Australia | Nov 06 2008
By Chris Shaw
Healthcare is rightfully regarded as a defensive sector of the market given demand remains fairly consistent regardless of the economic environment at the time, but as ABN Amro Morgans points out, this doesn’t make all stocks in the sector a Buy simply because their earnings should be less volatile in the current uncertain conditions.
Analysts Scott Power and Tanya Solomon have used a recent conference on the “Future of Australian Pharmacy” to update their views, thoughts and analysis of the pharmaceutical sector in Australia. Their conclusion is that a cautious view seems appropriate given a number of new players have entered the sector on the distribution side and also because of ongoing regulatory changes in the industry with respect to generic drugs that are causing some uncertainty.
According to the analysts, the most likely outcome of the government regulated price declines for generic drugs mean the pharmacy wholesalers and generic drug distributors such as Ascent Pharmahealth ((APH)), Australian Pharmaceutical Industries ((API)) and Sigma Pharmaceutical ((SIP)) will have little choice but to give better deals to the large pharmacy chains.
As an example of the changes, the broker notes from August 1 this year drugs where it was demonstrated there was a high level of price competition were subject to a one-off price drop of 25%, while low price competition drugs are subject to annual price drops of 2% for the next three years.
While this implies some margin pressure, the broker suggests market talk of mergers of back office operations among the full-line wholesalers won’t solve the problem as they would likely create only short-term benefits. Over time, the gains would be offset by changes to the Pharmaceutical Benefits Scheme. Given this, the broker doesn’t expect these rumoured mergers to occur.
Looking ahead, the broker sees the signing of the next Pharmacy agreement in 2010 as very important for the industry’s outlook, as while no changes are expected, if the current terms of the CSO (Community Service Obligation) were lowered or the government was to cease paying it entirely, all companies in the wholesale sector would struggle.
The other potential source of pressure for the wholesalers is that larger pharmacy chains are continuing to buy up smaller pharmacies, which is increasing their market power and allows them to demand higher levels of discounts from the wholesalers, so keeping margins under pressure.
Given this environment and the potential for conditions to get more competitive, the broker has Hold recommendations on all three stocks. Ongoing margin pressure is seen as presenting further downside earnings risk for each company. More specifically, ABN Amro Morgans also sees any delays in putting new IT systems in place as a potential source of downside for API, while for Sigma the additional risk comes from any inability to meet management’s targets with respect to improving working capital and cash flow targets.
On the positive side, the broker sees potential sources of upside for each company, with delivery on earnings expectations the key for both API and Sigma and the successful integration of the Strides business the main source for Ascent.
In terms of how the broader market sees these companies, the FNArena database shows only ABN Amro covers Ascent (which in essence brings us back to Power and Solomon), while API is rated as Buy once and Hold four times and Sigma is rated as Hold five times and Sell four times by the major stockbrokers in the FNArena universe.
ABN Amro has price targets of $0.30 on Ascent, $0.61 on API and $1.32 on Sigma. These compare to average targets according to the database of $0.83 and $1.33 on the latter two companies. Shares in the three stocks today are mixed, with Ascent unchanged at 19c, API down 0.5c at $0.53 and Sigma down 2c at $1.36.
