Customer Dispute Overshadows Sigma

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Sigma Healthcare's dispute with Chemist Warehouse had sounded warning bells for brokers.

-Additional disruption to the sector from discounting by new wholesaler, CH2
-Potential overhang from dispute weakens overall growth profile
-What about working capital released from loss of the contract?
 

By Eva Brocklehurst

Sigma Healthcare ((SIG)) has commenced legal action against a key customer, Chemist Warehouse. The proceedings relate to the customer's use of an alternative wholesaler, which Sigma claims violates its existing supply agreement. Sigma expects the impact to be -$5-10m per annum in terms of operating earnings (EBIT).

Combined with a sluggish industry this suggests to UBS that underlying operating earnings growth could be -5% lower in FY18, whereas the company had previously guided to a 5% increase on FY17. The broker envisages additional disruption in the sector from discounting by the new wholesale chemist supplier, CH2.

Chemist Warehouse represents 7-8% of the pharmacy footprint, UBS estimates, with materially higher prescription volumes. In a contest of purchaser/provider power the broker is not certain that Sigma can prevail. Even if the resolution of the case were acceptable to Sigma, the broker suspects it would leave ongoing risk around the long-term relationship with Chemist Warehouse, and the issue of competition from CH2 would continue.

While an unsatisfactory outcome, such as the complete loss of the Chemist Warehouse contract, may not carry a material direct risk to earnings, given the low margin, volumes are significant, at over 30% of Sigma's total, and confer volume purchasing benefits to the company. UBS reduces forecasts for earnings per share by -10%, cuts the price target by -46% to 76c and downgrades to Sell.

The risk of losing Chemist Warehouse beyond the first half of FY20 is heightened by this dispute and is now Citi's base case. Chemist Warehouse accounts for around 37% of the company's total revenue. Citi now assumes a loss of the contract and a loss of one third of revenue in the second half of FY20.

The company could review its plans for capital expenditure to take account of the possibility that the contract is not renewed. Citi asserts the current three-year capital expenditure plan is incorrectly sized for a business that does not include Chemist Warehouse, as it would increase leverage, reduce the potential for buy-backs and increase execution risk.

The broker also suspects that any public visibility of the dispute will increase the price tension in other contract negotiations. The underlying operating environment is difficult, given poor prospects for pharmaceutical benefits scheme (PBS) revenues and the end of working capital benefits from the pull-back of customer credit terms. Citi also believes the multi-year distribution centre expenditure program must now be reassessed.

The broker downgrades to Sell on the uncertainty, reducing FY18-20 forecast for earnings per share by -15-46%, and finds better risk/reward elsewhere in the coverage. Target drops to 65c from $1.20.

Working Capital?

Credit Suisse has decided to be the contrarian. The broker upgrades to Outperform from Neutral. After assessing several scenarios with regard to the outcome of the Chemist Warehouse contract, the broker's base case assumes a renewal of the contract in 2019, albeit on less favourable terms.

While the risk is for a total loss of the contract, the broker believes the current share price is ignoring any working capital release as a result, and the potential to re-invest this in accretive acquisitions. Capital could also be returned to shareholders.

The release of working capital could be as much as $300m and the broker factors in $200m into its bear case to allow for future acquisitions and/or changes to working capital terms. The broker does not re-deploy this capital into acquisitions or capital management expectations at this stage.

Credit Suisse also delays the prospect of investment in the distribution centres for several years, although assumes a similar level of expenditure in outer years on the basis the centres will need re-development irrespective of lost volumes.The broker weights the probability of the scenarios and arrives at a valuation which downgrades the target to 90c from $1.20.

Morgan Stanley also notes potential for unforeseen consequences and maintains a Underweight rating. The broker believes the initiation of legal proceedings is a material negative, given the importance of this customer relationship. Moreover, the risk of recriminations/separation could overhang the company's earnings trajectory and stock price.

The broker encapsulates worsening trading terms for Sigma in its estimates, owing to greater competition among wholesalers, and this leads to a worsening working capital position over time. While growth in other and non-PBS revenues provide the offset to a flat PBS environment, low visibility on the growth profile weakens Morgan Stanley's conviction that growth is indefinitely sustainable.

There is one Buy rating on FNArena's database (Credit Suisse) and three Sell. The consensus target is $0.79, signalling -1.6% in downside to the last share price. This compares with $1.26 ahead of the litigation announcement. Targets range from $0.65 (Citi) to $0.90 (Credit Suisse). The dividend yield on FY18 and FY19 estimates is 6.7% and 6.8% respectively.

See also Other Revenue Sources Underpin Sigma on March 24 2017.
 

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