‘Defensive’ Pharmaceutical Wholesalers In Focus

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New research on the Pharmaceutical Wholesaling sector identifies three stocks with long-term defensive growth within an improving government funding framework.

-First-time research on three pharmaceutical wholesaling stocks
-Each seen providing exposure to long-term defensive growth
-Ebos Group and Sigma Healthcare impacted by Chemist Warehouse
-Transformative merger for Paragon Care

By Mark Woodruff 

In a market worth more than $15bn per year, the Pharmaceutical Wholesaling sector on the ASX includes three stocks uniquely positioned in terms of growth and value, according to new research by Ord Minnett. While very different opportunities, each company is considered providing long-term defensive growth within an improving funding framework.

Offering an attractive entry point into one of the highest quality operators in the sector, after a more than -30% share price decline since March, Ebos Group ((EBO)) warrants a Buy rating from the broker.

Sigma Healthcare ((SIG)) receives an Accumulate rating (one notch below Buy) as the business screens positively versus peers on a growth-adjusted basis, while Paragon Care ((PGC)) is also rated Accumulate following a share price rally of more than 100% since a merger announcement in March.

Collectively, these companies account for around 72% of the pharmaceutical wholesale market.

Ord Minnett’s Buy rating for Ebos Group is complemented by recent rating upgrades by Citi and Jarden.

Earlier this month, Citi upgraded to Neutral from Sell noting the stock price had underperformed compared to the 3% Healthcare sector outperformance against the ASX200 since the beginning of March.

The broker attributed this weaker showing to the unwinding of the Chemist Warehouse contract (potentially secured by Sigma Healthcare), along with recent removal from the Morgan Stanley Capital International (MSCI) index.

At upcoming FY24 results, the analysts will be focusing on the Chemist Warehouse-related impact on revenue and earnings in FY25, the Community pharmacy market growth rate ex-Chemist Warehouse, and further detail on targeted cost efficiencies of between $25-50m in FY25/26.

In an uncertain macro-economic environment, Citi will also be monitoring management’s animal care growth expectations.

Ebos Group is a leading wholesaler, distributor, and marketer of not only animal care goods, but also pharmaceutical and healthcare products in the APAC region. Revenue is split 80/20 between Australia and New Zealand, and the Healthcare segment generates 84% of group earnings.

Understanding and benchmarking performance to system growth is vital to Jarden’s investment thesis for Ebos Group.

Excluding the Chemist Warehouse contract, this broker points out Australian revenue within Healthcare over FY14-23 increased at an 8% compound annual growth rate (CAGR), compared to the PBS expenditure CAGR of 6%.

In late April, Jarden upgraded its rating for the group to Overweight from Neutral on stronger valuation support and greater confidence in forecasts for Pharmaceutical Benefits Scheme (PBS) core system support (which subsidises prescription medicines).

The analysts review of this PBS support, which underpins the group’s main revenue engines in Australian Community Pharmacy and Institutional Healthcare, provided the broker with more confidence management should be able to re-build from FY25 following the loss of Chemist Warehouse.

Certainly, Ord Minnett expects Ebos to emerge from the Chemist Warehouse contract exit as a higher quality, more diversified business.

An investment in the group not only provides investors with exposure to well-established growth strategies across defensive markets such as Community Pharmacy and Institutional Healthcare, highlight the analysts, but also a best-in-class capital allocation track-record.

The broker explains management has made more than 20 acquisitions over the last decade, with an average 16.5% return of capital employed (ROCE).

Ord Minnett has set an initial $33.50 12-month target price for Ebos Group, which raises the average target in the FNArena Database to $36.38, given the broker’s prior whitelabeled research from Morningstar had a $28.50 target (Hold).

This new average target of five covering brokers suggests just under 17% upside to the latest share price. There are now four Buys (or equivalent) and one Neutral rating by Citi.

Outside of daily monitoring, Jarden is Overweight with a NZ$37 price target.

Paragon Care

Compared to the $6bn market capitalisation for Ebos Group, Sigma Healthcare and Paragon Care weigh in at around $2bn and $761m, respectively.

Ord Minnett’s initial 46c target for Paragon Care closely aligns with Buy-rated Bell Potter’s 45c target, which was raised from 31c in late-May just prior to the shareholder meeting to approve the merger with CH2 Holdings, which ultimately completed on June 3.

At the time, Bell Potter stated the merger would be transformative in creating a leading healthcare wholesaler, distributor and manufacturer operating across healthcare markets in the Asia Pacific region.

At least $10.8m in annual cost synergies would commence from FY25 and be fully realised by FY26, explained the broker.

CH2 was previously a privately-owned distributor and wholesaler of pharmaceuticals, nutritional products, medical consumables, and complementary medicines. The company also provides logistics solutions to pharmaceutical and healthcare manufacturers, including warehousing and customer service solutions.

Ord Minnett expects a significant earnings growth opportunity for Paragon Care underpinned by ongoing market share gains and operational synergies.

The merged group creates an independent healthcare wholesaler, with a Top Two position in the Australian Hospital market, along with growth platforms in Australian Retail Pharmacy (circa 8% share) and APAC Medical Technology, explains the broker.

Further highlighted are cross-selling opportunities, including offshore expansion for CH2, along with management’s strong track record, and significant alignment with shareholders.

The average target price of Ord Minnett and Bell Potter corresponds with the latest 45.5c share price.

Sigma Healthcare

Ord Minnett would pay even more than Sigma Healthcare is offering for the proposed merger with Chemist Warehouse, a “category killer” with a best-in-class retail model. The business has leapt to a 29% share of the Australian retail market, more than three times the No 2 player.

While the merger target has more than 60% store roll-out runway left in Australia, Ord Minnett’s also sees potential for material upside offshore, as the business model is exported to other countries with fragmented markets and weak store level economics. 

The broker lists Chemist Warehouse’s compelling fundamentals including the current market position, the growth opportunity, and a high return on invested capital (ROIC).

Looming in the background are competition concerns the merged company could favour Chemist Warehouse stores or worsen terms for non-Chemist Warehouse pharmacies, potentially harming independent pharmacies currently supplied by Sigma Healthcare.

While acknowledging risks exist, with an ACCC decision expected by September 4, Ord Minnett recommends investors Accumulate shares in Sigma at current levels.

Management at Sigma and Chemist Warehouse considers there are good arguments why the proposed merger will not lessen competition and will continue to engage with the ACCC to address any potential concerns.

Citi agrees competition issues can be addressed (but the process may be delayed) and Morgans remains confident the deal will go through and complete by January 2025.

On the other hand, Shaw and Partners believes the merger in its current form is unlikely to receive ACCC approval and excludes merger adjustments from forecasts for Sigma Healthcare.

The current risk/reward ratio for the deal appears unbalanced to Macquarie, with the market underestimating the risk of an amended deal with altered economics.

A first glance at the database suggests Ord Minnett’s “initiation” on Sigma Healthcare is an upgrade to Accumulate from Hold and a lift in target to $1.35 from 78 cents. In reality, the changes reflect the transition of research coverage to in-house from whitelabeling Morningstar research (as also occurred for Ebos Group).

The new target raises the average of six covering brokers in the FNArena Database to $1.15 from $1.06 suggesting nearly -15% downside to the current share price. Ord Minnett has become the high-marker with price targets set by all of Shaw and Partners, Morgans, Macquarie, Citi and Morgan Stanley below the present share price.

There are six brokers monitored daily covering Sigma Healthcare in the database including one rating of Accumulate, three Holds (or equivalent) and two Sell ratings.

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