Due to the uncertain regulatory environment, including the...

Due to the uncertain regulatory environment, including the potential for supermarkets to ultimately play a greater role in the pharmacy industry, we have reduced our overall assessment of the stock’s investment quality, and lower our Accumulate and Buy trigger prices to $2.40 and $2.20 respectively from $2.55 and $2.35. We retain a Buy on the stock as we believe SIP remains in a strong industry position, both in wholesaling and manufacturing. And SIP itself may be looking attractive to a predator.

SIP’s share price has weakened considerably in the face of a number of uncertainties and industry dynamics some of which impacts are difficult to quantify. An issue is an increasingly harsh regulatory environment around the pricing of generic drugs. Following a mandated 12.5% fall in a drug group when an equivalent generic compound launches, the government then legislated a once-off 25% price cut in August 2008. SIP appears confident these price cuts will have little impact on margins as it will simply grant pharmacies a much smaller discount. This implies potentially substantially lower margins for pharmacies, and with generics representing a growing proportion of the drug market, a commensurately greater dent in pharmacy profitability. It remains to be seen whether the generics suppliers such as SIP will not share some of the pain.

There is a perception that Ranbaxi Laboratories, one of the fast growing Indian pharma’s, could become a serious threat. This concern may be overblown given that company’s negligible market share in Australia, and is probably a reaction to Ranbaxi’s aggressive pricing of a particular product. While we are confident SIP’s generic business is strong with a potent management group, the opportunity for generics players created by ballooning drug patent expiries over the next few years means it would be naïve to discount entirely the possibility of an increasingly competitive market place. SIP’s new marketing package, Embrace, that ties pharmacies into accepting a broad suite of product including SIP’s generics portfolio should provide a robust defence against new players and other incumbents sniping for market share. Also the cuts in generics pricing will be a deterrent. The expanded service offering represented by Embrace creates an additional layer of integration between SIP and its customers and is proving very popular. By March 2007 around 800 pharmacies had already signed up to the package with half won over from non-Sigma aligned banner groups. Embrace customers must order 85% of their total wholesale drug supply from SIP. In return they receive preferential pricing across SIP’s entire offering. The increased volumes and efficiencies compensate for the lower prices.

An issue that is not obviously surmountable is the cost borne by wholesalers distributing product to regional areas where the distances and low volumes are uneconomic. Due to inadequate funding by the government this service is costing SIP around $800K a month. Management had previously been confident of redress, but is becoming less so and appears resigned to a less than optimal resolution of the issue. This and perhaps the lower pricing in the Embrace offering meant that the strong sales growth in wholesaling reported in the last full year result to January 31, 2007 was disappointingly accompanied by little operational leverage, ie profit growth was only marginally above sales growth (+12.9% vs +11.0%). Increasing volumes from Embrace should begin to provide an offset.

Also weighing on the share price is SIP’s missing out on buying Symbion’s consumer products division and the opportunity to share infrastructure costs with that company’s wholesaling division, after a consortium of private equity and Healthscope bought Symbion. SIP may have another tilt at API, the third major drug wholesaler, although competition concerns could see such a bid blocked or at least diluted. Should consolidation occur without SIP’s participation, it should still benefit from a less competitive, duopolistic environment. That said there will always be the potential for the government to chisel away further at the wholesalers’ profitability.