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Uncertainty Hinders Sigma Pharmaceuticals

Small Caps | Sep 11 2018


Uncertainty is likely to hinder Sigma Pharmaceuticals until a firm earnings base is established after the exit of its major customer.

-Possibility some of the contract moves to DHL before June 2019
-Accenture appointed to undertake restructuring initiatives but strategy unclear
-Lower PBS prices and slowing retail sales likely to be problematic


By Eva Brocklehurst

Industry conditions remain challenging for Sigma Pharmaceuticals ((SIG)) and uncertainty is likely to prevail until there is more clarity on the longer-term profitability of the business post the loss of the Chemist Warehouse contract.

The company is also materially increasing expenditure on its new distribution centre, hospital pharmacy and IT. Morgan Stanley suggests, given fixed costs, the return profile of these investments is highly dependent on a continuing relationship with Chemist Warehouse. So this is not considered an optimal time to be investing for growth.

Then there is the additional challenge that Sigma is facing in losing its major customer. Brokers have learned that there is a possibility that $700m from the over-the-counter portion of the contract may move to DHL earlier than June 2019. At this stage Citi assumes some impact on earnings before June.

DHL has been awarded distribution of the $700m portion of the $1.7bn contract. The contract for the remaining $1bn in pharmaceutical products has been awarded to EBOS. Morgan Stanley envisages material risk until the Chemist Warehouse agreement expires and a firm earnings base is revealed.

The stock re-rated in 2016 as it delivered on a growth strategy and secured contract terms with Chemist Warehouse, the broker notes. Around 41% of FY18 revenues are attributed to Chemist Warehouse and the impending exit provides little confidence for predicting the earnings outcomes in the future.


Results in the first half signalled that $41m in operating earnings (EBIT) is required in the second half to reach FY19 guidance of $75m and there should be -$6m in cost reductions that can help achieve this.

Citi reduces estimates for FY19 by -10% because of the timing of capital expenditure. The broker agrees industry conditions are challenging, as the community pharmacy market is growing at just 0-1%. All wholesalers are intent on improving efficiencies and external conditions are unlikely to change over the near term.

Credit Suisse has downgraded to Underperform from Neutral after the first half result. The broker incorporates a deteriorating earnings profile until FY22 and agrees excess capacity and fixed cost base need to be addressed.

Accenture has been appointed to execute restructuring initiatives but the future strategy remains unclear. Credit Suisse suspects any restructuring would also involve large costs which would weigh on reported earnings for the next few years.

Citi believes growth in the hospital distribution base will continue, but not enough to offset the loss of Chemist Warehouse. The broker forecasts an additional $100m in hospital revenue for Sigma in FY21. The company is likely to focus on deploying the ungeared balance sheet and, as there are limited opportunities within the existing business ,Citi does not expect any material acquisitions.

Sigma will update the market on FY20 guidance at the results in March next year and has reassured investors that $300m of working capital will be released at the end of the Chemist Warehouse agreement. Credit Suisse assumes $225m of the $300m capital release will be used to fund acquisitions. If the capital is not deployed over the next three years the broker's valuation will fall.

Credit Suisse believes the current share price factors in the potential upside from future M&A but does not encapsulate the downside risks associated with restructuring or an early transition from Chemist Warehouse.

Beyond Chemist Warehouse

The company's branded pharmacies have outperformed the market in like-for-like sales. Amcal grew 2%, Guardian 5.3% and Discount Drug Stores 3.0%. These pharmacies account for around 40% of total revenue and should increase to around two thirds beyond June 2019.

Citi expects community pharmacy revenue will be flat or decline slowly going forward. Sigma supplied pharmacies have been doing relatively well but lower PBS prices and direct distribution, as well as slowing retail sales, are likely to prove problematic.

Cost reductions should do the heavy lifting but UBS still envisages risks to earnings because of ongoing top-line pressures and the early roll-off of the Chemist Warehouse volumes. The main drivers of the ongoing pressures include a material impact from PBS price reductions, an acceleration in sector competition, and sluggish retail trading.

The main positive in the outlook, UBS suggests, is the outcome of the government's review of funding obligations, due in October, with potential changes to the regulatory framework reducing the ability of manufacturers to seek direct distribution.

The company is exploring ways to use its excess warehousing capacity that will exist after June 2019 and there is potential to fill the space with contracts that have a higher earnings margin than the community pharmacy business.

FNArena's database shows three Sell ratings and one Hold (Citi). The consensus target is $0.47, signalling -17.5% downside to the last share price. The dividend yield on FY19 and FY20 forecasts is 6.6% and 3.6% respectively.

See also, Goodbye Chemist Warehouse, Hello Capital Return? on July 3 2018.

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