Small Caps | Oct 03 2023
This story features SIGMA HEALTHCARE LIMITED, and other companies. For more info SHARE ANALYSIS: SIG
While interim results for Sigma Healthcare met expectations, brokers see margin upside from improved operating leverage.
-Sigma Healthcare released in-line interim results
-Chemist Warehouse contract will boost margins
-No capital raise expected by Citi
-Risk of increased government regulation
By Mark Woodruff
August's interim result for pharmaceutical wholesaler and distributor Sigma Healthcare ((SIG)) proved largely in line with expectations, but one take-away is the company is on track to deliver higher earnings margins.
Sigma engages in both the manufacture and distribution of pharmaceutical products through pharmacies, the grocery channel and as private label. The company is one of three major pharmaceutical wholesalers in Australia with 20% market share.
Most of the distributed pharmaceuticals are subsidised on the Pharmaceutical Benefits Scheme (PBS) and analysis by Citi highlights the sector's growth has largely mirrored the growth in the PBS over the past decade.
In recent years, government reforms to curb growth in the PBS have negatively impacted Sigma.
However, the company wrested a large Chemist Warehouse contract from Ebos Group ((EBO)) in early-June worth $2bn annually. This contract added to the company’s existing Chemist Warehouse contract of $1bn for fast-moving-consumer-goods (FMCG) products, which represented around 30% of Sigma’s annual sales.
The company will now supply both PBS medicines and higher-margin FMCG to Chemist Warehouse for five years, having previously lost the PBS contract for the prior five-year period to Ebos Group.
Even though Sigma is set to emerge stronger after the contract win, the company is still vulnerable to industry or company-specific events, according to Ord Minnett, given its low single-digit operating margin.
At first half results, management targeted a medium-term earnings (EBIT) margin range of 1.5%-2.5%, which compares with Ord Minnett’s 2% mid-cycle estimate.
The FY23 margin was 0.5%. The broker forecasts a 0.6% margin in FY24 and a further increase as management grows the higher-margin third-party logistics division and exclusive label products.
Improved operating leverage is also anticipated from the larger Chemist Warehouse contract.
Adjusting for the sale of the Hospital business and abnormal sales of rapid antigen tests in the previous corresponding period, wholesale sales on a like-for-like basis rose by 8% to $1.5bn in the first half.
Ord Minnett attributed the sales increase to improved stock availability and strong growth in over-the-counter volume across all regions.
Like-for-like earnings (EBIT) of $15.9m were broadly in line with the broker’s expectation after adjusting for one-off items including the $8.7m Hospital business sale.
The company achieved a -21% reduction in operating expenses as leverage began to kick-in after IT and distribution centre investments over the last six years, explained Ord Minnett.
Including one-offs, management reaffirmed its FY24 reported earnings guidance range of $26-31m. This implies second half earnings of $6.1m, should the midpoint of guidance be met.
While earnings guidance is achievable, Morgan Stanley felt FY24 and FY25 margins will be softer than previously expected and lowered its 12-month target price to 75 cents from 80 cents.
Sigma operates through the Amcal, Guardian, PharmaSave and Discount Drug Stores retail brands, and also provides services to retail pharmacists in Australia.
The company has continued to develop its private and exclusive product range, with 300 products in the pipeline, and 250 expected to be launched in FY25. Key categories include medicines, health & wellbeing, as well as beauty, fragrances and gifting.
Sigma declared a fully franked interim dividend of 0.5cps and the company should comfortably achieve its unchanged 55% dividend payout ratio, according to Ord Minnett, especially as the company’s investment cycle is largely complete.
This broker forecasts -$40m in total capital expenditure over the next five years compared to -$260m over the past five years.
One of those prior investments has been in a new enterprise resource planning (ERP) software system, which has been 100% stable and is standardising many of the company’s processes.
System uptime is now better than pre-ERP implementation, running above 99.9%. Given past implementation issues, Shaw and Partners suggested these outcomes should drive not only investor confidence, but also company earnings.
The disposal of the Hospitals business was the main driver of a -21.1% decline in inventories compared to FY23, explained Macquarie.
A -$150m investment in working capital will be needed for the Chemist Warehouse contract which begins on July 1, 2024. The company intends to finance this cost through a combination of extended terms from suppliers and debt. There is also potential for the sale and leaseback of the company’s remaining warehouses.
Citi is not anticipating an equity raise though acknowledged forecasting is difficult given Sigma remains in transition ahead of the commencement of the Chemist Warehouse contract.
Management plans to disclose further details on the implementation plan for the contract at full year results.
While net debt was $82.2m at the end of July, up from $67m on January 31, management noted the gearing level should peak around October next year.
The winning back of the entire Chemist Warehouse contract represents an important milestone, noted Shaw and Partners, as it allows an increase in capacity utilisation to a more optimal level and the restoration of the earnings margin.
According to this broker, there is a chance Sigma Healthcare will increase its capacity utilisation either by participating in M&A activity or by being acquired.
On the one hand, Macquarie sees upside risk via operational leverage from the extra Chemist Warehouse volume. On the other hand, the broker is wary of the impact on margins should government regulation become tighter.
FNArena's daily monitoring of Sigma Healthcare consists of five brokers. Shaw and Partners has a Buy rating, while Ord Minnett, Macquarie, Citi and Morgan Stanley all have Hold (or equivalent) recommendations.
The average target price of these five brokers rose to 81.4 cents following interim results from 76.8 cents prior, which suggests 18% upside to the latest share price.
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