Reforms to the Pharmaceutical Benefits Scheme (PBS) have had a large impact on the financial performance of pharmaceuticals over the last couple of years, however conditions are now easing, offering opportunities in a demographically favourable sector.
Sigma Pharmaceutical Limited (ASX:SIP) is Australia's largest pharmacy driven wholesaler through the brands Amcal (including Amcal Max) and Guardian. The recent acquisition of Central Healthcare adds access to the large private and public hospital markets. Other initiatives by Sigma include the further development of exclusive and private labels, which are expected to cover over 300 products by the end of the 2014 calendar year; a heavy investment in data driven software allowing pharmacies to optimise store layouts and increase stock turns; plus the further automation of company owned distribution centres.
Following the 2013 collapse of Harrison Group (which operated 14 pharmacies and 6 medical centres) Sigma expensed $7.4m of bad debts in its latest (calendar) financial year. In common with other pharmaceutical wholesalers, generous terms (up to 60 days credit) are offered to pharmacies on stock. Sigma is carefully reducing term length with the aim of moving to a 45-day cycle. Although improved credit controls and reviews are now in place, retail pharmacies continue to do it tough presenting a continuing risk for wholesalers.
Sigma Pharmaceutical is well capitalised with no debt and $67 million in the bank. The acquisition of Central Healthcare will provide a positive impetus to profits in the current year and beyond. Growth in earnings over the next few years is estimated to be at least 6% per annum. A share price of 72c places Sigma on a 2014 (calendar year) price earnings ratio of 13.7. Sigma looks a solid buying opportunity with sustained growth prospects.
On face value Australian Pharmaceutical Industries Ltd (ASX:API) has a similar profile to Sigma, however there are stark differences:
1. API has higher exposure to direct retail – 22% of revenue versus Sigma at 4%.
2. Sigma's net margin is 2.4%; compared to API's 1.8%.
3. On three-year averages Sigma's bad debts total 0.1% of revenues; API's 0.8%.
4. Although Sigma has generous terms on stock, it doesn't directly put money into the retailer's business. API does through direct loans and an arrangement with Amex, where API assumes credit risk and the payment of all fees. In vulnerable times, this places API at much greater risk of bad debts/write-downs. Recently an asset impairment charge of $131m was signalled.
API's underlying earnings remain strong however and the current share price of 55c is likely to prove a reasonable buying point for this stock. Current debt to equity ratio is 20%.
Foolish takeaway
With pharmaceutical suppliers experiencing setbacks over the last few years it's a good time for investors to take a look at the opportunities available. With a high level of fixed costs in their businesses both Sigma and API have good leverage to any upturn in conditions. The effects of PBS reform are moderating as both companies make adjustments in their distribution platforms and sales mix. In my view Sigma is best positioned to benefit, although API has more upside to any further rises in consumer confidence.
