Sigma’s Win Not Neccessarily Ebos’ Loss

This story features SIGMA HEALTHCARE LIMITED, and other companies. For more info SHARE ANALYSIS: SIG

While Sigma Healthcare is a clear winner in gaining the Chemist Warehouse contract from Ebos, the damage is not that significant for Ebos in broker views.

-Sigma Healthcare’s contract win utilises spare capacity 
-Greater diversification softens blow for Ebos Group 
-Brokers materially increase Sigma’s target price 
-Share placement aligns Sigma with Chemist Warehouse 

By Mark Woodruff

As part of its FY23 results presentation back in March, pharmaceutical wholesaler and distributor Sigma Healthcare ((SIG)) noted its was building capacity and capability to execute upon its plans.

The company had completed its distribution centres and IT infrastructure investment program and had recently sold its earnings-dilutive hospitals distribution business.

Consequently, brokers welcomed news last week the company had wrested a large Chemist Warehouse contract from Ebos Group ((EBO)). 

Mind you, upside enthusiasm for Sigma on capacity utilisation wasn't matched by downside despair by brokers for the more diversified Ebos over the low-margin contract loss.

Ord Minnett believes the contract can be retained by Sigma in perpetuity given the company is well placed to negotiate suitable terms to utilise its excess capacity.

The contract is worth $2bn annually and adds to Sigma’s existing Chemist Warehouse contract of $1bn for fast-moving-consumer-goods (FMCG) products, which currently represents around 30% of group sales.

Sigma engages in both the manufacture and distribution of pharmaceutical products through pharmacy, grocery channel and private label. 

The firm operates through the Amcal, Guardian, PharmaSave, and Discount Drug Stores retail brands, and also provides services to retail pharmacists in Australia.

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, the largest trans-Tasman healthcare and animal care business. 

Ord Minnett points out the contract is less meaningful for Ebos, representing around 10% of group profit, and management is choosing to focus on higher-margin animal healthcare and medical devices distribution.  

Ebos is no one trick pony, confirms Macquarie, and has a number of growth opportunities, in particular via Terry White, Medical Technologies (devices) and Animal Care.

The group is the largest and most diversified Australasian marketer, wholesaler and distributor of healthcare, medical and pharmaceutical products. It is also a leading marketer and distributor of recognised animal care brands.

While the contract loss is a short-term setback, Morgans remains comfortable in management’s ability to navigate a changing customer mix.

The strategy of diversifying away from regulated low-margin pharmaceutical distribution will, according to Ord Minnett, deliver ongoing superior returns on invested capital and consistently higher operating margins compared to competitors.

Further contract details

Sigma has bought some certainty with the new contract, according to Morgan Stanley, by issuing 127m shares at 64.2c ($81.5m) to Chemist Warehouse at the start of the supply contract. The placement represents around 10.7% of Sigma’s shares post issuance and helps to align both parties’ interests.

However, the analysts ponder whether the new equity stake may result in some disruption to the remainder of Sigma’s customers based on competitive grounds.

In addition, Chemist Warehouse will have the option to acquire certain non-core assets from Sigma with a value of $24.5m, otherwise Sigma will pay this amount to Chemist Warehouse.

Shaw and Partners raises its rating for Sigma to Buy from Hold as the new contract not only allows increased capacity utilisation but also a restoration in longer-term earnings (EBIT) margin to around 2% from the broker’s prior forecast of 1.4%.

Morgan Stanley also upgrades its rating for Sigma to Equal-weight from Underweight and raises its FY24 and FY25 EPS estimates materially, given Sigma’s large fixed-cost leverage.

This broker understands Ebos was providing a good level of services to Chemist Warehouse and believes the post-announcement share price fall allows for the loss of the contract. As a result of these views, an Overweight rating is retained.

Jarden takes a dimmer view of the contract loss. It’s felt the investment case has changed for Ebos in the absence of scale benefits via Chemist Warehouse for its Community Pharmacy division. 

FY23 guidance and additional earnings for Sigma

Management at Sigma has reiterated earnings (EBIT) guidance of $26-31m for FY24, with an EBIT margin of 1.5-2.5%. 

Assuming the low end of this margin guidance, and the $2bn of incremental revenue from the new contract, Macquarie forecasts an additional $30m in earnings for Sigma in the first full year of the contract, which the broker nets against a -$21m contract amortisation charge.

The broker’s total amortisation charge over five years is -$105m and comprises the cost of issued shares and the sale of non-core assets to Chemist Warehouse.

FNArena's daily monitoring consists of five brokers who actively cover Sigma Healthcare. Four of those brokers issued updated research last week and the average target price rose by 34% to 76c, which suggests -7.6% downside to the latest share price.

There are three Hold (or equivalent) ratings in the database, along with one Buy and one Sell rating.

For Ebos Group there are three Buy (or equivalent) ratings, one Neutral (Citi) and Ord Minnett’s Lighten recommendation in the database. The average target price fell by -7% to $35.06, which suggests 8.6% upside to the latest share price.

However, Citi is yet to update its research following the contract loss and the New Zealand dollar targets for Macquarie and Morgan Stanley are not taken up in the average A$ target price.

Macquarie lowered its target by -12.5% to NZ$41.85, while Morgan Stanley decreased its target by -7% to NZ$44.00.

Underweight-rated Jarden is not a database broker. This broker lowered its target for Ebos Group by around -13% to NZ$35.70.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

FNArena is proud about its track record and past achievements: Ten Years On

Click to view our Glossary of Financial Terms