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Aust Pharma Beset By PBS Uncertainty

Australia | Apr 27 2015

-Priceline outperforms
-Uncertainty over PBS changes
-Should manage funding cuts

 

By Eva Brocklehurst

Australian Pharmaceutical Industries ((API)) has made strides in its operating earnings despite a weak environment. The pharmacy wholesaler/retailer’s cash flow and debt position have improved, which drove first half results. Operating profit was up 31% against the prior first half. This is coupled with a working capital profile that rivals competitor Sigma Pharmaceutical (((SIP)), in Morgan Stanley’s view.

Still, the company’s ability to resist mounting pressures in its industry are a key uncertainty and Morgan Stanley retains an Underweight rating. The worst may be over in terms of industry headwinds but the broker believes it will take time for that to become evident. Independent customers are still under pressure while there is the threat of further increases to prescription co-payments. The broker also suspects the company has lost distribution market share to Sigma.

Morgan Stanley anticipates cost savings in pharmacy distribution as a percentage of total revenue will contribute to improvements in operating margins, but these will still be at a level below competitors. That said, the broker acknowledges the company’s shift in focus towards winning retail market share and diversifying away from the government’s pharmaceutical benefits scheme (PBS) funding. Negotiations for the sixth community pharmacy agreement continue ahead of the expiry of the current agreement in June. 

Credit Suisse increases earnings forecasts by 6-10%, driven by higher revenue assumptions and lower interest expense. The company tightly controlled costs in the first half, particularly in warehousing and distribution despite the headwinds emanating from the PBS. All up, the broker considers the outlook is favourable but awaits the outcome of pharmacy agreement in terms of the implications for the company’s wholesale division.

The retail side, Priceline, drove the overall growth with like-for-like sales up 3.9% in the March quarter. Macquarie considers the 17% increase in group earnings can largely be attributed to Priceline and this was impressive, given the broader industry is relatively subdued. The broker acknowledges the challenges in the distribution business and the possibility of adverse outcomes from the upcoming pharmacy agreement, or the Commonwealth government’s budget in May.

The stock is now trading at a significant premium to Sigma, Macquarie observes, driven by the stronger earnings growth as Priceline continues to outperform. The broker is cautious about the longer term outlook for Priceline, given increased competition from new entrants such as Sephora and the supermarkets, but near-term earnings appear unaffected and the risk of a near-term de-rating is considered low.

A stable cost base highlights the potential leverage in the Priceline franchise model, in Deutsche Bank’s view. The risk of a poor funding outcome from the PBS is a threat but should have little impact on the retail operations. The broker maintains any funding reductions should be manageable as the company and its competitors have a reasonable buffer in the form of discounts offered to pharmacies. This should ensure profitability of the wholesale operations even if funding is further constrained.

Deutsche Bank increases forecast revenues from the retail operations to allow for a faster store roll-out and better operating margins. Given the relatively flat cost structure in the franchise model much of the benefit falls to the bottom line, the broker observes.The company expects to have 420 Priceline stores by the end of FY15. 

There are three Hold ratings and one Sell on FNArena’s database. The consensus target is $1.39, signalling 14.9% downside to the last share price, and compares with 94c ahead of the first half results. Targets range from $1.10 to $1.75.
 

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