Introduction
Pakistan is a developing country and is the 26th largest nation in terms of purchasing power parity. A member of BRICS community, the nation has shown signs of becoming one of the world’s largest economies by 2025. In the past, the country had suffered from the ills of political disputes, energy constraints, poverty, growing population and non-conducive business environment that had halted the growth of the country. However, during the past few years, Pakistan has shown some optimistic signs of economic improvement with consistent growth in GDP and other macro-economic factors. Still, many factors such as social and political instability continues to impede the investment process.
In this paper,we will evaluate a possible investment opportunity of acquiring a UK based company with the intend to set up the manufacturing facility in Pakistan. Accordingly, we will be critically analyzing the macro-economic factors in the nation and the valuation scenario of a UK based company.
Pakistan, as a country, had largely been known for significant dependence on the natural resources, with around one-fourth of the population living under poverty. However, owing to the creation of some prudent macro-environment, Pakistan has experienced an impressive real GDP growth accompanied by a decline in the poverty. According to the official data released under Pakistan Economic Survey 2014-15, the nation achieved a GDP growth rate of 4.2 percent compared to 4.03 percent for the previous year. The statistics confirm that post experiencing the stagnancy or rather the GDP outlook for many years in the past, the nation has achieved a commendable achievement. However, despite of consecutive year of increased growth rate, the nation has yet again failed to achieve the budgeted real GDP set at 5.1 percent. This displays a need for additional reforms to be set by the government in order to absorb rising unemployment and other growth related factors.
It is considerable that the concern for Pakistan as being recognized as a semi-industriazied nation continues to be a concern as the economic expansion for the year 2014-15 was yet again led by services sector as the manufacturing industry was hobbled by -3.3% owing to deficiencies in power supply and weak external demand. On the other hand, the growth in the agricultural sector remained modest at 2.9%, while the proportion of private fixed investment to GDP slipped to 9.7% compared to 10% on account of energy constraints and weak business environment,especially for smalls-scale enterprises. On the other hand, the primary exports contributing to the EXIM section of GDP consisted of carpets, sports goods and material, leather and cotton, while Oil continued to be the major imported commodity.
Inflation
The financial year of 2014-15 witnessed a dramatic fall in the inflation rate, with the pace of decline even better than the peer South-Asian countries. The significant decline is attributed to fall in the oil price that plummeted by around 50% during the same period. In fact, inflation rate, which is now at 11-year low point, is primarily of the massive fall in the oil price. In addition, the inflation rate for food and other consumable items also dropped significantly, signaling towards adequate food supplies, which when aligned with lower price for oil, resulted in a lower inflation rate. Apart from the impact of lower oil prices globally, the lagged effect of monetary tightening by State Bank of Pakistan in 2013, also led to ease in inflation in the country. However, with a consistent fall in the oil prices on account of increasing supply glut and with no sign of production cut from OPEC members, State Bank of Pakistan has now eased the interest rates, which now stands at 42-year low of 7% only. However, despite of the loose monetary policy being adopted by the country, Interntional Monetary Fund predicts that if the oil prices do not rebound and take an upward trend, and the country continue to enforce sustainable fiscal policy, and if there are no outliers or unexpected incidents, Pakistan may now see a constant and sustainable rate of inflation .
The average annual inflation rate for July, 2014 through to April, 2015 was 4.81 per cent.
Interest Rates
Post achieving the significant decline in inflation rate using monetary tightening, State Bank of Pakistan has now started following a loose monetary policy and by the end of 2015, the central bank of Pakistan had slashed the interest rates for four times bring the prime lending rate down by 300 basic points from Novemeber, 2014 to April, 2015. A low inflation rate along with the adoption of the loose monetary policy by the central bank will act as a boon to the Pakistani economy and a clear indication that the government now wants to spur the economic activity. In fact, the trend of lowering of the interest rates is a manifestation of improvement in macro-economic conditions of the country reflected in the form of multi-year low inflation and improved external account.
Exchange Rates
Depreciating Pakistani Rupee against the USD has been a great source of concern for the economy. Most importantly, it is the importer community that is hardly hit by the depreciating Pakistani rupee, which is depreciating by 8-10% every year. Currency experts have also raised concerns and surprise over the consistent appreciation of US dollar against Pakistani Rupee in spite of higher remittances and record foreign reserves.The currency experts expect the Pakistani Rupee to trade at Rs 108 against US Dollar. While the government officials cites widening current account deficit, excessive government borrowing, absence of foreign flows, lack of foreign investment and repayments to the International Monetary Fund as the reason for depreciation of Pakistani currency, however, financial experts cite that at times when the inflation rate are consistently declining, GDP growth gaining momentum and with private sector rebounding, the Pakistani Rupee will fall up to the level of Rs 108-110 against the USD.
On the other hand, economists states that since there is no significant change in the amount of import volumes, the depreciation in the local currency is not fundamental and signals towards the interference and influence of the exporters in the currency market, who might be putting pressure on government to depreciate the Pakistani rupee in order to gain competitive advantage in the overseas market.
Foreign Direct Investment in Pakistan
Apart from the exchange rate, FDI is the second concern for the Pakistani economy. By the end of 2008, the nation received net FDI of $5.7 billion, however, by the end of 2013, FDI plummeted to $1.57 billion. However, the trend continued to get worst and by January, 2015, the amount of foreign direct investment in Pakistan declined further to $545.4 million compared to $553.20 million in 2014. It is considerable that in January, 2015, the amount of FDI inflow decreased by a massive 85 percent to $16.3 million as against $108.1 million in January 2014. With this share, Pakistan receives less than 1 percent of the total world FDI.
Important to note, economists have repeatedly cited that political instability, lack of transparency, poor law and order situation, energy crisis, red tapism and non-favorable taxation system for the foreign investors are some of the main reasons that is contributing to poor FDI inflow. Even State Bank of Pakistan (SBP), in a recently issued report, accepts that law and order situation and political uncertainty are impeding the FDI inflow in the country. Additionally, a conservative social and cultural environment in the country is also a major issue for the foreign investors as they fail to align with the local labor sentiments. Lastly, the taxation system in the country is not favorable as while the corporate tax rate is levied at 35%, for non-residents, a 15% rate is also levied on royalty and technical fee and 30% tax for other related payments.
Therefore, an overall non-conducive environment for overseas investors is resulting in record decline in FDI inflows in the country.
Company Profile- GlaxoSmithkline PLC
Founded in the year 1935, GlaxoSmithkline PLC is one of the leading pharmaceutical company in the world. Headquartered in Brentford, London and listed on the London Stock Exchange, the company develop, manufacture and market pharmaceutical products including over-the-counter medicine and health related consumer products. The company operates its business through five segments, namely, Global Pharmaceuticals, HIV, Pharmaceuticals R&D, Vaccines, and Consumer Healthcare. By the end of 2015, GlaxoSmithkline was the sixth largest pharmaceutical company in the world.
Micro Environment- Outsourcing Industry
Citing the impeccable success of football manufacturing for FIFA world cup by Pakistan based entrepreneurs, many overseas companies have started trusting the innovation and manufacturing expertise of the nation’s outsourcing industry. As a result, the nation is turning out to be a favorable destination for outsourcing manufacturing process. It is considerable that giant entities such as Adidas and Nike Inc. have outsourced the football manufacturing process to Pakistan based companies and has eventually benefited in terms of labor cost. Apart from low cost labor, some of the other factors that favor Pakistani outsourcing industry are:
Continuously improving risk rating and tight regulations for intellectual property protection
Consistent investment in better infrastructure and high-end machinery
New-age managers with professional expertise in multi-nationals are able to align the interest of multinationals and local labors
Entry Strategy- Outsourcing
Considering the macro-economic environment in Pakistan, the appropriate strategy for GlaxoSmithkline will be to outsource its production to a third party in Pakistan. It is considerable that even though the GDP of the nation is constantly improving and interest rates are now lucrative enough to set-up the company-owned manufacturing unit in the country, however, it is the other related factors that guides the company to opt for outsourcing as the entry strategy. Important to note, owing to the vast amount of labor population in Pakistan, the average rate per labor is significantly lower than what it had been at its other location. However, social unrest and cultural difference is a major impediment for GlaxoSmithkline to set up its own unit in Pakistan. Rather, the company should get into a contract with a local company, which is already experienced with drug manufacturing and understand the needs of local labor and their cultural associations.
Next, the unfavorable FDI environment, especially red-tapism, bribery and tax system, will not allow the company to set their own unit in both ethical as well as potentially profitable purpose. Therefore, outsourcing the drug manufacturing process and eventually transferring the burden of handling local government officials and the tax system will be a logical step.
Last, the strong position of the Pound Sterling against Pakistani Rupee will largely favor the company in terms of keeping the costs low. It is considerable that while the company will make payments to the outsourcing company in Pound Sterling, the depreciation position of Pakistani Rupee will allow the company to spend lower amount of contractual payments and this will consequently boost the company’s profits.
Porter Five Forces
-Bargaining Power of Buyers
Since the company is intending to outsource the production and benefit from the low cost labor in Pakistan, bargaining power of buyers is a negligible factor in the given scenario.
-Bargaining Power of Suppliers
With only a handful of projects being awarded to Pakistani suppliers from overseas, the locally based supplier, i.e. the entity outsourcing the drug manufacturing process for GlaxoSmithkline will not have a dominating bargaining power. However, in terms of negotiation with the company over labor wages as part of the open cost agreement, the company might face a mild bargaining issue with the supplier. Overall, the bargaining power of supplier will be at low level only.
-Threat of Substitution
Since the entry strategy is to outsource the production process and gain from the cost advantage available in Pakistan in terms of cheap labor and energy resources, the threat of substitution is negligible factor here.
-Barriers to Entry
The company will face low barriers to entry if it opts for outsourcing the production process. In such case, the company will only be contracting with the a locally based drug manufacturer and will thus be able to avoid all the barriers relating to government licensing and other issues
-Existing Rivalry
Since the scenario here is the outsourcing of manufacturing process with a drug manufacturer in Pakistan, threat of competition will not be an issue of consideration here.
Cost of Capital
-Market Value of Debt: Short-term debt+ Long-term debt
= 1308+15324
= £16632 million
-Cost of Debt= Interest Expense/ Total Debt
= 719/16632
= 4.32%
-Market Value of Equity: Number of shares outstanding* Stock price
= 2420*40.58
= £98203.60 million
-Cost of Equity: Risk free rate+ Beta(Equity Risk Premium)
= 1.43+ 1.06(6)
= 7.79%
Here:
RFR= 10 year UK Guild Rate= 1.43%
Beta= Volatility of stock returns to market index= 0.74
E(rM) = Expected market risk premium= 6.63%
WACC=Weight of Debt* Cost of Debt(1-tax rate)+ Weight of equity*Cost of equity
= 16632/(16632+98203.6)* 0.0432(1-) + 98203.6/(16632+98203.6)* 0.0779
= 0.1448* + 0.8552* 0.0666
=
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