Corporate Treasury Management

As requested by Sigma Pharmaceutical’s board of directors, this report consists of a financial performance assessment and a recommended growth strategy for Sigma Pharmaceuticals in order to build on and improve its current operations. This report consists of a step-by-step analysis of the current situation of the internal and external environment including PEST, Porter, and McKinsey 7-s as well as a detailed financial analysis to provide an outlook of the company’s strength, weaknesses, opportunities, and threats.

The report then puts forward two diverse strategies– one to enter into the Chinese pharmaceutical market via a joint venture and the other is to enter into a new market segment; biotechnology. Finally, the report then discusses which option put forth seems the most appropriate. To support these decisions details of the projected costs, proceeds, funding decisions, risk management, dividend policy, and the financial summary of the company for the next three years are included. We would be happy to discuss this report with you in the future in regard to any clarification that you may require. Yours sincerely, Sagar Mehta Sahil Kirpalani

Shanya Samarasekera Shaohua Lu | | Shaolin Yang Executive Summary Over a prolonged period, Sigma Pharmaceuticals Ltd. has built its name and position in the Australian pharmaceutical market by providing quality and in-demand medical products/drugs that work hand-in-hand with the medical fraternity. Constant quality improvement and innovation in drug manufacturing have led us to consider expansion as a primary objective to retrieve and safeguard Sigma’s position in the pharmaceutical market.

With a detailed analysis, this report critically evaluates the firm’s success and failure in managing its resources optimally for maximizing return in comparison with the past and present performance. Methods adopted to evaluate Sigma’s position are PEST Analysis, Peer Analysis, McKinsey’s 7S, Porter 5 Forces, and standard financial analysis. With the internal analysis, it has been found that a reduction in the increasing proportion of revenues has contributed to increase in debt. Two different business strategies have been drawn from the SWOT Analysis – Project 1: Overseas expansion in China

Pharmaceutical market with Jilin Aodong Medicine Industry Group Co. Project 2: Acquisition of Biota Holdings Limited for diversification and expansion in biotechnology research and project. Detailed financial and quantitative analyses for the two strategies have been shown in the report. After evaluation, it is recommended that Sigma expands overseas into the Chinese Pharmaceutical market for our strategic plan. The entry cost of China is estimated to be $108M and is expected to give $437M of NPV. With the examination of Sigma’s capital structure and related financing decision factors, we recommend Sigma to adopt internal financing.

Following the Damodaran and manual optimal capital structure calculation, by reducing our debt proportion, Sigma Pharmaceuticals’ would be able to enjoy lower WACC, ultimately increasing the value of the firm. The dividend analysis in this report shows that we are currently overpaying as a result we suggest Sigma should maintain their dividends from the past year or try and reduce them depending on the expected market and shareholder reaction, for the forthcoming year if possible, in order to accumulate cash for further expansion and development.

To conclude, the expansion in China’s pharmaceutical market is a good strategic plan which would enable Sigma to become more competitive and fill loopholes, if at all any of the company.

The purpose of this report is to assess the current financial status of Sigma Pharmaceutical Limited as well as its environmental conditions to develop a possible strategy for its growth and development.

Scope

The scope of the report will consist of an examination of the internal and external environmental factors of Sigma, detailed financial analysis, and the impact of the strategy proposed on dividends and shareholders. 1. 3 Methodology In conducting our analysis the 5 Porter Analysis, PEST, McKinsey 7 and SWOT were used. Spreadsheets obtained from Damodaran were used along with manual calculations of the current and optimal capital structure.

Financial ratios, forecasted financial statements, and capital budgeting was calculated using information obtained from Sigma’s annual reports.

Assumptions and Limitations

The main limitation faced was in regards to the lack of access to financial, strategic and other required information. As a result of this, assumptions required to be made when making the assessment, have been listed within this report.

Company Overview

Background Information

Sigma Pharmaceuticals is Australia’s leading developer and manufacturer of prescriptions, over-the-counter and generic pharmaceutical products (Sigma, 2008) as well as a distributor to pharmaceutical companies across Australia.

History

It is a result of many mergers and acquisitions and still continues to grow in the same manner. Primarily Sigma Pharmaceuticals Limited is the result of a merger between Arrows Pharmaceuticals with Sigma Company Limited. Prior to the merger with Arrow Pharmaceuticals, Sigma Company Limited already consisted of Amcal; which it acquired in 1998, Guardian Pharmacy banner group acquired in 1997 as well as Herron Pharmaceuticals and Chemists’ Own both acquired in 2003.

In 2003 Sigma Company and Arrows Pharmaceuticals merged, which resulted in Sigma Pharmaceuticals Limited.

Corporate Horizons, Objectives, and Strategies

Sigma’s strategy involves being the most efficient healthcare service company in Australia. It aims to do so by being the leading pharmaceutical product manufacturer and marketer, and the most efficient pharmaceutical wholesaler in Australia (Sigma, 2008). It wishes to expand its pharmaceutical division, and market. It is continually seeking new business opportunities to further develop and grow its business.

External Analysis

PEST Analysis

3. 1. 1 Political Australia’s political and regulatory environment is currently quite stable. Compared to other countries within the Asia region, Australia is regarded as having a very low risk of instability. In terms of political stability, Australia is ranked fourth in the world in the 2007 IMD World Competitiveness Yearbook along with having the most transparent government policy out of a list of 55 economies (Department of state and regional development, 2007).

Because the pharmaceutical industry in Australia plays an important role in the supply of medicines for the Australian population and in the development of Australia’s industrial base (Medicines Australia, 2008) it constantly faces a lot of policy attention. The Commonwealth government plays a primary role in monitoring this industry with an aim to ensure the safety and high quality of medicines and medical devices in the marketplace hence Australian pharmaceutical industry is highly regulated, where changes are made to regulations on a continuous basis.

Such policies include the Therapeutic Goods Act 1989 a framework designed to ensure public health and safety. It sets out all the requirements needed to be followed in advertising, labeling, product appearance, and appeal guidelines. In terms of safe storage and scheduling substances, this is covered by the relevant State or Territory legislation (Department of Health and Aging, 2005). Another very important policy in place that affects the pricing of drugs is the Pharmaceutical Benefits Scheme

Economic

Australia is currently in a prosperous economic environment. This can be seen via its GDP (year to March 2007) of $714. 1 billion (CIA, 2007) which stands slightly higher than those of other countries like that of UK, Germany and France. Australia’s emphasis on reforms, housing market booms and growing ties with China have been primary factors for the economy’s growth (CIA, 2007). The inflation rate is at 3. 2% per annum, and the Reserve Bank official interest rate is 6. 50% (CIA, 2007).

According to the RBA, Australia’s interest rate is currently high, and it is not going to reside anytime soon.

Social

Due to the current social trends in Australia, it is becoming transparent that health care is a critical social element of social welfare. Such major concerns include its ageing population, low fertility rates and obesity. Overweight and obesity pose a major risk to long term health by increasing the risk of chronic illnesses. In Australia 32. 6% of adults were reported as overweight in 2004–05 (Biggs, 2006).

Another major issue is the aging population. An aging population will result in a negative decline in economic productivity. But this has lead to a growth in spending on innovative medicines, such as pharmaceutical drugs relating to macular degeneration and Alzheimer’s disease. At the same time, whilst Australia is in an ‘aging crisis’ the current birth rate is declining overall affecting the growth of Australia’s population. Australia’s small population will only allow for limited growth in the industry.

Technological

The pharmaceutical industry is classified as a high-technological industry, heavily reliant upon technological advances. Technological advances have changed the face of drug discovery. For example thanks to what is called lead synthesis programs new compounds can be synthesized in record numbers and at ultra-high throughput screening of supreme speed (Schmidt & Smith, 2001). The APMA reports that over the last ten years pharmaceutical research aided by improvements in technology has brought more than 300 new medicines to Australian patients.

Industry Analysis

Within Australia there are a number of local pharmaceutical companies which supply prescription medicines. The pharmaceutical industry in Australia has a turnover of nearly $7 billion and exports more than $2. 4 billion to markets all over the world. Making it one of Australia’s largest exports of high technology manufactured goods (Pfizer Australia, 2008). However, to some extent the industry market power is constrained by the monophony power of the Government through its price negotiations under the Pharmaceutical Benefits Scheme (PBS).

The removal of price as a marketing option means that pharmaceutical companies must resort to other measures to have their medicines rather than another company’s medicine prescribed (Biggs, 2006) This industry can be broken down into many sectors of business such as generics, prescription drugs central nervous system, cardiovascular and metabolic therapeutic areas. Prescription drugs currently account for the bulk of demand, consisting of over 80% of total sales. However this sector market share is expected to stagnate over the next five years (Business Monitor, 2008).

On the larger scale though, Australia is only a small part of a global pharmaceutical industry. Australian sales average around 1% of the world market (APMA 2000) and are competing in a global industry that is dominated by large multinational corporations which enjoy economies of scale in the development of intensive corporations, where most multinational pharmaceuticals companies have operations in Australia. 3. 3 Competitors Analysis Sigma faces many competitors. However three prominent competitors have been identified. They are Pfizer Australia Pty Ltd, Symbion Health Ltd and Alphapharm.

Pfizer Australia Pty Lt

Pfizer Australia is one of Australia’s leading healthcare partners. They are providers of prescription medicines and animal health products. They employ more than 1100 staff and annual exports from their manufacturing plants have an Australian market value of AU $100 million (Pfizer Australia Pty Ltd, 2008)

Symbion Health Ltd.

Symbion Group Limited (SYB, formerly Mayne Group Limited) is a healthcare-focused company currently comprised of 5 divisions: Pathology; Medical Centre’s; Imaging; Pharmacy Services; and Symbion Consumer (Fin Analysis, 2008).

Currently Symbions’ market capital is 2, 633. 57 million and a company beta of 0. 88 (Yahoo, 2008) 3. 3. 3 Alphapharm Alphapharm is one of Australia’s leading pharmaceutical companies. They develop, manufacture, market and export prescription medicines and medicines only available at pharmacies. Their specialty is bringing generic medicines – also known as patent-expired medicines – to market (Alphapharm, 2008). They are currently not listed on the Australian stock exchange.

Porters Five Forces

Bargaining Power of Customers

The customers of Sigma Pharmaceuticals are mainly pharmaceutical goods retailing outlets, supermarkets and other groceries (except convenience stores), department stores and hospitals (except psychiatric hospitals). The end use of these products though is largely a result of aging and sickness which is inevitable, hence making pharmaceuticals a necessity. But as few of the products produced by Sigma Pharmaceuticals could be substituted drugs of competitor companies, the bargaining power of their customers is classified as medium.

Bargaining Power of Suppliers

The major inputs of the pharmaceutical industry are sourced from the chemical product manufacturing industry in Australia. Other suppliers to Sigma Pharmaceuticals are also from the soap manufacturing, cosmetic and toiletry preparation and contract packaging industry. There are quite a few companies present in the Australian chemical industry and this number is growing, especially due to an increase in foreign investment, but as a result of the unique characteristics of chemical compounds, investment in research and development and existence of patents, the bargaining power of suppliers is classified as medium. .

The threat of New Entrants

Barriers to entry in this industry are high. The reasons for this are explained below:

• Several established, both local and global companies, operate with significant market strength.
• Existence of long patents on drugs.
• Research and development costs are high.
• The high level of initial investment required to establish a manufacturing plant.
• Government regulation is stringent, including requirements of high quality and compliance standards. Hence, threat of new entrants is classified as low. However, it should be noted that the barriers to this industry are decreasing. .

Threat of Substitutes

Certain medical devices, alternate therapies, or hospitalization may be substituted for drugs; however on a cost to value basis these options are less appealing. Although the use of alternative therapies such as homeopathic remedies, acupuncture, and herbal medicines is increasing, they are as of now still considered medically unproven. Overall the threat of substitute products is relatively low as their use is not widespread or other substitutes to pharmaceuticals such as generic products are produced by the pharmaceutical companies themselves. (Oliver Gassman, 2004) .

The intensiveness of Completive Rivalry

In the case of Australia, threat of competition in the Medicinal and Pharmaceutical Manufacturing industry is medium. A low level of concentration exists in this industry as only the top four players (Sigma Pharmaceuticals being one of them) account for roughly 30 to 35% of the local market. This level of concentration is in line with global trends and will increase in the future because of the existence of large foreign companies in the country. However it is noted that the number of small companies entering this industry is also increasing. .

Internal Analysis

Corporate Government Analysis

During 2006-2007, the board of directors consisted of 7 out of 8 non-executive independent directors, including the chairman. The managing director of Sigma is Mr. de Alwis; the only executive director. All the independent directors are separated from each other. To aid in the corporate governance process the company has founded a Risk Management & Audit Committee and Remuneration & Nomination Committee to assist the firm in carrying out its duties and solving some detailed issues.

The committees also discloses and reviews the process of valuing the performance of the board and the directors and where need provides advice on remuneration policies and practices. Therefore, the structure of board of Sigma group is consistent with principle 2 of the best practice of corporate governance recommended by the Australian Securities Exchange (ASX Corporate Governance Council, 2007). Overall speaking, Sigma Ltd’s corporate governance framework follows the best practices of corporate governance suggested by the Australian Securities Exchange 4. Shareholders Analysis Based on Sigma group’s financial statement 2006-2007, the total issued ordinary shares were 12,312,156 on the 30th of June, 2006 and 24,760 shareholders of the company up until 26 March 2007. Table 1 below depicts the top 10 largest shareholders of Sigma as on 26th of March, 2007 controlling 38. 63% of the firm’s total issued shares. However, it must be noted that majority of these top 10 shareholders are institutional investors unlike Mr. Paul Duchen who is a substantial shareholder holding 2. 28% shares of the company, placing him 9th in the top 10.

In addition, only Arrow Group ApS and Queensland Investment Corporation owned 5% or more shares of Sigma (Sigma Annual Report, 2006-2007). Table 1 Top 10 Share holders of Sigma Pharmaceuticals Ltd. [pic] (Source: Sigma Annual Report, 2007)

McKinsey’s 7 S Framework

The 7-S Framework of McKinsey is a management model focusing on 7 factors which are Shared Values, Strategy, Structure, Systems, Staff, Style and Skills. By balancing these 7 mutual related factors, a manager could operate the company holistically and effectively.

Shared Values

Sigma’s corporate objective is to maximize returns to shareholders under an acceptable risk management. To achieve this objective the Board draws on corporate governance to contribute to Sigma’s performance (Sigma Annual Report, 2006-2007).

Strategy

In order to be the leading Australian pharmaceutical manufacturer and marketer, and the most efficient and effective pharmaceutical wholesale and retail service provider in Australia, Sigma continually makes acquisition in the industry.

In the following years, Sigma will keep reducing the attention in distributed products. On the other hand, it is going to enlarge the range of branded and generic prescription which is higher margin and the OTC products (Sigma Annual Report, 2006-2007).

Structure 

As a leading pharmaceutical company in Australia, Sigma owns a special selling structure. Referring to Figure 1, this special selling structure has been depicted. The major sales pipelines under the Sigma umbrella are pharmaceutical, healthcare wholesale and healthcare retail.

Within each pipeline there are several sub-companies that are response for different segment of sales, such as Herron and Arrows produce their own branded products of pharmaceutical; Amcal and Guardian are response to generate private label goods. Furthermore, the sub-companies also have inter-cooperation such as the Amcal and Guardian which is under Healthcare Retail will make promotion of the pharmaceuticals during their largely increasing retail stores in Australia (Sigma Annual Report, 2006-2007).

Systems

Sigma has a sole inputting system which is called “Embrace” program.

In this program, pharmacists are to sign an agreement with Sigma to be their first line wholesaler. As a reward, all the generics and OTC providers will have access to Sigma’s comprehensive range of goods and services, including access to its generic pipeline. Also, as a part of the Embrace program, members are able to buy all of their Sigma goods electronically. This system provides a win-win business relationship between Sigma and its members. Furthermore, it strengthens Sigma’s position in the competition (Sigma Annual Report, 2006-2007).

Staff

Sigma Pharmaceutical Limited has close to 1,900 staff at present. The firm treasures all staff, considering them as the primary asset of the company. The professionals come from diverse backgrounds, and are all highly motivated. The high quality staffs are the trumps of the company there high caliber ensure Sigma remains a leader in the competitive market (Sigma Annual Report, 2006-2007).

Style

Sigma has a sophisticated and integrated board committed to framing the strategic direction and corporate framework to maximize returns to shareholders at an acceptable level of risk.

A strong and committed management team engages in execution of the strategy.

Skills

The company’s core competence in the industry has been enhanced by the Embrace program. The largest and second-largest healthcare retail brands which are Amcal and Guardian owned by Sigma also add the ability to the firm in competing with other companies in the market. Moreover, the outstanding board and management team, as well as the high quality employees with diverse range of culture and background are also one of Sigma’s strong skills (Sigma Annual Report, 2006-2007).

Company Financial Analysis

Common Size Analysis

The common size analysis of the balance sheet over the 2005-2007 periods indicates that intangible assets constitute a significant proportion of the company’s total asset, on an average around 58%, and shows an overall upward trend in these three selected years (Appendix 1). Described in the company’s 2007 Annual Report, the intangible assets of Sigma comprise Goodwill, IP License Agreement, Trademarks & License fees, Brand Names and Development Costs amongst which goodwill contributes to almost 72% of the total intangible asset value.

The decline in the company’s goodwill and intangible asset value in total can be a result of the reduced acquisition activities of the company compare to the previous year results. On view of the liabilities, the balance sheet common size analysis illustrates a dramatic increase in the non current financial liabilities from a 4. 80% in 2006 to a 14. 77% in 2007. This has resulted from the company’s utilization of the existing revolving debt facility. From the common size analysis of the income statement (Appendix 2), the profit after tax and net profit attributable to shareholders (members of Sigma Pharmaceuticals Ltd. , shows a negative leap of 1. 07% in 2007, compared to last year’s net profit of 4. 84%. This is a result of their stagnancy in expansion activities as well as the decreasing share price and the fall in sales in the past 3 years. These decreasing factors, as well as the increase in expenses, have led to this downfall.

Trend Analysis 

The trend analysis of Sigma’s balance sheet (Appendix 1) shows an increase in inventories by 23. 99% in 2006 and an overall increase of 41. 86% in 2007 over the past 3 years.

The rise in inventories may affect the adequacy of the firm’s liquidity as it takes time to convert inventories into cash. This 3 year period also observes the ample investment in property, plant and equipment of Sigma as this value has been high by almost 40% in 3 years, with more than a 30% increase being in one year itself. This escalation is attributable to the new purchase of manufacturing equipment as well as updating of their technological base. The trend analysis of Sigma’s Income Statement (Appendix 2), exemplify the increasing revenues over the past 3 years, showing an increase of 22. 3% from 2005-2007. The expenses on the other hand continue to grow alongside with revenue, paying particular attention to warehousing & delivery expenses, sales and marketing expenses, cost of goods sold and most noticeably plant rationalization and restructuring costs. There has been a 3% decrease in profits from 2006 in 2007, whereas the increase in profits from 2005 to 2006 was more than 45%.

Financial Ratio Analysis

Liquidity Ratios

There are two essential ratios for liquidity; current and quick ratio.

The Current ratio is the test for business solvency; to see if the firm can meet its short-term debts from its current assets. The targeted current ratio varies across industries and depends on the business nature of the company. Generally, a current ratio of 2:1 is considered acceptable but if the ratio falls below 1:1 it is implied that the company’s current assets are not sufficient enough to meet its short-term obligations. A Quick ratio is a ratio to test the immediate solvency of the company. The minimum acceptable ratio is 1:1. As seen in Table 2 above, Sigma’s Current Ratio has decreased in 2006 in comparison to the previous year by 0. 38. However it has managed to recover its asset state back in 2007 with a current ratio of 1. 89, almost achieving the optimal. The fall in 2006 was a result of the current liabilities growing at a faster rate than its current assets. In 2007 both the liquidity ratios show a rise, with the current ratio taking a huge positive leap. None of the years have reached an optimal ratio or reached the rule of thumb i. e. :1 for Current Ratio and 1:1 for Quick Ratio. Current Liabilities grew by 62. 16% from 2005 to 2006 whereas dropped 57. 79% in 2007. Trade payables were one of the most affecting factors to the current liabilities which showed an increase of 20. 25% from 2005 to 2006 after which it dropped by a mere 3% in 2007.  Compared to the competitor Symbion Health Ltd., the liquidity ratios of Sigma have been superior in the current financial year 2007. Whereas in 2005 and 2006, Symbion’s performance was moderately better.

The company has improved/maintained its standards in 2007.  Debt Ratios include the debt ratio, debt to equity ratio, and times interest earned ratio. The debt ratio fell by 45% from 2005 to 2006 and then remained stagnant in 2007. The debt to equity ratio also showed a considerable dip of 69% from 2005 to 2006, after which only a 0. 01% dip occurred in the following year. In 2007, both these ratios were at their lowest and highest in 2005 amongst the compared timeframe.

As it is known, the higher the ratio, the higher the debt, therefore this indicates the firm’s debt is increasing. This can be due to the fact that Sigma is looking for finance from an external source which is evident from a substantial rise of long term financial liabilities in 2007. The times interest earned ratio had rose in 2006 but declined again in 2007. In all 3 years, it has remained above 4, which is an acceptable standard as per the rule of thumb. This shows that Sigma has the ability to meet its interest obligations when they are due.

Symbion’s debt level was much lower compare to Sigma in 2005 having a difference of about 53%, but in 2006 and 2007, the debt levels of Symbion increased by more than 50% surpassing Sigma’s stagnant debt ratio. It is at Debt to equity comparison where Symbion and Sigma both have significant differences. In the year 2005, where Sigma had one of the highest levels of debt, Symbion portrayed the lowest, later boiling down to a stagnant stage. Whereas Symbion saw an increase in its debt levels then, this made Sigma ore stable in debt level than Symbion.

Activity Ratios

The activity ratios that will be considered are average day’s inventory, average collection periods, average payment periods and asset turnover ratio. The asset turnover ratio decreased in 2006 by more than half, however showing a slight increase again in the following year. This indicates that Sigma is increasing its inefficiency to utilize its assets and generate more revenue.

The Average Collection Period measures the efficiency of the management in collecting the debts of the business within a shorter collection period, resulting in a greater cash flow of the business. The Average payment period measures the efficiency of management in paying its creditors/suppliers. The longer the payment period, the greater the cash retained in the business. From the above graph and table, it can be inferred for the: Average Day of Inventory- days inventory has been rising which could have resulted from the decline in sales the company has been facing and the decrease in demand for Sigma’s products.

Also the increase in inventory by 72% over a stretch of 3 yrs would contribute to the same. The Average Collection Period – the collection period has dropped from 43 days to 28 days, which is a good sign in terms of recovering bad debts and solving cash flow problems. The Average Payment Period has reduced from 53 in 2005 to 49 in 2007. This means Sigma has contracted its payment period and is not able to retain more cash inside the firm. Symbion’s Activity ratios are brighter than Sigma. Throughout the past 3 years, Symbion has maintained better days of inventory than Sigma.

With the maximum reaching 40 days, Sigma’s lowest has been 41 days. The collection period also displays a good performance showing that Symbion is faster in converting its debt from other suppliers. Although the payment period is not that widespread between the two companies, the collection period is what works to the advantage of Symbion since it has cash reserves on hand for a period of time, on which it can earn interest by paying late and earning early. The Cash Conversion Cycle has been negative for Symbion in the past 2 years, which is commendable in the manufacturing industry.

Sigma yet needs to improve few of its activity ratios.

Profitability Ratios

The Gross Profit Margin has remained between 11. 5% and 12. 5% over the past three years. This can be considered a bit of stagnancy in maintaining profits by the company. Whereas the net profit margin has shown both an increase and decline. 2006 showed a profit of 4. 84% that is an increase of 2. 05% from the previous year, although in 2007 this profit took a negative leap by 1. 07%. This tells us in regards to Sigma for every dollar of sales there is approximately 12. 9 cents left after incurring all relevant expenses. Throughout there has been a drop in the last financial year analyzed i. e. 2007, for which all factors starting from sales to share price to purchases or investment have contributed. Currently, the net profit margin of the company is 3. 77% which means that 3. 77 cents of every dollar of sales is converted into profits after taking tax considerations into account. This is substantially decreasing along with sales figures. This drop has occurred in spite of sales revenue taking an upward slope. Over a period of time, ROA has taken a negative leap throughout the three years. The company’s ROA has declined from 6. 94% to 4. 92% over a span of three years. This again is another factor at par with the deteriorating numbers throughout the income statement and balance sheet. Investors of Sigma have received a lower return on their investment consecutively in all 3 years. A huge drop of 11. 73% is a result of the company’s dropping share price which is a return of the declining figures in the balance sheet in all aspects of sales, assets, increasing liabilities, etc.

Dividend Ratios

Sigma’s dividend ratios [pic] It is difficult to create an average of the company on how much of dividends it pay annually. There have been a vast amount of drastic changes in the dividend policy. An increase of 50. 89 from 2005 to 2006 led to a major drop of more than 72% in 2007. The negative figures faced by the company in pharmaceuticals as well as the stock market have resulted to retaining their earnings and reducing their dividend.

Not a very motivating sign to the investor along with the dropping share price, this sends a wrong signal in the market about the company’s confidence in its own shares. The company in the current year has retained earnings with a probable future prospect view of being able to invest in worthwhile projects. Table 10: ROE decomposition – Du Pont System of Analysis [pic] The DuPont Equation provides a complete ratio analysis that allows assessing the return on equity of one firm by decomposing it into three important elements: a profit-on-sales component, an efficiency-of-asset-use component and a use-of-leverage component (Gitman et al. 2005) The DuPont results indicates that from 2005 to 2007, the net profit margin rose and dropped giving a positive difference of 2. 05% and then taking a negative dip of 1. 07%. In 2006, the financial leverage multiplier (Total Assets / Equity) after experiencing a downfall in 2005 rose by a mere 0. 07, maintaining its level and not deteriorating any further. The total asset turnover faced a more than double decline in the year 2006 whereas again regained a minor part in 2007. The overall drop in three years is 1. 18.

However, as a result of the overall decrease in all net profit margins (although one year, the decline has simultaneous effects on other factors of DuPont) and financial leverage multiplier, the firm’s ROE has declined as well from 19. 30% to 7. 57% in three years’ time. 6. 4 Cash Conversion Cycle The cash conversion cycle is the number of days between paying for inventory and receiving the cash from selling the goods and services. The lower the cash conversion cycle is the better as the company’s funds are not tied up for a vast period of time but instead can be available for other uses.

The cash conversion cycle is depicted in the graph below. Figure 3: Cash Conversion Cycle [pic] Basically, the cash conversion cycle comprises three main components and is shown by the following equation: Cash conversion cycle = days inventory + average collection period – average payment period. Sigma’s Cash Conversion Cycle: 2005: Cash Conversion Cycle = 41. 21 + 43. 60 – 53. 00 = 31. 80 2006: Cash Conversion Cycle = 52. 35 + 43. 12 – 63. 97 = 31. 50 2007: Cash Conversion Cycle = 55. 59 + 28. 53 – 49. 68 = 34. 45 The cash conversion cycle for Sigma has been gradually worsened over the three years.

The cycle almost remains the same of 31 days in years 2005 and 2006, and finally ends up increasing by three days at 34. 45 days in 2007. However the ineffectiveness of managing the cash conversion cycle is a result of increasing day’s inventory. When observed, the collection period has a commendable difference on the beneficial side. But again, the decline in payment period doesn’t help the cash flow statement and tells us about Sigma’s lack of reserving cash with them for a long time.

Share Performance Analysis 

The share price has been at a low since the merger with Arrow in December 2005.

Soon after the tie-up, Sigma’s share price peaked at about $3. 25, before falling for the first half of 2006, then rallying in line with the market. However, more recently Sigma has fallen below $2. 25 mark. The company had seen a boom overview right before the merger, seeing the highest share price in the past 4 years at $13. 54. As of 31st December 2007, the company share price is at $1. 58. Sigma has not been able to outperform the market since December 2005. While the index has increased steadily, Sigma’s price has plunged tremendously. From 2005 to 2007, the company has lost almost 88% of its share value.

Strategy Analysis

Strategy one: Joint venture project in China 8. 1. 1 Reasons for being selected in the Chinese markets 8. 1. 1. 1 Great opportunity provided for foreign companies As a member of the World Trade Organization (WTO), the Chinese pharmaceutical industry is required to integrate more completely into the global economy

• These WTO commitments are creating additional business opportunities for overseas pharmaceutical companies
• Currently sales derived from foreign investment companies have made up 22. 23% of the total Chinese domestic market (Assess China, 2006, para. 4, 5). (Appendix 5)
• Other advantages include higher consumer demand for pharmaceuticals and lower labor costs in Chinese market. 8. 1. 1. Great prospect in China Pharmaceutical industry
• Over the last few decades, China Pharmaceutical industry has become the one of the largest pharmaceutical producers in the world with an annual average growth rate of 16. 72% (Assess China, 2006, p. 41). (Appendix 5) • China Pharmaceuticals market is forecasted to become the largest by 2010 due to the rapid growth of China’s macro economy, improvement of urbanization, and an increasingly aging population (Returns, 2008, para. 2). (Appendix 5)
• The pharmaceutical products sales revenue raised at 17. % year-on-year, and the gross profits increased by 29. 6% from year 2006.
• During 2005 and the first two month of 2007, the monthly sale income has maintained a range between RMB 250 million and RMB 500 million, with an average month-to-month growth of 22%. (China Pharmaceutical industry, 2007, para. 2). (Appendix 5)

• Also, importantly China’s huge and gradually aging population has created an immense consumer demand for pharmaceuticals and a strong biopharmaceutical sector has almost guaranteed a prosperous pharmaceutical market profile.

8. 1. 1. 3 Tremendous Government Supports Enormous supports from Australian Government for Australian businesses to compete and grow in the international market.

Export Market Development Grants (EMDG) scheme, provide financial assistance to SMEs to expand to overseas market (Austrade, 2007). (Appendix 5) .

General Background

• JiLin AoDong Medicine Industry (Group) Co. Ltd is one of China’s Leading Pharmaceutical companies which has been ranked as the 31st in the medical industry of China. At the end of 2007, the firm has generated a total sale of 845,146,602. 11RMB, an increase of 9. 6 % compared to the year before. The net operating profit after tax of the company was 487,203,915. 33 RMB in 2006 and was 1,992,259,763. 58 Yuan in 2007, raised about 308. 92% (JiLin AoDong, 2008).
• As the 52% shares of JiLin AoDong Corporation is owned by the Chinese Government, the company has a very high reliability where it has obtained a credit ranking of AAA. It was listed on the Shenzhen Stock Exchange of China in 1996 and it controls one major company, 7 sub-medicine manufacture companies, one medicine distribution company and two companies for providing the material of medicinal products.

It also has investment in other 12 companies. The major products of JiLin AoDong Corporation are herbal made medicines, which are sold all over China. Some of the products has founded its famous brand in China and has quite a large number of fixed customers. From the beginning of 2002, JiLin AoDong Medicine Industry (Group) Co. Ltd invested about 5 million RMB into renovation and reconstruction of the workshop and facilities of the material providing companies and setting up standardized management and control computerized software system. (JiLin AoDong, 2008)

Why JiLin AoDong needs Sigma

After China joined the WTO, the Government is willingly to open the economy and encourages all the Chinese company to cooperate with foreign companies. This means there is not many limitations of overseas investment injection. Also, to acquire the investment of Sigma, JiLin AoDong Medicine Industry (Group) Co. Ltd have opportunities to enhance its strength further by using the money for researching new products, increasing outputs or enlarge the market scope and so on to make more revenue without making new debts or issuing more equity. On the other hand, to cooperate with Sigma which is a leading pharmaceutical company in Australia, Jilin AoDong Company could expend its products into Australian Market through Sigma’s large sales pipelines. It will also benefit by some new advantage management concept and method provided by Sigma. Besides, Jilin AoDong could get more experience of international business management by collaborating with Sigma.

Mission Statement

Therefore the aim of this joint venture is simply to ensure that Sigma stays ahead and/or alongside other companies, as well to grow Sigma and expand its market to maximize the firm’s value.

Objectives

• Increase company’s profit via overseas expansion
• Establish company’s brand name in the Chinese Pharmaceutical market
• To salvage current fall in the company’s share price via injecting positive news to the market
• Use China as the milestone to further expand its operation internationally

Structure

A joint Venture is a type of business activity which involves two or more companies conjoining their resources to run a special operation. In this case, the two parties that will participate in this project are Sigma Pharmaceuticals Limited and JiLin AoDong. The joint venture project will be drawn out as a 30/70 proposition (30% contributed by Sigma), any cash inflows and cash outflows will be divided and responsible by the two companies. (Appendix 11)

Possible Project Benefits

This overseas expansion project will bring enormous benefits to Sigma in both the short and long term.

Under the Market Efficiency theory, any positive news about the company will boost investors’ interest, as a result, the share price will regain its strength in the market and be persistently rising; such event driven factor can resolve the recent deterioration in Sigma’s share price. In terms of the long run, this joint venture is a step toward entering the Chinese market, learning about conducting business in China, and about the Chinese market in general, and building up corporate connections in the country. Having a good base will enable Sigma to further expand in a later phase of this project with greater ease and comfort.

Another benefit is also the spread of Sigma’s good name in China, i. e. brand awareness and overall giving Sigma an international reputation increasingly their creditableness.

Possible Project cost Actual costs associated with setting up the operation in China are items include rentals, wages, plants and equipments, overhead costs, floatation costs of setting up the joint venture, and relocation costs for Australian professionals. Other than that, costs associated with building infrastructures and relevant assets are relatively minimal due to the joint venture.

Strategy Two

8. 2. 1 51% Acquisition of Biota Holdings Limited: Value Creation in Acquisition. Biota Holdings Limited is a leading anti-effective drug development Company based in Melbourne, Australia. It is believed that the acquisition will bring Sigma Pharmaceuticals greater strength for its pharmaceutical business operation. Research and development being the core operations of Biota Holdings, it will be a good addition to Sigma Pharmaceutical’s already prospering manufacturing, wholesaling, and retailing activities.

Currently, Biota Holdings limited’s revenues are at an all-time high because of the royalties it is receiving from its Relenza flu drug. It has also recently signed a USD 102 million licensing deal with Boehringer Ingelheim to develop a treatment for the Hepatitis C virus (HCV) and other potential diseases. The proposal is to use the retained earnings of Sigma Pharmaceuticals to buy a 51% stake in Biota Holdings Limited whose market capitalization is AUD187 million. Sigma has some fascinating drivers to persuade Biota to undertake the above merger.

However, the calculation of some financial measurements, such as the Net Present Value and Internal Rate of Return, of the merger has been performed to provide a more objective view of the benefits that the acquisition may give Biota. With the 51% acquisition, the shareholding ownership of Biota will change if the project is accepted. The total initial investment is expected to be AUD 115 million which includes 51% of the shares of Biota Holdings at a 15% premium and an additional 5% to cover the costs involved in the acquisition.

Using the above information, it is calculated that the NPV of the merger is projected to be AU $256,967,954. 31 and the internal rate of return (IRR) amounted to be 30. 83%. (Appendix 13)

Comparison of Projects

To some extent, Sigma can implement both projects as they are independent. At the same time, the company can either invest in domestic projects or expand its operation overseas. Nevertheless, due to resource constraints, particularly limited funds available, Sigma should select a single growth strategy to pursue.

As a result, a comparison between the two projects in terms of both strategic rationalization and financial justification needs to be undertaken to facilitate the company’s investment decision.

Financial Assessment

Capital budgeting has been conducted to financially evaluate these two projects. The result shows that although the joint venture in China requires a higher initial capital, it yields a better result for the firm as it has higher NPV, IRR and lower payback period.

Although the Profitability Index of China project is not as strong as the Acquisition project, the value addition of China’s venture to the company will be much larger than taking over of the Biotech company. Financially, all the project evaluation techniques support the joint venture project in China. However, Sigma has to consider whether it has sufficient capital to pursue this investment as the project requires the company to contribute 30% of the initial investment which is equivalent to $108. 42 million. 8. 3. 2 Sensitivity Analysis (Appendix 10) Table 12: Sensitivity Analysis of Joint Venture in China (Appendix 10) pic] Table 13:Sensitivity Analysis for Acquisition of Biota (Appendix15) [pic] Sensitivity analysis is necessary in evaluating the projects as it helps to see how the results of the project changes when the input variables varies. In the best case scenario, in terms of NPV [core factor of project analysis – (Damodaran, 2007)] the joint venture in China is superior to the acquisition project as in the most likely case. Although the profitability index and IRR are higher than China Project, the core reason is the initial investment in this project and the growth rate of China compared to Australia.

As well, despite both the internal and external conditions moving unfavorably in the worst-case scenario, the China joint venture project will yield a higher IRR, and higher profitability index and take a shorter time to recover the initial investment.

Risk Profile

The expansion to the Chinese market will expose Sigma to country risk. China is now rated A1 with a stable outlook in terms of the sovereign rating, so the likelihood of sovereign intervention is quite low.

However, this is the first overseas operation of the company, risks might occur due to the differences in the legal system and the bureaucracy of the host country. To deal with this country’s risk, a risk premium of 0. 95% is embedded in the discount rate when evaluating the project. Industry Risk – Risk Level – Medium The Pharmaceutical market in China is gaining popularity, so is now attracting foreign investors in worldwide. Sigma can be a brand name in the Australian market but is still a new face outside its home market. It will be likely to confront fierce competition, especially from U. S. enterprises that also come to operate in China. On the other hand, little international intervention has been observed as of now, which might give Sigma an edge in creating a base. Foreign Exchange Risk – Risk Level – Medium Revenues generated from the joint venture are in Chinese Yuan (CNY) but most of the cost also incur in this currency. AUD/CNY exchange only has an impact when Sigma repatriates its profit from the joint venture. The depreciation of CNY against AUD will reduce the actual income in AUD that Commander gets from its overseas investment.

Interest Rate Risk – Risk Level – Medium

Sigma is now not only affected by the interest rate movements in Australia but China as well. The interest rate is most likely to rise in the near future as Chinese authority want to cool down its economy expanding at overtaking speed and control inflation. Liquidity Risk – Risk Level – Low The profit from the overseas investment might enhance cash flow position of the firm when it repatriates the distributed profits. The risk analysis indicates that the overall risk level of Joint Venture in China is at medium level and can be mitigated by various measures to be discussed below.

Nonetheless, this is an issue of risk-return trade-off. The overseas expansion is riskier but it promises a more attractive return. 8. 3. 3. 2 Acquisition of Biota Holdings Limited Country Risk – Risk Level – High The biotechnology industry is exposed to the global market through partnerships and research initiatives. Currently, Biota Holding’s foreign partnership portfolio includes Boehringer Ingelheim, Daiich-Sankyo, Medimmune. Recently, the German Government placed an order for Relenza, which generated $39. 8 million in royalty income for Biota.

Although it is based in Melbourne, Australia, alliances and cashflows could be affected by unanticipated changes in exchange rates and political risk in foreign markets. (Damodaran, 2006). Hence it is classified as high. Industry Risk – High The industry risk for Biota Holdings is classified as high mainly because of 3 factors: a) Being at the cutting edge of scientific development, level of technology change is high, and the speed of this change is obstructed by a number of factors. b) One of the main legal issues this sector faces is that of the legal definition of patentability.

Discoveries are also deterred by third-party patents, which are expensive to make use of. (IBISWorld, 2008) c) The effect of changes in prices of commodities produced and used is high too. Foreign Exchange Risk – Low Because Sigma and Biota Holdings Limited are both Australia Companies, there is no foreign exchange rate risk between them. From the view point of macroeconomics, economics factors could be the only factors having an influence on them. Interest Rate Risk – Medium Interest rate as a normally significant economic factor could affect the acquisition between Sigma Pharmaceuticals and Biota Holdings Limited.

As the RBA increased the interest rate in March which is very soon and the 7. 25%interest rate seems to suit the fast increase of Australia’s Economy. So in the short-run, the interest rate is low. While, for the long run, it will be predicted to be medium Liquidity Risk – Medium As the acquisition is being funded by internal revenues, there is a loss in liquidity for Sigma Pharmaceuticals. Also, on looking at the current ratio and quick ratios after the acquisition, although they are not improving, their effect is minimal in the downward direction.

Thus, overall the firms ability to meet its short-term obligations is affected slightly, but there is a possibility that this negative effect increases in the future.

Strategic Rationalization

Unmistakably, both overseas expansion and expansion growth strategies provide strong positive NPV and satisfactory IRR figures; however the overseas expansion is compelling and lucrative over the acquisition proposal. Unanimously, the overseas expansion project has attributes that are more strategically rationale and perennial.

Therefore, the China Joint Venture operation should be evolved and predominated over domestic acquisition. 9. Proposed Funding Strategy The result of Sigma’s capital structure analysis indicates that the company currently operates beyond its optimal capital structure with the intensive use of debt. At the existing capital structure, 37. 71 percent of the firm’s total assets financed by debt while the optimal financial mix suggests that debt should only account for 20 percent sources of funding (Appendix 7) Therefore, borrowing should not be a choice of the firm to finance its new roject; it now only can rely on internal or external equity financing. As discussed in the part of share price performance analysis, the company share price has dropped drastically to $2. 25 in June 2006 from $13. 45 in December 2005, the highest the company has achieved till date is only $13. 54 per share on December 5, 2005. Furthermore, at present, the market does not have a positive perspective about the share price of the company, hence it now might not be good timing to raise fund by issuing new shares.

All things considered, internal financing seems to be an appropriate selection for Sigma in the present situation. Indeed, with regard to company financing, this selection of the company follows the hierarchy of financing sources proposed by the Pecking Order theory in which internal funds are preferred (Donaldson, 1961 cited in Peirson et al., 2006). The theory is supported by evidence in Australia which demonstrates that in recent years internal cash flow is generally the largest source of finance for Australian non-financial companies (see table below).

Moreover, this financing source does not involve any transaction cost such as floatation cost in case of issuing new shares. As show on 2007 Balance Sheet, Sigma has A$ 132 million as retained earnings, thus it can use A$ 108 million out of this source to fund the selected project. 10. Revised Mission, Vision and Strategy

As a part of Sigmas aims and objectives its plan is to aggressively grow the pharmaceutical division, maximise long-term returns to shareholders at an acceptable level of managed risk and increase profitability and market share of the healthcare division (Sigma, 2008). All three can be achieved by the suggested strategy of expanding overseas to the Chinese pharmaceutical market. This expansion will allow Sigma to increase its markets by taking advantage of the current growth in overseas markets such as China; a developing nation, with a large growing population and hence a growing demand for pharmaceutical products.

The joint venture project is a means of getting a ‘foot ‘ into this market, establishing Sigma’s name whilst learning about operating in China, and at the same time acquiring a network in China when further steps are wished to be taken. The other major objective of maximizing long term returns to shareholders at an acceptable level of managed risk will also be achieved as long as the firm’s optimal capital structure is acknowledged. The joint venture will be primarily funded by retained earnings and thus no additional debt or equity will be used in this project.

Therefore in the long run, the firm’s value should increase as well as shareholders’ wealth.

Recommended

The projected income statement (Appendix 16) shows that if Sigma does not implement the project in China; the average annual net profit growth rate is around 28 percent during the next three years. Otherwise, the company can enjoy higher profit growth rate of approximately 48 percent per annum on average. This is resulted from the distributed income from the joint venture in China.

The total assets of the company exhibit an upward trend from 2008 to 2010 in spite of Sigma targeting a reduction in its account receivables and inventories by 10 percent each year. This reduction was to increase the cash equivalent investment from the annual profit which would assist the firm to better managing liquidity risk. But irrespective of that, the company’s assets increasing will work as an added advantage and will be able to manage both its cash and non-cash investments. Based on the projected financial statement, several main financial ratios of Sigma will be revised as follows:

Apparently, the implementation of the joint venture project in China improves the profitability ratios of the firm. Without the project, its ROA only rises from 7. 57% in 2007 to 8. 86% in 2008, while with the implementation of the project a higher ROA is achieved. The new investment even has a greater impact on ROE. The company will progress in ROE even if the project is not followed, but the returns increase on the implementation of the project. The figure is supportive of the company’s decision to expand overseas as it will add more value to shareholders’ wealth.

More importantly, the use of internal funds to finance the project and use the added profit every year to gradually retire debt will help the firm to approach the optimum capital structure (20 percent).