API/Sigma Merger Plan Rears, Again

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A merger of Australian Pharma Industries and Sigma Healthcare is logical but ACCC issues are uppermost in broker views.

-Earnings outlook for both companies is subdued
-Delay engaging with API, as Sigma awaits Accenture report
-Outlook for Sigma needs clarification, post Chemist Warehouse
 

By Eva Brocklehurst

Australian Pharmaceutical Industries ((API)) has upped the ante on Sigma Healthcare ((SIG)), raising its stake in the business and announcing details of a takeover plan. API and Sigma are the number two and number three drug distributors in Australia, and there is a large crossover in the footprint of both as well as duplication of warehouses nationally.

API expects pro forma gross cost savings of $60m by the third year of the merger, arising from distribution and corporate functions. The proposal would mean API owns 63% of the combined entity and Sigma would receive 0.31 API shares and $0.23 cash for each share. At the last close this implies around $0.686 a share for Sigma and a 46.5% premium to the one-month VWAP.

Citi expects underlying community pharmacy revenue and earnings to be flat or decline slowly going forward. Sigma-branded pharmacies have been doing relatively well in a difficult environment but there are several headwinds in tow, including lower PBS (pharmaceutical benefits scheme) pricing, direct distribution by some pharmacies and slowing retail sales.

Credit Suisse estimates a combined API/SIG would have 40-45% market share, roughly in line with EBOS, post the transfer of the Chemist Warehouse contract. The broker suspects Sigma has been offering large discounts to pharmacies in an attempt claw back market share and needs scale for operating leverage.

Sigma announced in July that its major customer Chemist Warehouse was moving suppliers, and this was a catalyst for a material downgrade to future earnings expectations as well as weakness in the share price. Ultimately, this has prompted the bid from API.

Bell Potter, not one of the eight stockbrokers monitored daily on the FNArena database, believes API's decision to go public with the details of its offer is a rational and well timed strategy, aimed at jolting the Sigma board into action. Intent has been signalled via the acquisition of a 12.95% stake in Sigma and an overview of the merger plan.

Despite the deal being beneficial from an industry perspective, Credit Suisse points out a binding offer is yet to emerge and the ACCC (Australian Competition and Consumer Commission) may object. The broker does not consider the deal will be accretive for API until FY22 and, with the negative earnings risk in the short term, considers an Underperform rating appropriate for both stocks.

The major issue, all brokers concede, is getting around the ACCC, yet there are also significant conditions to the bid, including the usual due diligence and board recommendation from Sigma. Citi observes there is plenty of time to reflect on the potential outcome as the next catalyst is likely to be the Accenture report in February from Sigma.

Sigma has confirmed it is awaiting the outcome of the review before making any decision on due diligence. Credit Suisse suspects, while Sigma may be willing to engage with API, the delay could mean the deal does not eventuate.

Consolidation

Brokers consider the economic rationale for consolidation of the industry is strong, as pricing of prescription medicines is now largely generic and there is significant overcapacity and duplication. In a market where there is increasing price pressure on the PBS, no increase in the funding pool, and Sigma is losing 40% of its distribution revenue, consolidation is key to improving profitability.

API has recorded only modest earnings growth over the last two financial years, while Sigma shareholders have endured reductions to dividends and a slump in the share price, Bell Potter points out.

The broker believes the outlook for Sigma shareholders is also poor, as large reductions to earnings are in train. While not providing equity research on Sigma, the broker believes the rationale for the merger remains compelling. Bell Potter maintains a Hold rating and $1.66 target for API.

ACCC

in 2002, the ACCC dismissed the merger of API and Sigma on the grounds that it created a duopoly in the wholesale distribution market and the two largest entities would hold around 90% of the market.

Since then, an additional wholesaler has been introduced, DHL is increasing its presence and more manufacturers are choosing to go direct. Nevertheless, Credit Suisse points out market share is still concentrated and this may be of concern to the ACCC.

Citi asserts the ACCC is increasingly unpredictable and, while it is hard to argue this merger would not lessen competition, points out this is an unusual market. The federal government sets drug prices and the drug distribution sector is highly regulated.

Morgan Stanley believes the FY21 operating earnings (EBIT) outlook for Sigma needs clarification as the company will be in a significantly weakened competitive position. As a result, the broker suggests the ACCC may have a more lenient view versus history with respect to consolidation in the industry.

FNArena's database shows three Sell ratings and one Hold (Citi) for Sigma. The consensus target is $0.47, signalling -19.0% downside to the last share price. The dividend yield on FY19 and FY20 forecasts is 6.5% and 3.6% respectively. There are two Sell ratings for API. The dividend yield on FY19 and FY20 forecasts is 4.7% and 4.9% respectively.

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