Show me the money!

I’m talking about profits, you know, EBITDA (Earnings before interest, tax, depreciation and amortisation. Excluding items outside the ordinary operations of the business such as asset sales a positive EBITDA number basically tells you that the company gets more money for the goods it sells or services it provides than it costs to sell those goods or provide those services and because EBITDA usually approximates a company’s cashflow we can say that there is more money coming into the business than going out. This is a positive sign if we want to stay in business and something we should be looking for when investing in a business. Of course a heavily debt laden company can be EBITDA positive and cash flow negative because of interest payments but lets put those aside for now and assume a modest level of gearing.

This is very basic stuff yet the management of some listed companies seem to forget it or at least they wish investors would forget it. Instead they chatter incessantly about revenue growth but neglect to mention the word profitability. Cygenics (CYN) is a prime example. Cygenics, who are in the business of blood banking have been busy scurrying around South East Asia setting up blood banks and achieved impressive revenue growth of 130% in FY06. What is less impressive is the increase in the loss they made of -6.2m at the EBITDA level up from -5.1m in FY05, and FY06 NPAT of -6.6m up from -5.6m in FY05.

I lost count of the times 'revenue growth’ was mentioned in CYN's FY06 annual report but not once did I see any mention of profitability or an estimate of when they expect to become profitable. In the same report the company claims “The group has sufficient funds to finance its operations.” (CYN annual report FY06, p.37). The following day the company released its 1Q07 cashflow report which tells a different story, 1Q07 revenue increased 56% on pcp “more clients were signed up during the quarter than any previous quarter,” great! However CYN burnt a total of $1.8m in the quarter. At that rate, even if they fully utilized their overdraft facility of $0.43m they would be out of cash before the end of FY07. Then just less than a month later at the AGM the company announces a placement of 10.2m shares at $0.32 raising an additional $3.26m.

Obviously then they didn't have the funds to finance their operations. Amazing how management wasn't appraised of the situation 1 month earlier, actually barring complete incompetence management most certainly knew about their predicament so why wasn't it alluded to in the annual report? Obviously the extra $3.26m will come in handy, at current cash burn levels giving them aproximately 5 more months of working capital. However as a shareholder I think I would be more than a bit annoyed after reading the annual report and believing the company had adequate working capital only to find out one month later that my shareholding had been diluted 15% because the company was underfunded. Oh sorry, how silly of me, I forgot shareholders don't read annual reports.

Interestingly in a presentation made by the company at the end of November 2006 the second last slide gives 5 reasons why the company believes they are a “compelling investment opportunity.” The third reason being that they have a “scalable and proven business model.” Well not yet they don’t, they have proven there is demand for their products and services, what they haven’t proven is that they can run a profitable business.

Probiotec (PBP) - not really a biotech

"Probiotech is a brand owner, manufacturer, marketer and distributor of a range of over the counter (OTC) pharmaceuticals, complimentary medicines and specialty ingredients." (PBP propectus p.9) Not to be confused with what are considered your usual biotech companies - companies that research and develop drugs for prescription medicines, vaccines and high strength pain killers that undertake years of clinical trials often having to continually raise capital to stay afloat until they are fortunate enough to strike a licensing or commercialization deal - which more often than not they don't. I remember reading somewhere on Marketwatch.com that about 1 in 10 biotechs actually 'make it'. I don't know how accurate those numbers are but even if they are exaggerated they're not encouraging.

Probiotech on the other hand has a portfolio conisisting of 122 TGA approved products consisting mainly of OTC pharmaceuticals and complementary medicines with a limited range of prescription pharmaceuticals. Thus they have established brands already in the marketplace such as Milton, Biosource, David Craig and Arthro-flex to name a few. PBP believe the pharmaceutical manufacturing business will become dominated by fewer players offering more products to an increasingly health aware,ageing population. The increased awareness and willingness to use supplements to enhance the lifestyle of Australia's ageing population is seen as the main drivers of industry growth. The company considers the capital intensive nature of the pharmaceutical manufacturing business presents high barriers to entry into the industry and therefore they are well positioned to take advantage of future industry growth and consolidation.

Turning to the numbers, the prospectus forecasts a doubling of profit from NPAT of $2.1m in FY06 to $4.3m in FY07 on the back of a 29.6% increase in sales. Thus the company is anticipating increased profit margins refecting a change in the product mix of sales and price increases. Looking at the historical half year information annualising the 6 months results to June 2006 gives Sales of $45m and EBITDA of $7m implying increases in Sales and EBITDA in of 19.5% and 35.7% respectively to achieve the company's prospectus forecast. The company expects the growth to be achieved through a combination of organic sales growth from the Milton product range, price and margin increases in the company's nutritional product range and a more than 10% increase in pharmaceutical contract revenue. PBP aim to release a new product every month in fiscal 2007.

A point of concern is the company's current ratio post listing of 0.93x (numbers in the above table are pre-listing) a current ratio of at least 2x is considered solid. Also the relatively high debt to equity ratio of 69% whilst not critical would not want to creep any higher than current levels. I will be watching these two ratios closely to see improvements in working capital and cashflow. For these reasons I would expect any acquisitions in the near term to be done via equity rather than debt. I would be more comfortable with no acquisitions until the balance sheet looks more solid and there is evidence of strong cashflow generating ability coming through.

The stock listed at a 16% premium to the offer price of $1.00 and is currently trading at $1.12 which is 12.1x FY07 earnings. In the two months since listing the stock has drifted to $1.12 on low volumes. Whilst with listed companies it is often the penchant of management to talk up their share prices PBP have been silent in the past two months with no announcements of significance by the company which I am comfortable with as I would much rather see management getting on with the more important function of running the business than talking up the price of their stock.

My Portfolio: 2 month return

After 2 months my portfolio consisting of a huge 2 stocks is up 6.8% after transaction costs. PWK's share price has increased almost 15% since purchase while PBP is down just over 4%. PWK's share price appreciated 4.1% from a month earlier whilst PBP declined a further 2.6%. PWK is now trading on FY07 earnings of 26.5x whilst PBP is trading at a relatively undemanding 11.9x. A recent announcement by PWK to build a submarine cable in collaboration with VSNL (NYSE: VSL) from Guam to Australia aimed at vastly improving Australia's International fibre capacity has helped the share price along whilst PBP has drifted on low volumes in the absence of any news.

Pipe Networks (PWK) a compelling growth story

PWK first came to my attention in November when the company upgraded it's FY07 earnings forecast to $4.7m - $5.0. Digging a little deeper I found a company that is going through a phase of rapid growth by exploiting a niche position in the fast growing Australian network infrastructure services industry. Currently PWK runs Australia's largest Internet exchage reaching across 6 capital cities and operates Australia's third largest metropolitan fibre optic network. PWK also provides secure sites for their clients IT equipment needs.

After a placement and rights issue in FY06 the company has significant cash reserves ($9m as at 30 Jun 06) and a newly negotiated debt facility of $10m to fund further expansion. In addition the company generaterd $7.6m cashflow from operations on $13m in revenues in FY06. Earnings are underpinned by medium term contracts of 3 to 5 years for their services and with the potential to extract more revenue through add on services such VOIP in the future. A recently signed MOU with VNSL to build a submarine cable from Guam to Australia to increase Australia's international fibre capacity gives PWK further scope for growth.

I have followed the company's guidance for FY07 earnings forecasts and given their short track record as a listed company may surprise to the upside. My forecasts for FY08 are fairly conservative given the company's strong balance sheet and earnings growth opportunities. I've also been conservative on margins considering the opportunites to extract further revenues from new service offerings. Whilst the company has been a stellar performer and is trading at 27x FY07 earnings I believe this is more than justified given it's current growth profile and potential.