Reference no: EM13489283

Health Products Ltd is listed on the JSE Securities Exchange South Africa. The company formulates, markets and distributes a range of health products, from vitamins to nutritional supplements. Health Products Ltd distributes its own brand of vitamin products, but also  imports a range of nutritional supplements (such as meal replacement powders, fat burners and protein energy bars), from various leading international suppliers.

The vitamin tablet and capsule range of Health Products Ltd includes multi-vitamins and concentrated vitamins and minerals on their own as well as in combination with natural herbal products. Consumer surveys have revealed that the Health Product brand is perceived as one offering "value for money" and that the combination of vitamins, minerals and herbal substances in most products is perceived to be superior to those of competitors.

The market for vitamins and nutritional products is growing at over 15% per annum in South Africa because of increasing consumer awareness of the beneficial influence of nutrition on health. Health Products Ltd is therefore considering various growth alternatives, such as the introduction of related products like libido boosters and energy drinks. While these products still need to be researched and developed in-house, the benefit of leveraging off the Health Products brand is compelling. The company has historically outsourced the manufacture of vitamin products to contract manufacturers. The shareholders of SunX (Pty) Ltd have approached Health Products Ltd regarding the potential acquisition of the SunX business. These shareholders, who have retired and are no longer actively involved in the business of SunX (Pty) Ltd, want to sell their shares. SunX (Pty) Ltd manufactures and distributes their own brand of suntan creams and sprays. The business achieved revenue of R80 million for the year ended 30 June 2005 and profit after tax amounted to R15 million. The shareholders have indicated that they would be prepared to sell their shares based on a value of R120 million. The Marketing Director of Health Products Ltd is excited by this potential acquisition opportunity as SunX (Pty) Ltd and Health Products Ltd have many retail customers in common, and it would enable Health Products Ltd to increase its share of shelf space with most major retailers.

The abridged financial statements of Health Products Ltd and its two divisions for the year ended 30 June 2005 and the corresponding budgets for the 2006 financial year are summarised below.

HEALTH PRODUCTS LTD
ABRIDGED COMPANY INCOME STATEMENTS
Actual
results
Budgeted
results
June 2005 June 2006
R'000 R'000
Revenue 157 300 190 800
Vitamin Product division 47 800 62 140
Nutritional Product division 109 500 128 660
Profit before interest and tax 48 307 58 300
Vitamin Product division 19 837 24 850
Nutritional Product division 28 470 33 450
Profit after tax 33 650 40 500
Notes

• Head office costs of R12 500 000 in the 2005 financial year were fully allocated to the divisions, based on turnover levels. Head office overheads include depreciation of 3 R1 600 000 (2006 budget: R1 700 000). The above 2005 divisional profit before tax is after the deduction of allocated head office costs. Head office costs in total are budgeted to increase by 15% in the 2006 financial year.

• Interest income amounted to R2 280 000 in 2005 and is forecast to be R2 540 000 in the 2006 financial year.

• The gross profit percentage of the Vitamin Product division was 75,1% in 2005 while the Nutritional Product division achieved a gross profit percentage of 51,9%. The lower margin in the Nutritional Product division is attributed to the cost of importing products and the royalties payable to overseas suppliers. The 2006 budget is based on a 75% gross profit percentage in the Vitamin Product and 50% gross profit percentage in the Nutritional Product division.

• Dividends of R18 000 000 were declared and paid to shareholders during the 2005 financial year. Management estimates that dividends in the 2006 financial year will amount to R21 500 000.

VITAMIN PRODUCT DIVISION
ABRIDGED BALANCE SHEETS
Actual
results
Budgeted
results
June 2005 June 2006
R'000 R'000
Current assets 10 360 12 470
Inventories 1 850 2 250
Trade and other receivables 8 510 10 220
Current liabilities
Trade and other payables 3 150 3 930
Net divisional assets 7 210 8 540
NUTRITIONAL PRODUCT DIVISION
ABRIDGED BALANCE SHEETS
Actual
results
Budgeted
results
June 2005 June 2006
R'000 R'000
Current assets 33 900 38 580
Inventories 14 400 16 930
Trade and other receivables 19 500 21 650
Current liabilities
Trade and other payables 7 580 9 240
Net divisional assets 26 320 29 340
4
HEALTH PRODUCTS LTD
ABRIDGED COMPANY BALANCE SHEETS
Actual
results
Budgeted
results
June 2005 June 2006
R'000 R'000
Non-current assets
Plant and equipment
7 400
8 800
Current assets 76 360 97 220
Inventories 16 250 19 180
Trade and other receivables 28 010 31 870
Cash and cash equivalents 32 100 46 170
Total assets 83 760 106 020
Capital and reserves 68 550 87 550
Current liabilities 15 210 18 470
Trade and other payables 10 730 13 170
Tax 4 480 5 300

Total equity and liabilities 83 760 106 020

Health Products Ltd had a market capitalisation of R385 million in October 2005 based on the ruling share price of R3,85 a share. The chief financial officer has determined the company's cost of capital to be 13,6% based on a risk-free rate of 7,2% and the published beta coefficient of Health Products Ltd of 0,8. Health Products Ltd has no interest-bearing debt on its balance sheet, but it could raise mediumterm facilities at an interest rate of 9,5% per annum.

The board of directors of Health Products Ltd is considering various issues and requires independent advice and assistance to resolve and address them. The issues can be summarised as follows:

Share options

Health Products Ltd operates a share option scheme for eligible employees, including the executive directors. Options are allocated to employees at the ruling share price on the day that the options are awarded. Employees are entitled to exercise 40% of the options in year 1, a further 30% in year 2 and the last 30% in year 3. Employees may exercise these share options at any time for a period of ten years after it is awarded, but unexercised options are forfeited if employees leave the company.

The Chief Executive Officer (CEO) of Health Products Ltd currently has 750 000 options at an average strike price of R1,40, of which 500 000 options have vested. He has elected not to exercise share options to date, but entered into a derivative trade with a leading South African bank in April 2005. In terms of the derivative trade, the CEO sold 600 000 call options on Health Products Ltd shares at a price of R4,00 per share. The shares of Health Products Ltd were trading at R4,20 per share on the day that the derivative trade was entered into. The company announced the details of this derivative trade in compliance with the terms of the listing requirements of the JSE Securities Exchange SA.

After the announcement of the CEO's derivative trade, Health Products Ltd received adverse press coverage, with some journalists alleging that the behaviour of the CEO was unethical. The company responded swiftly by issuing a press statement to the effect that it had complied with the rules of the JSE Securities Exchange SA and that this derivative trade had been entered into by the CEO in his personal capacity.

The board of directors of Health Products Ltd is concerned that the adverse press coverage negatively affected the share price of the company, as the average price-earnings ratios of similar listed companies are currently 20% higher than that of Health Products Ltd. The board is now considering whether it should prohibit employees from entering into derivative trades involving the company's shares in order to prevent a repeat of the negative publicity that followed on the CEO's actions.

Excess cash resources

The chief financial officer has expressed concerns about the excess cash the company has on its balance sheet and is of the opinion that the company should use these cash resources for acquisition and expansion purposes. He is furthermore of the opinion that the company should use debt to lower its cost of capital.

The board of directors has taken note of the chief financial officer's comments about surplus cash resources on the balance sheet. In addition, the board is concerned that the dividend policy of the company may be sending inappropriate signals to the investing public and institutions. It may be perceived that Health Products Ltd has no strategic plans for utilising cash resources and hence that the company is paying out a significant portion of its annual profits as dividends.

The board is considering various alternatives for using the cash reserves of the company, including acquisitions, but it is also of the opinion that if no suitable opportunities are identified, the company should implement a share buyback transaction.

Business Intelligence

Health Products Ltd has been approached by XYZ Technology to consider the acquisition and implementation of their Business Intelligence (BI) solution. XYZ Technology is a leading BI solutions provider in South Africa and has consulted and managed the introduction of BI solutions at various large companies. XYZ Technology has indicated that a BI solution would enable Health Products Ltd to significantly improve its customer relationship management and financial management initiatives.

The following extracts were taken from a recent XYZ Technology presentation to Health Products Ltd:
"...our BI solution enables our clients to develop customised analytical tools to provide insight into customer behaviour and their own business operations. BI should be a strategic weapon enabling companies to collate data from their existing applications and from external sources, and to convert it into information in order to make better business decisions. We have already identified that our BI solution would improve the quality of management information at Health Products Ltd, improve customer profitability analysis and optimise the present Information Technology infrastructure."

"...XYZ Technology can assist in all key phases of introducing a BI solution including the initial information audit, defining multiple user requirements, upgrading of IT infrastructure, installation of our unique BI software and its integration with existing applications. Our firm could also act as project manager for the entire process."

The board of directors is keen to evaluate the feasibility of implementing a BI solution but requires an outline of the process and key issues that need to be considered before it decides to proceed.

REQUIRED

(a) Review and analyse the abridged divisional and company income statements and balance sheets of Health Products Ltd for the year ended 30 June 2005 and the budgeted information for 2006, and critically comment on the following:

(i) The actual versus budgeted financial results of the company and each of its divisions;

(ii) The working capital ratios of each division; and

(iii) The return on total asset ratios for each division and the company as a whole.

(b) Discuss the strategic and financial issues to be considered in evaluating whether to pursue the acquisition of SunX (Pty) Ltd.

(c) Discuss the issues arising from the CEO's derivative transaction in April 2005 from the perspective of -

(i) the shareholders of Health Products Ltd; and

(ii) the employees of Health Products Ltd.

State, and motivate, your opinion as to whether the CEO's actions were ethical.

(d) Critically discuss the opinion of the chief financial officer and the concerns and initial recommendations of the board of directors regarding the surplus cash position of Health Products Ltd.

(e) Outline the process that Health Products Ltd should follow in evaluating whether to pursue a Business Intelligence initiative and list the key issues to be considered prior to making a decision to proceed.