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Date : 07/02/2023

Probiotec

ASX :

PBP

Market Cap : $179.72 Million

Dividend Per Share : $0.055

Dividend Yield : 2.53 %

Buy

52 Week Range : $2.02 - $2.42

Share Price : $2.21

A pharmaceutical company with stable cash flows and healthy dividends.

Company Analysis

Probiotec (ASX: PBP) is a manufacturer, packer, and distributor of a range of prescription and over-the-counter (OTC) pharmaceuticals, complementary medicines, consumer health products and fast-moving consumer goods.

Probiotech owns six manufacturing facilities in Australia and manufactures products on behalf of a range of clients, including some international pharmaceutical companies. It has a large list of clients. Some of the more familiar names amongst them are Blackmores, Red Bull, Pfizer, Asahi, Nestle and Lavazza.

A Simple & Defensive Business

PBP is a very simple business to analyse. Their clients (200+) enter into contracts for PBP’s manufacturing and distribution services. Therefore, manufacturing capacity, supply chain, and labour availability are the biggest requirements for the company.

The company is renowned for its high-quality manufacturing facilities, and given its track record of cost efficiency, this is a well-oiled process that is only going to increase in capacity as the years roll by.

The two latter requirements were disrupted due to the effects of the pandemic, and now, as the situation eases, supply chains are normalising. Labour availability is becoming stronger with immigration becoming more liberal in Australia. PBP is thus a recovery play.

Setting the Stage for PBP’s Recovery

Despite a range of challenges thrown at the company, including supply chain disruptions, inflationary pressures and labour shortages, to name a few, PBP delivered an outstanding result in FY22. Record revenues were converted into record earnings.

Strong cash flows were also delivered, which reduced net debt over the year. Late in the year, we saw a return in demand for cold & flu products as restrictions were lifted, and the company showed good operational performance to meet this rapid increase in manufacturing volume.

In addition to the financial results, PBP has also kept an eye on the future with significant investment in new equipment to improve capacity and capabilities, which we forecast will be needed to meet the business trajectory. They have also invested in a range of cost-out, efficiency programs and upgrades across their operating and information systems, which the company has said they will continue to invest in.

PBP has also invested heavily in additional sales resources over the past year, and this is reaping benefits with their future sales funnel showing promise. As a group, Probiotec now has access to most global and local pharmaceutical and FMCG companies to continue to grow the overall business with a broader customer base.

This diversification has begun to deliver a myriad of new business wins, with a range of further discussions that are suggested to be in the works. Global supply chains have seen considerable disruption coupled with material increases in global freight costs. Whilst Probiotec has navigated this backdrop, it has caused a shift in supply chain planning and long-term strategic sourcing with many of its customers. This thematic is a key focal point for PBP and its customers. A continued interest is expected from its clients as they look at securing their supply lines and localising more of their supply within Australia.

The past 12 months have seen a range of cost-out initiatives delivered. The focus has been ramped up on automation, IT systems and efficiency programs. This will be a persistent short, mid, and long-term initiative of the group. The current footprint of PBP results in significant duplication in operating costs, especially across NSW, with four operating sites. PBP is well-progressed in its plans to consolidate its NSW sites into a state-of-the-art new custom-built facility that is forecast to deliver material savings to the group. This is one strategy that will bring a range of efficiency gains, capacity increases and a world-class, ultra-competitive site to fruition. Importantly, we can also expect continued margin and efficiency improvements from sharing and implementing the best systems and processes from each site.

Company Updates


Source: Tradingview.com

The PBP share price has delivered a very strong return of 145% over the past 5 years. However, given the impact on the business we discussed, the past year has not been great in share price performance. With an easing operating environment, PBP is positioned to do well once again. Additionally, we think the company has been smart in optimising its operations during a challenging year to position itself for a strong recovery.

Probiotec is now one of the dominant players in the pharmaceutical contract manufacturing and packing market in Australia. Their strategy includes organic growth, capitalising on emerging manufacturing trends, and as history suggests, PBP has never been shy of M&A to push for growth.

Probiotec does have a good track record in operations. In the same 5-year period when the PBP share price generated 145%, PBP saw its Return on Assets, Capital, and Equity expand smoothly. Following the temporary blip we discussed, these metrics are returning to where they used to be. This is a good sign and confirms that Probiotec’s business is positioned well to recover and resume its growth.

Probiotec’s Demand Drivers

The defensive nature of the Probiotec business throughout the past two years has positioned it strongly as we emerge from the pandemic. Whilst the company has faced headwinds, including reduced demand in key categories throughout FY20 and FY21, these challenges began to unwind in FY22, especially in the second half of the financial year.

This saw the business deliver a strong result for FY22 across all metrics. Following on from FY22, several things have changed, and we are now seeing some encouraging tailwinds behind the business despite a challenging operating environment around supply chains, freight, and labour costs.

The most noteworthy changes we are seeing are:

Demand

Demand across the group’s portfolio, especially in its key pharmaceutical manufacturing and packing area, has returned strongly. This has been driven by the return to above pre-pandemic numbers in the cough, cold and flu category. Additionally, there has been a recovery in the pain / analgesic and antihistamine categories, with demand at higher levels than historically seen. PBP says this is related to increased usage in these categories resulting from higher levels of virus circulating, and its product portfolio is used to treat Covid related illness.

New Business Onboarding

We have seen the impact of the previously awarded and contracted business commence, which will continue in FY23 (which was delayed throughout the last two years). The level of enquiry and new business opportunities remain at elevated levels, which we expect to see the benefit of in FY24 and beyond.

Onshoring

The business is seeing a concerted push by PBP’s clients to localise or bring manufacturing and packing within the region (Australia) and diversify their supply chains to mitigate the following:

  • Political risk in overseas supply markets;
  • Supply chain disruption and avoid out-of-stock positions and bring more responsiveness and flexibility to their supply models;
  • Freight costs which are particularly relevant for packed product (which has a larger footprint and hence physical freight cost to import).

Whilst freight costs have unwound recently, they will likely not return to pre-pandemic levels. This will result in a net ongoing competitive advantage for local manufacturing, and in particular, packing.

We think there will be a fundamental shift in global supply chains to increase the level of domestic manufacturing and packing. This shift is something we believe will be prevalent for the foreseeable future. The impact for Probiotec is expected to be an increased level of packing opportunities across the pharmaceutical sector as well as other sectors, including its co-pack businesses. This trend has already commenced and is expected to continue with an implementation timeline of 6-12 months and be an ongoing thematic in PBP’s business.

We also expect this trend to extend to the manufacturing sector, which would positively impact pharmaceutical manufacturing operations. Whilst not all of PBP’s clients can be expected to fully transfer large products from their current bases overseas, the company expects to see dual supply opportunities and an increased level of enquiry and opportunity.

Investment Thesis

As the business began recovering in FY22, PBP reported stunning numbers to back it up. The results were driven by strong organic growth and a partial return of cough, cold & flu product sales that were suppressed during the pandemic. Highlights of which are:

  • Record revenue of $182.3m, +14% on FY21 Proforma and above $175m – $180m guidance
  • EBITDA of $32.8m, +34% on FY21 Proforma and at the upper end of $32m – $33m guidance
  • Underlying Earnings Per Share of 16.8 cents, +38% on FY21 Proforma
  • Fully franked final dividend of 3.5 cents per share, resulting in a full-year dividend of 5.5 cents per share, +10% on FY21

A strong outlook for the future with several growth opportunities and industry tailwinds is expected, and this is why we think PBP is a very good pick for a year that is sure to throw a few curved balls.

Probiotec’s Balance Sheet is fairly strong. While the company holds $48.5 million in long-term bank debt, they have $22.2 million in cash. PBP is also generating strong cash flows despite the challenging operating environment. The leverage (Net Debt/EBITDA) stands at 0.8x – putting the company in a healthy position to successfully pay off its debt.

More Fever, Cold, Cough, and Flu is Good for Probiotec

Despite the uncertain operating environment, Probiotec should be able to achieve growth in sales and earnings in FY23. Cold and flu sales recovery is expected to continue into FY23. With weather patterns growing wilder every year, winters are turning out to be harsher – leading to increased cold and flu conditions. This should benefit PBP with an expected reset above historical levels for at least the near term.


Source: PBP

Labour shortages and supply chain disruptions continue to impact operational output and efficiency, expected to ease in the future. PBP is known to be actively pursuing accretive M&A opportunities, given its balance sheet strength and strategic priorities.

In the long-term, onshoring tailwinds continue to gather momentum, with discussions in progress with several major clients regarding the localisation of manufacturing and supply.

Significant new business opportunities are being developed and implemented from an extensive and high-quality client base. The full impact of the pipeline of new business opportunities is continuing to be realised, and this is very positive news for PBP in the long term.

Sydney Site Consolidation will Deliver Growth to the Bottom Line

Late last year, PBP announced that it had agreed terms with a major Australian developer for a circa 30,000 sqm facility in Kemps Creek, NSW. Once operational, this site will house the majority of Probiotec’s current NSW pharmaceutical and FMCG packing businesses and deliver material financial and operational benefits to the company.

Since the start of FY18, Probiotec has completed five acquisitions in NSW. Following this acquisitive period, Probiotec has been undertaking an extensive process to identify a new large-scale facility in NSW to consolidate its footprint in the state. The Board and senior management team see this as a highly accretive opportunity via this consolidation of its NSW footprint. The site consolidation is expected to:

  • Significantly reduce overhead expenses,
  • Remove duplication of products,
  • Simplify logistics to deliver shorter turnaround times for customers,
  • Improve coordination & efficiency of consolidated IT systems,
  • Support the opportunity to cross-sell services across the enlarged platform,
  • Increase capacity to meet increasing customer demands & any future acquisitions,

The project is expected to deliver cost savings of $3m to $5m per annum from 1 January 2025. The new facility will deliver increased capacity, capabilities, and efficiency. It will also have low project cost with the developer responsible for the build and majority of specialised fit-out, and a payback of just about 2 years from the commencement of facility operation makes it a good project, financially.

Organic Growth is Boosting Earnings & Dividends

PBP is expected to deliver strong revenue growth in FY23, which is expected to continue into FY24 as the momentum in the business and new products are fully onboarded. We expect to see slight margin pressure in FY23, largely relating to short-term impacts (labour, freight, inflation) and the lag in the group passing on and realising contracted and approved price increases with its customers.

We expect these margin pressures to unwind in FY24. PBP has not provided formal full-year guidance. However, the Board and management have advised revenue for the first half of FY23 is expected to be in the range of $100m-$105m and EBITDA in the range of $15.5m-$16.5m.

Achieving the mid-range EBITDA target would mean that PBP’s earnings would have grown 7% compared to 1H22. This is a very healthy growth rate, particularly considering the site consolidation effects are yet to roll in, and all this growth is organic.

Probiotech has continuously increased its dividend payout in the last seven years, from 1.5 cents in 2016 to 5.5 cents in 2022. So, with the recent jump in earnings and the company’s solid cash balance, we estimate an FY23 dividends payout of at least 6 cents per share, resulting in a minimum expected dividend yield of 2.8%.

We understand that a dividend yield of 2.8% does not sound very lucrative, with the risk-free rate in Australia currently standing at over 3% and increasing. But this dividend yield is based on an expected dividend payout ratio of only 35%. The company has a high retention ratio as it has many growth opportunities that can create more value for shareholders than giving them cash, leaving plenty of upside potential for its future dividend payouts and share price.

On the valuation front, PBP looks appropriately priced for its expectations. PBP is priced as a defensive stock as it is currently trading with an FY23 P/E of 10.6x, with its organic growth priced in. Outperformance and M&A deals will add to the upside.

Recommendation

Probiotec is a simple but efficient business that has already attracted some of the best companies in the world as its clients. They manufacture, package, and distribute pharmaceuticals and other products. Therefore, manufacturing capacity, supply chains, and labour availability are the biggest requirements. As we emerge from the pandemic, the latter two factors are easing, and PBP is increasing its manufacturing capacity to capture the rise in demand for cold & flu medicines. Hence, PBP is positioned well for the recovery.

PBP’s financials are already looking upbeat, and the company is expected to continue to grow organically at a modest pace through 2023 and 2024, all the while keeping its door open for M&A opportunities to further bolster opportunities. As we discussed in the report, with growing earnings, dividends should also move in the same direction. PBP also trades at fair valuation multiples, and given its defensive nature in a rather turbulent market environment, we recommend a ‘Buy’.

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