a comprehensive review

Upstart competitors look like putting a dent in Sigma's exemplary growth record this year. But while the industry is changing quickly, this company has staying power.
‘The devil is in the detail’, so they say, and Sigma Pharmaceuticals is caught up in more than its fair share of devilish detail at the moment. Although you’d hardly notice it when visiting your friendly pharmacist to get a prescription filled, the pharmaceutical industry is experiencing great change. How it will all pan out won’t be known for years, but the impact is already being felt by the companies involved, and it was behind Sigma’s recent profit downgrade (see our update on 3 Jul 07 (Buy – $1.745)).
To explain what’s going on, we need to start with some background. The way pharmaceuticals are priced and sold in Australia is highly regulated, partly by means of the Pharmaceutical Benefits Scheme (PBS), which subsidises the cost of many medicines. But growth in the PBS has been getting out of control lately and the Government is keen to bring it back into line.
Raft of changes
As part of a raft of changes to the PBS last year, the Government agreed changes with the pharmacy industry. These changes had the effect of reducing the gross margin that wholesalers (such as Sigma, Symbion and Australian Pharmaceutical Industries) were allowed to charge on drugs from 10% to 7%.
On its own, this would obviously have hurt these wholesalers, which already operate on thin margins (although Sigma’s wholesaling margins are by far the best in the industry). So to compensate the industry for the 3% margin cut, and in recognition of the essential community service function that the drug wholesalers provide, the Government agreed to pay $150m a year into a ‘Community Service Obligation’ (CSO) pool. This amount is set to increase over the next few years as the market grows.
In return for certain commitments, the pool funds payments to the pharmaceutical wholesaling industry to ensure that medicines are delivered to pharmacies regularly, especially in rural and remote communities. It’s similar to the ‘Universal Service Obligation’ under which Telstra has to provide essential services throughout Australia and gets funding (not nearly enough it believes) to help it meet the extra costs of doing so.
The problem with the CSO system is that the three main pharmaceutical wholesalers aren’t getting the full amount from the CSO pool. A new entrant, logistics company DHL, has also claimed it is a wholesaler and is receiving payments from the pool for making deliveries to pharmacies. Not surprisingly, the three main wholesalers have contested the payments made to DHL, claiming they are against the spirit of the CSO. While there is reason to think DHL may be banished from the paddock eventually, for now it is milking the CSO cow.

Less in the kitty
That means less in the kitty for everyone else, including Sigma. With the Government-imposed reduction in wholesaler margins, and compensation from the CSO pool not fully offsetting that reduction, Sigma’s margins are under pressure. If DHL can be unclamped from the CSO teat, though, then Sigma’s profit before tax should get a $10m a year boost.
So that’s what’s going on in the Healthcare division. As we said on 3 Jul 07, though, we are slightly more concerned by developments in the company’s Pharmaceuticals division, which manufactures a range of over-the-counter medicines and generic drugs. As you’ll remember from our initial review of 17 May 07 (Long Term Buy – $2.42), Sigma hung its hat on the future growth of the generic drugs market by merging with Arrow.
The volume of generic drugs sold in Australia is set to increase sharply. About $1.7bn worth of branded drugs will come off patent over the next few years and somebody has to supply their generic equivalents. Sigma and AlphaPharm (recently acquired by international generics giant Mylan Laboratories) each have about one-third of the current generics market, and therefore look to be in the box seat.
Volumes to increase sharply
But competition appears to be increasing, with existing players and some new entrants jostling for position during the current period of uncertainty. Pricing across the entire industry is under pressure, but an aggressive Indian generics company, Ranbaxy, in particular, is heavily discounting the prices of the highest selling generic drugs.
Adding to this pricing pressure is the Government, which wants to see a growing, but competitive, generics market. Generic drugs cost the PBS, and therefore the taxpayer, less – particularly when the Government pushes through price cuts, as it did recently on many generic drugs, with further cuts set for next year. The Government expects these moves to save the taxpayer $580m over the next four years.
Now, none of this is new – these changes have been flagged for some time. What we don’t know is how it is all going to play out; indeed, no-one can know. At the moment, the Government-mandated price decreases and industry discounting are affecting Sigma’s profitability – and it may well continue. Sigma is expecting a recovery in second-half profit, which we’ll examine in more detail shortly, but the uncertain competitive environment probably isn’t going away any time soon.
Bear hug
But let’s look at what we do know. Sigma’s wholesaling and generics manufacturing strategies are inextricably linked – and we see that as a source of competitive advantage in the long run.
We mentioned in our 17 May review that Sigma has been signing up pharmacists to its ‘Embrace’ program (937 pharmacists had joined by the annual meeting in May). Under this program, pharmacists get exclusive pricing, a financing package, electronic ordering, and the convenience of dealing with one main supplier. In return, pharmacists agree to source at least 85% of their business through Sigma and, importantly, to substitute 35% of their prescriptions for generics.
The Embrace program is clearly designed to lock pharmacies into the company’s wholesale division, as well as provide a ready-made market for the generics produced by its manufacturing arm. Indeed, we’d call it more of a bear hug than an embrace.
We also spoke to a non-Sigma aligned pharmacist to get the inside view, and his comments were revealing. First, he said that smaller generics players would likely find the going tough because they typically didn’t carry a full line. Even if certain drugs were heavily discounted, it often wasn’t worth the extra paperwork for the pharmacist to deal with a smaller supplier.
Our man on the inside also noted that pharmacists are ‘pretty set in their ways’ (aren’t we all?). Getting them to take a risk, as they see it, on a new generic that isn’t manufactured in Australia (only Sigma and Alphapharm have local manufacturing operations) isn’t necessarily easy. Whether it’s risk aversion, or just human inertia, the willingness of people to change is frequently overestimated by new market entrants.
These factors, in our view, will make it more difficult for the new kids on the block to gain market traction. But we’re also realistic – discounting tends to grab market share and hurt industry profitability in the short term. In the long run, though, the strongest companies tend to win through – and Sigma is no 97-pound weakling.
Profit to be flat
Let’s now return to Sigma’s recent downgrade. The company expects profit for the year to 31 January 2008 to be flat, but with a 65% weighting to the second half. So we can deduce that Sigma is hoping for a profit of about $68m in the second half (beginning 1 August). As you can see from Table 2, this implies a strong second-half recovery, representing growth of 23% on the previous corresponding period.
Table 2: Second half snap back? Given the industry pressures, that might seem like an optimistic target. And it may well be, although managing director Elmo de Alwis isn’t known for aggressive forecasts. But there are some very sound reasons for expecting a second-half recovery.To start with, the second half will include efficiencies from Sigma’s new Dandenong manufacturing facility. Perhaps more importantly, though, Sigma is launching about a dozen new generic drugs this year. In particular, three ‘blockbuster’ generics are being launched over the next few months and, as the only wholesaler with a manufacturing arm, Sigma looks set to capture significant market share. If de Alwis is correct, then the stock is trading on a prospective PER of 14, and a dividend yield of 5.1% fully franked.
Putting on our gloomy hat, though, let’s assume de Alwis is being too optimistic. High-quality companies have a habit of bouncing back, but it doesn’t always work out like that. So, rather than rising 23%, let’s now imagine that second-half profit falls an arbitrary 10% to $50m. The 2008 net profit figure would then be around $86.6m, down 17% on last year. After adding back amortisation of $9.9m, we'd get depressed earnings per share of 10 cents, placing the stock on a forecast PER of 17. That’s not a high number for a quality pharmaceutical company going through a rough patch.
On-market buyback
We’ve so far ignored the effect of the additional on-market buyback that was also announced with the downgrade. Sigma has authorised a buy back of up to 10% of its shares on issue, which at current prices will cost around $162m. This should increase earnings per share, and we believe the company can accommodate the extra debt without much trouble.
So can we draw any conclusions from all this?
Clearly there’s a lot of uncertainty in the pharmaceutical industry at the moment. And investors are doubly upset because Sigma has recently been pipped at the post in its attempts to buy Symbion’s wholesaling arm (it also walked away from acquiring Australian Pharmaceutical Industries last year). Uncertainty and frustration make for unhappy shareholders, and a 29% price fall since 17 May 07 (Long Term Buy – $2.42) has been the result.
But even if we assume profits fall this year, we think the stock looks too cheap. If a few things go right – such as the issue with the CSO pool being resolved or Sigma’s market share continuing to improve – then profits could stage a quick turnaround.
Once we raise some cash, we’re likely to add Sigma to the Growth Portfolio (we’re currently fully invested and therefore need to sell something first). There are never any guarantees in such a fast-changing industry, but we’re confident enough to call Sigma a BUY.