The New Criterion: tough medicine ahead for the drug distributors

Tim Boreham

Independent Investment Research

Sigma Healthcare has put a brave face on the loss of a chemist supply contract that accounts for about 40 percent of its revenue, arguing that there wasn’t much point refreshing the deal if it wasn’t going to make a decent margin out of it.

Unconvinced, investors marked down Sigma stock by a symmetrical 40 per cent non Monday’s news, with the contract loss overshadowing other issues in the sector that’s heavily competed by a handful of full-line wholesale distributors.

Sigma said it failed to come to amenable terms with the fast growing Chemist Warehouse and MyChemist chains, with the contract transferring to the NZ-based, dual listed Ebos Group from June next year.

Broker Morgans bluntly dubbed the switch as a “major contract for Ebos and a major loss for Sigma.”

 Sigma CEO Mark Hooper points out the non-contract also frees up $300m of working capital and ensures a “clearer future”. Given the company is seen as undergeared, that enhances the prospect of some kind of acquisition.

The announcement shouldn’t exactly have been a bombshell, given speculation had swirled for months about whether the contract would be renewed and on what terms.

In May last year Chemist Warehouse told Sigma it would source some high-margin products on better terms from a competitor leaving Sigma with the less lucrative stuff.

Naturally, this cherry picking went down like a bitter pill in the Sigma camp, which dragged Chemist Warehouse to court (and won).

Sigma continues to supply the chemist “banner groups” Amcal, Guardian and PharmaSave (it also distributes to hospitals).

If it were merely the case of Sigma losing a big but low-margin contract, perhaps the market could have reacted better.

In truth, the drug distribution game is becoming increasingly unpalatable as the federal government continues its remorseless efforts to rein in the cost of subsidising prescription drugs.

Under the so called Community Service Obligation (CSO) scheme, the three participating distributors are required to provide any listed drug to anywhere in Australia within 24 hours.

In return, they get the benefit of a funding from a taxpayer funded CSO pool. Under a related mechanism, the price of drugs subsidised by the Pharmaceutical Benefits Scheme (PBS) are agreed on and frequently renegotiated (usually downwards).

In its accompanying trading update, Sigma reported that the latest agreed round of PBS price cuts (in June) had hit harder than expected; and that trading in May and June had been “particularly weak.”

Even before the contract loss becomes effective, Sigma has adjusted expected current year ebit (for the 12 months to January 31 2019) to $75m, from an expected $90m previously.

The company expects 2019-20 earnings of $50m – half the 2017-18 tally, But some pharma watchers are less generous that that with Morgan Stanley pencilling in only $35m.

“Overall trading conditions have deteriorated and we see potential for material risk beyond the Chemist Warehouse agreement not being renewed,” the firm intoned.

Rival Australian Pharmaceutical Industries (API, $1.54) – which supplies chemists including Priceline and Soul Pattinson – reports soft retail conditions, with 2017-18 results still expected to be marginally above the previous year’s.

Performance wise API could also do with a vitamin pill, although it managed to confine its half year performance (to February 28 2018) to an 8 percent earnings decline (to $26.8m on steady revenue of $2bn).

In the longer term, the chemists (and thus the distributors) face a shakeup if new entrants such as Amazon or logistic group DHL get serious about the pharmacy sector.

In the US, chemist stocks were whacked recently after the feared online giant said it would acquire an online pharmacy called PillPack.

Locally, chemists are protected against competitors such as supermarkets because of restrictive ownership rules.

In theory at least, pharmacies are meant to be owned by individuals who can control only a certain amount of stores, but these rules are being widely circumvented.

In any event there’s nothing to stop the likes of Amazon from competing in distribution – within or without of the CSO realm.

Last year drug maker AstraZeneca said it would distribute some of its higher-value drugs directly to pharmacies, using DHL. Pfizer also moved to circumvent the wholesale distributors in 2015.

Overseas, Amazon and DHL have already toyed with drug delivery using drones. In the UK, a mob called Med-Express experimented with an emergency delivery of Viagra and the morning after pill (presumably in that order).

Sagely Sigma and API have sought to reinvent chemists from being pill dispensers to providers of beauty care and front-of-the shop wellness products. At the periphery, they’re usurping – or complementing -- the role of GPs by providing services such as dietary plans and flu shots.

Reflecting the trend, API last month said it would fork out $61m for Clearskin Clinics, which has 44 mainly franchised outlets in Australia and NZ.

The clinics provide laser hair removal cosmetic injectables and acne treatments.

The chain is profitable: it’s expected to produce ebitda of $14m on revenue of $48m on a fully-owned basis (API moves to gradually to 100 percent ownership by September 2021).

This acquired business could indeed prove a thing of beauty if the fundamentals of the drug-running game continue to erode.

EBOS Group (EBO) $18.83

The owner of the Symbion distribution business, Ebos doesn’t get much attention on this side of the ditch. Yet its $NZ2.7 billion ($2.47bn) market cap overshadows Sigma’s $500m and API’s $780m.

Of course it’s about the get bigger thanks to those gaudy yellow and red Chemist Warehouse barns: management expects contract to add $NZ1.1bn of revenue a year, compared with the company’s $NZ7.5bn turnover.

Ebos CEO John Cullity also contends the contract – for an initial five years with a possible three year extension – will “generate an acceptable return on capital.”

Presuming the terms were more favourable than those offered by Chemist Warehouse to Sigma, the Kiwis must be either cannier negotiators or are working off a lower cost base that makes the deal stack up.

Broker Morgans has no doubt the deal will be accretive in Ebos’s hands, estimating the contract will add 7.4 percent to Ebos’s earnings per share in the 2019-20 year.

While Ebos runs diversified healthcare and consumer brands, Symbion – acquired for $NZ1.1bn in 2013 – remains a key driver of the business.

Ebos also owns pet care brands including Blackhawk, Masterpet and Animates, so if the drug distribution game truly goes barking mad at least it’s got something to fall back on.

Tim Boreham edits The New Criterion

Disclaimer: The companies covered in this article (unless disclosed) are not current clients of Independent Investment Research (IIR). Under no circumstances have there been any inducements or like made by the company mentioned to either IIR or the author. The views here are independent and have no nexus to IIR’s core research offering. The views here are not recommendations and should not be considered as general advice in terms of stock recommendations in the ordinary sense.








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Editor of New Criterion
Independent Investment Research

Many readers will remember Boreham as author of the Criterion column in The Australian newspaper, for well over a decade. He also has more than three decades’ experience of business reporting across three major publications.

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