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Why the Sigma Healthcare Ltd share price has plunged 26% today

Unfortunately for its shareholders, the Sigma Healthcare Ltd (ASX: SIG) share price has been one of the worst performers on the local market this morning.

In early trade the shares of the company behind pharmacy chains including Amcal and Chemist King are down a massive 26% to 87.5 cents.

Why have they been crushed?

According to a shock release this morning, Sigma has advised that it has commenced legal proceedings against My Chemist/Chemist Warehouse Group (MC/CW).

At present Sigma acts as an exclusive supplier to MC/CW, but the latter has stated its intention to acquire certain products from an alternate wholesaler.

Management believes this to be a violation of its supply agreement. With its offers of mediation and binding arbitration rejected, the company had no choice but to initiate the legal proceedings.

What does this mean financially?

Asides from legal costs, management believes that if MC/CW goes ahead with its plan, it will impact Sigma’s earnings before interest and tax by between $5 million and $10 million per year. This is approximately 5.5% and 11% of its most recent full-year EBIT by my calculation.

As a result, management has advised that this and the weak retail environment could lead to a 5% drop in underlying earnings this year.

Should you buy the dip?

This decline has left its shares trading at just over 14x trailing earnings. Whilst this could arguably be a buying opportunity, I do feel that this is a worrying development.

With the current MC/CW supply agreement due to expire in June 2019, I would be very surprised to see it renewed following today’s announcement. This could leave an even bigger gap in its earnings in the future.

Whilst I have been a big fan of the company in the past, unfortunately I think this changes everything and makes it one to avoid now.

Instead of Sigma, investors might be better off looking elsewhere in the healthcare industry at companies such as Ramsay Health Care Limited (ASX: RHC) and Fisher & Paykel Healthcare Corp Ltd (ASX: FPH).

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Motley Fool contributor James Mickleboro 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.

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