the rights issue will need to be 90% or so subscribed to by the minorities for the most cash per Adcock Ingram share to be obtained. Below that maximum, the percentage rise to at least 95%. In other words, it requires overwhelming take up by minorities.

At the maximum share and minimum cash combination of 49/51, which happens with no minority subscription, then Adcock Ingram shareholders get a maximum 15.44 new CFR shares. Those shares are in theory worth R37 with the cash worth a similar amount. This give high leverage to both the CFR share price and currency.

Final pricing is uncertain and will be a function of the eventual CFR share price and the exchange rates, only the switch ratio is known.

Intangible assets are a feature of Pharma

CFR as at September 2013 had total equity of $690m and gross debt of $498m  (gross gearing of 72%). Of the $690m, intangible assets and goodwill came to $606m. Deferred tax asset was $28m. This means tangible net asset value is $56m.

Using the current exchange rate of R10.35 to the US dollar, Adcock Ingram as at September 2013 had ordinary shareholders’ equity of approximately USD350 million and gross debt of USD140 million. Net of intangibles, tangible NAV is USD213 million. The doubling in the intangibles value on the balance sheet since September 2012 is as result of the Cosme deal in India.

In all pharma companies, there is a sizable intangible component. There is cash generating capacity of the intellectual property in particular. Many brands will be indefinite useful life intangible assets. So book value understates the extra value that derives from continuing investment in promotion of the brands. For example, over 80% of Aspen’s long term assets are good will and intangibles and the cash generating potential of dossiers, product pipeline, brand recognition and positioning is very much tied up in its large market cap.

Large costs and gearing involved

In combining the two entities, USD56 million in costs are incurred. This is equal to 100% of Adcock Ingram’s attributable earnings in F2013 (R587 million).

The net position, post transaction, is gross debt of approximately USD1.2 billion. Half of that comes from acquisition debt because and CFR will be using Adcock Ingram’s assets as security for this debt.

Interestingly, Bidvest has posed a legal challenge in seeking a declaratory on Section 44 of the Companies Act.

Figures supplied by CFR and Adcock Ingram in the presentation of 15 November indicate a 60/40 pro forma revenue and EBITDA split.

If we assume that the Adcock Ingram balance sheet is allocated 40% of the new debt then that equates to USD240 million. On top of the USD140 million in existing debt that is USD380 million or 109% of existing Adcock Ingram equity, excluding share of the USD56 million in transaction costs.

At a 6% interest rate new borrowing will costs roughly USD15 million per annum to service. Those cash flows will go abroad from South Africa.

Pro forms equity post deal is essentially the USD690 million of CFR, plus USD350 million of Adcock Ingram plus new equity net of costs of USD600 million. That suggests new CFR equity of USD1.6 billion. Total debt of USD1.2 billion is thus 75% of equity.

The run rate on CFR EBITDA for the first nine months of the fiscal is USD170 million. I have assumed Adcock Ingram will have generate USD120 million going forward which gives a combined result of USD290 million. Against this, the circular indicated USD40 million in transaction costs. This leaves us with clean EBITDA of USD250 million.

Total debt of USD1.2 billion to pro forma EBITDA is thus approximately 5x. This compares with 1.2x for Adcock Ingram as it is on a stand-alone basis. CFR as a stand-alone business has a ratio of 3x presently.

Servicing the interest bill associated with the deal will cost approximately USD36 million.

On a stand-alone basis, CFR has incurred USD22.3 million in interest for the first nine months which equates to USD30 million annualised.

Adcock Ingram has interest payments based on its latest accounts of USD9 million. The total interest bill is thus USD75 million – or over R750 million.

The EBITDA interest cover ratio of the combined entity will thus be will be 3.3x and I estimate operating interest cover of 2.6x.

Adcock Ingram in F2013 had a net interest cover ratio of 15x operating profit. On the same basis for the first nine months of its fiscal, CFR had an interest cover ratio of 5x.

If CFR had to assume USD600 million on its own balance sheet together with almost USD500 million in current debt, the debt to EBITDA ratio would be 6.5x and the EBITDA interest cover ratio would be 2.5x.

A debt to EBITDA ratio of 6.5x is rather higher than the 2.5x maximum suggested by Fitch.

So simply servicing the interest bill associated with this deal will cost at least USD36 million extra than the individual entities have to service currently. This is money that will not be available for reinvestment and dividend payments.

The implication is that CFR requires the Adcock Ingram balance sheet to execute on its deal. I struggle to see how CFR could execute on this deal without a combination of new equity, yet to be raised, and the cash generating assets of Adcock Ingram.

For Adcock shareholders, they would be a minority partner in the new larger entity and will have little influence on its future destiny.

There is little to prevent cash flows in a consolidated entity being appropriated from South Africa to service group debt in excess of the 40% proportion of new debt I have assumed to be apportioned to Adcock Ingram. This too applies to cash flows funding dividends.

The synergies CFR claim of approximately USD440 million is unproven and difficult to reconcile with the operational results of the respective companies. It translates to 80% of annual Adcock Ingram revenue alone and on a business with a 20% EBITDA margin would take years to realise under an optimistic scenario.

Financial conclusions on the CFR/Adcock Ingram deal

The numbers suggest that the foreign direct investment alleged is not new net investment adding to the stock of capital in South Africa. This is a take-out of a JSE company on fairly uncertain terms.

Relative to CFR, Adcock Ingram has the stronger balance sheet and servicing capability but the Adcock Ingram balance sheet and its cash generation is important for a leveraged deal to succeed.

Adcock Ingram shareholders will be a minority part of the new equity with no consequential say. There is little to “enhance South Africa’s profile as an investment destination with a secondary listing.”

Chilean company law differs from South African company law in respect of minority protection. For example, a shareholder ordinary resolution under Chilean law requires the approval of an absolute majority, certain amendments to a company’s by-laws require an ordinary resolution, a termination of CFR’s secondary listing on the JSE would not require any shareholder approval and would only require the approval of the CFR board.

There will in any event be net foreign exchange outflows from South Africa to service debt taken on by CFR to finance the transaction. As a consolidated entity, CFR could use additional cash generated in South Africa in future to send abroad and thus further deplete the foreign investment claims.

Proxies are due the 13th of December and the general meetings on the 18th of December.

Adcock Ingram shareholders will make up their own minds but they should be careful what they wish for and not get blinded by the gross number on offer.

If the deal is taken you get some cash and you get some shares and become a minority in a larger entity. The future value of those shares in a relatively illiquid secondary listed CFR is indeterminate. And given the leverage and the pressing need to secure savings and pay down debt and service interest, the dividend situation is likely to take a back seat.

* Mark Ingham is an independent investment analyst who owns Ingham Analytics. He wrote this report for Sasfin. As it is now in the public domain, we have been given permission to republish.

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