Nearly four and a half years ago Sigma Pharmaceuticals announced a merger with Arrow Pharmaceuticals and its share price soared by more than 20 per cent in a day. The markets excitement about that deal has, however, come back to haunt Sigma.
Three weeks ago Sigma sought and was granted a trading halt from the ASX because, it said, it expected to make an announcement to the market in relation to revised earnings guidance arising from "year-end adjustments." Then it was silent.
Today the company shed some light on the reasons for the suspension of trading and the nature of the adjustments.
"As a result of increased market pressures, in the generics business in particular, the future cash flow forecasts that support the carrying value of goodwill have declined. The reduction in the expected cash flows, combined with changes in Sigmas estimated cost of capital, are likely to result in a material reduction in the carrying value of goodwill," the company said in an update to the ASX.
Sigma has a lot of intangibles in its balance sheet $1.33 billion of which nearly $1 billion is goodwill. There is, however, a particular issue that relates to the Arrow purchase.
The markets euphoria about the merging of the two biggest local generics manufacturers, and the consequent reduction in the significance of the low-margin and difficult Sigma wholesaling business within its portfolio, put a rocket under the Sigma share price and the apparent value it paid for Arrow.
The deal was purely scrip-based. When it was announced it valued Arrow at about $666 million. Three months or so later, when it closed, the increase in Sigmas share price had pushed the notional value up to $975 million.
While obviously a very positive endorsement of the deal, it had unfortunate balance sheet effects because the acquisition accounting treatment of the deal meant Sigma booked more than $300 million of extra goodwill in its accounts, relative to what it would have had to absorb had the deal been accounted for at the price when it was announced.
That wouldnt have mattered too much while Sigmas share price remained at around the $3 level it reached after the announcement that it would acquire Arrow but, of course, then came the financial crisis and sharemarket crash. Even as the markets recovered, Sigma, which had raised almost $300 million of equity last year at just over $1 a share, continued to languish around 90 cents.
Its problems appear to be two-fold and compounding. Late last year there was heavy discounting in the generics market, which would not only have impacted its profitability but its expectations of future cash flows. Couple that with the steep decline in its share price and the inflated value at which Arrow was being held in its balance sheet was unsustainable.
It appears there will be some other negatives when Sigma finalises and issues its results. It referred to adjustments to reported profits that include inventory provisioning and write-downs, redundancy provisions and licence carrying values. Separate to the goodwill, it has about $300 million of trademarks and licence fees.
While write-offs of intangibles represent non-cash items, and the company says its operational and trading performance remains sound, it also said it doesnt expect to be able to pay a final dividend for 2009-10. Given that it had retained earnings of $154 million at its last balance date, and earned $32 million in the first half, that signals some very substantial "adjustments." It wouldnt surprise if all the "excess" goodwill booked in the Arrow deal, as well other non-cash losses, was stripped from the accounts.
While, in cash terms, Sigma might not be threatened by the adjustments we wont really know what its underlying position is until the detail of its earnings and its impairment charges is released most banking covenants have clauses relating to reported earnings.
Without any earnings, it would be technically in breach of its debt covenants, which explains the lengthy silence and trading halt the company has been renegotiating its banking arrangements. Sigma says that its covenants will require revision and renegotiation and this would take time, but that discussions had been positive and constructive.
It appears Sigma still has its banks support. Whether chief executive Elmo De Alwis still has his boards support is a more open question.
The $300 million raising last year was supposed to place Sigma in a strong position, with negligible ($90 million) of on-balance sheet debt and gearing. At the time Sigma was forecasting modest growth in reported after-tax earnings for the full 2009-10 year (Sigmas balance date is 31 January).
While that might be regarded as fertile ground for an action by those shareholders who provided that equity, there was an interesting slide in the presentation that accompanied the raising, within the section dealing with "key risks."
Sigma drew attention to the Australian Securities and Investments Commissions identification of impairment of assets as a particular issue for Australian companies (and a focus for ASIC). The company noted its high level of intangibles and its history of growth through brand acquisitions and referred to its periodic assessment of the carrying value of its assets, including brands.
"Impairment charges can be significant and operate to reduce the level of a companys profit and, potentially, its capacity to pay dividends," it said.
With hindsight, even if they didnt know it, investors were being forewarned.
The Sigma experience is also a warning for other companies carrying high levels of intangibles in their balance sheets and perhaps raises a question for the accounting regulators about the timing of the fair value calculations in accounting for scrip-based acquisitions. "
SIP Price at posting:
90.0¢ Sentiment: None Disclosure: Held
