The Motley Fool

Sigma Pharmaceutical Limited and Australia Pharmaceutical Industries Ltd: Should you buy?

The thematic of an aging Australian population is a strong tailwind set to support healthcare stocks, which is a reason why private hospital operators like Ramsay Health Care (ASX; RHC) have outperformed the market.

On a similar line of reasoning pharmaceutical retailers and wholesalers, like Sigma Pharmaceutical Limited (ASX: SIP) and Australian Pharmaceutical Industries Ltd (ASX: API) should also benefit because greater demand for healthcare services should lead to higher drug sales. However because of the dynamics acting on the pharmaceuticals industry there are three reasons why I think they don’t make good investments.

Capped wholesaler margins

Both Sigma and API are vertically integrated players with a strong presence in both retail and wholesale, but the wholesale segment can make up a significant portion of this if API’s figures represent industry norms (75%). A large number of drugs are subsidised by the government via the PBS scheme, so the industry is heavily reliant on government expenditure.

Under the PBS a wholesaler’s margin is capped at 7% of the government determined manufacturer price. However in reality the actual margin is smaller because they provide discounts and incentives in order to secure business from retail pharmacies. The continued success of big box discount pharmacies like Chemist Warehouse will continue to put downward pressure on wholesaler margins as bargaining power shifts to retailers.

Wholesale by-pass

Historically drug manufacturers sell to pharmacies via wholesalers, with a small level of direct selling from manufacturers to fill bulk orders from pharmacies. Pfizer’s decision back in 2011 to establish exclusive direct distribution relationships with pharmacies raised speculation on whether other major drug manufacturers will follow suit.

These moves will reduce wholesaler revenues as less volume passes through them, but will also lead to an outsized hit to profits. To give a sense of perspective a report from Deloitte estimates that if the top four drug manufacturers (including Pfizer) went direct to retailers then wholesale profits will fall over 50%.

To make matters worse for wholesalers there is also a growing threat of by-pass coming from downstream. The increasing scale and self storage capabilities of discount pharmacies like Chemist Warehouse make them less reliant on wholesalers.

Patent cliff

Over the past few years several blockbuster drugs have come off patents and this is set to continue over the next few years. The majority of these drugs are biological drugs (rather than chemical drugs), and there is currently conjecture overseas as to whether the generics will be good substitutes for branded ones.

There seems to be no such doubts in Australia however, with the PBAC (who decides which drugs should be listed for subsidy in the PBS) being the first in the world to recommend a generic biological drug as a suitable substitute just a few weeks ago. This seemingly paves the way for other generic biological drugs to be listed on the PBS, which will hurt wholesaler profitability.

Some players, like API, are mindful of these threats and have been growing their retail presence to reduce their wholesale exposure. Over the past five years API’s revenues from the retail segment have steadily grown from 18% to 25% of total revenues due to the success of its Priceline stores.

With strong momentum in the form of like-for-like store growth, improving franchise satisfaction from customers and a strong loyalty program the company has a strong retail platform to reduce its risks from wholesale.

Even with this in mind though the current operations of both Sigma and API are quite exposed to the risks outlined above, and as such they would not be my investment picks.

However there are good stock picks out there, especially with the tumult kicked up by “Grexit” and China. The analysts at the Motley Fool have handpicked their top stock for the year so make sure you check it out.

Where to invest $1,000 right now

When investing expert Scott Phillips has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for more than eight years has provided thousands of paying members with stock picks that have doubled, tripled or even more.*

Scott just revealed what he believes are the five best ASX stocks for investors to buy right now. These stocks are trading at dirt-cheap prices and Scott thinks they are great buys right now.

*Returns as of June 30th

Motley Fool contributor Simon Chan has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

Related Articles...