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Sigma Farewells API, Heralds New Contract

Australia | Dec 17 2019

Sigma Healthcare has adjusted guidance to account for the renewed Chemist Warehouse contract, while Australian Pharmaceutical Industries finally takes its hat out of the merger ring.

-Downgrades FY20 guidance to reflect investment in new CW contract
-Brokers question whether full Project Pivot savings can be achieved
-Execution risk in strategy to diversify away from PBS

 

By Eva Brocklehurst

It's now official. After a rebuff from Sigma Healthcare ((SIG)) to its advances early in the year, suitor Australian Pharmaceutical Industries ((API)) has decided to step away, selling its stake in the company.

Meanwhile Sigma Healthcare has now adjusted its outlook to account for the renewed Chemist Warehouse contract, which was obtained last month. The company has downgraded FY20 operating earnings guidance to $46-47m, from the lower end of $55-60m previously, to reflect the investment that will be needed.

Australian Pharmaceutical Industries has sold its 12.96% stake in Sigma Healthcare for $0.60 a share, representing a -$3.5m loss, having acquired the stake in December 2018. This ends, for now, the long-running conjecture over a merger of the two.

Sigma finally rejected the merger talks in March, instead opting to focus on its cost reduction program. Brokers had considered the economic rationale for consolidation strong, as there is significant overcapacity and duplication.

Yet, Credit Suisse had ascertained last December that a deal would not be accretive for Australian Pharmaceutical until FY22 and subsequently expected it to sell, given Sigma's indifference, confirming consolidation of the wholesale pharmaceutical distribution industry is unlikely.

Chemist Warehouse

Sigma Healthcare will resume as Chemist Warehouse's first line FMCG (fast moving consumer goods) wholesaler from December and has had to reinvest some of the early benefits from its ongoing cost reduction program, Project Pivot.

The company has stated that the new contract is the only reason for the downgrade to guidance and the core business is performing “ahead of expectations”. Sigma expects earnings growth to accelerate in FY21 as the new contract reaches its $700-800m annualised run rate.

The new deal with Chemist Warehouse provides for an upturn in volumes and distribution centre utilisation. Still the products will not carry any CSO (community service obligations) reimbursement and require material working capital involvement.

This reflects a challenged wholesale market, Credit Suisse asserts, with increasing price pressure on PBS (pharmaceutical benefits scheme) medicines and no increase in the CSO funding.

Moreover, EBOS Healthcare holds a commanding 40% market share, creating greater competition among small operators. The broker also is sceptical about any material improvement further out for CSO wholesalers, given the current tight funding environment.

Sigma Healthcare remains confident about achieving the $100m in targeted cost reductions. Around 55% of the program has already been actioned and it aims to achieve 60% of these savings from the Chemist Warehouse transition, 30% from operating efficiencies and 10% from 'smart spend' programs.

UBS remains of the view that execution on the $40m in savings not tied to Chemist Warehouse will be more difficult post the reinvestment, and it will also be difficult to determine the actual quantum of savings achieved.

Credit Suisse recognises the reinvestment has a short-term impact that should be more than offset once the sales volume ramps up, but still questions whether the full $100m in savings from Project Pivot can be achieved and sustained. The broker lowers estimates for FY20 operating earnings to $46.3m.

Value?

Credit Suisse considers the return of the Chemist Warehouse contract positive and supportive of the company's growth strategy but the stock appears expensive.

There is also execution risk in the strategy to diversify away from PBS as the company will need to win new contracts and tenders in other areas to fill out the excess capacity in its distribution centre. The relatively small market position also limits future growth projects.

Citi is more confident and upgrades to Neutral on the back of the decline in the share price. The broker expects investors will look through FY20 and focus on FY21 guidance, which will be provided at the FY20 result on March 26, 2020.

FNArena's database has three Sell ratings and one Hold (Citi). The consensus target is 54c, suggesting -9.6% downside to the last share price.

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