Sandstone Insights: merger risks place Sigma Healthcare in hot water

ASX code: SIG

Suggestion: Sell

Need to know

• Chemist Warehouse has a strong pipeline of growth, and a merger creates transformational synergy opportunities, but these are more than priced in
• Australian Competition and Consumer Commission (ACCC) outcome sees merger likely to proceed in our view, though a failure to merge would see materially lower value for the stand-alone Sigma entity
• Despite a solid growth outlook, the current valuation appears overoptimistic given significant regulatory and execution risks. We commence coverage with a sell rating.

Sigma Healthcare merger with Chemist Warehouse Group

Sigma Healthcare (SIG) is a leading Australian pharmaceutical wholesaler and distributor. The company is currently in the spotlight due to a proposed merger with Chemist Warehouse Group (CWG), a major player in the retail pharmacy sector. This merger aims to create a vertically integrated entity with enhanced market reach and operational synergies.

There are three key issues currently facing SIG:

1. The ACCC decision
2. The value of the CWG deal
3. What SIG would look like as a standalone entity if the merger is not approved

Sigma Healthcare company overview

SIG is a prominent player in the Australian pharmaceutical and healthcare sector. The company operates primarily as a wholesaler and distributor of pharmaceutical products, supplying a wide range of prescription and over-the-counter medicines to pharmacies and hospitals across Australia. SIG has three key business operations:

1. Pharmaceutical wholesaling and distribution: SIG's core business is the wholesale distribution of pharmaceutical products. The company sources medicines from manufacturers and supplies them to pharmacies, hospitals, and other healthcare providers. This includes both prescription drugs and over-the-counter medications.
2. Retail pharmacy services: SIG supports a network of branded and independent pharmacies under various banners such as Amcal, Guardian, Discount Drug Stores, and PharmaSave. These banner groups provide marketing, operational support, and purchasing power to member pharmacies, enhancing their competitive position in the market.
3. Third-party logistics (3PL): SIG also offers third-party logistics services, managing the storage, handling, and distribution of pharmaceutical products for other companies. This service leverages Sigma’s extensive warehousing and distribution infrastructure.

Chemist Warehouse Group overview

CWG has a strong market position in the Australian retail pharmacy market and tends to over-index in retail categories given its business model focuses on high volume, lower margin price positions. The superior sales productivity is likely to support more store openings and expansion overseas. We expect close to double-digit sales growth per annum over the next five years, with an increase in profit margins given synergies and positive store mix. As a result, we expect Earnings Before Interest and Taxes (EBIT) growth of about 15% per annum over the next four years.

CWG network sales chart

CWG had 557 stores in Australia, of which about 518 are branded Chemist Warehouse as of December 2023. The company has a banner called MyChemist in Victoria with 21 stores and Ultra Beauty as an in-store site within 17 locations. We believe the CWG banner can reach around 600 stores by 2027 FY end, or about 16% growth in Australia. Longer-term, we see the Australian banner reaching about 760 stores over the next ten years, a run-rate of 24 store openings a year.

CWG store count by state over-indexing Victoria chart

CWG's Australian store count is much higher in Victoria compared with other states. 40% of its store base is in Victoria, compared with 26% of Australia’s population. A simple analysis where we calibrate store count to the proportion in Victoria would suggest the store count can reach 825 stores around Australia. Our long-term figure of around 760 stores is below this level because some locations will face regulatory hurdles.

Aus population by state chart

CWG store rollout growth chart

What's the ACCC thinking?

Competition is the key concern from the ACCC. SIG and CWG have argued that the proposed merger will not lessen competition as the addition of the CWG banner group to the SIG corporate structure does not differentiate it from other wholesalers with multiple retail banner group offerings. We expect the transaction to ultimately proceed but will almost certainly end up in court to appeal an outright refusal or disagreeable undertakings that accompany an approval.

Long-term outlook for Chemist Warehouse earnings

CWG has network sales of about $8.9 billion in 2024 financial year (FY) end, which is expected to grow over the next 5 years at around 8-9% per annum. We expect half of this growth to come from additional stores and half from like-for-like sales growth.

The company’s stores in Australia and New Zealand are highly productive and therefore further store openings are possible. We see modest EBIT margin expansion from about 6% in 2024 FY end to about 7.5% over the next five years. CWG operates with a high volume, low margin mindset, with margin expansion coming through synergies and scale to fixed cost overheads.

Sigma earnings step-up

SIG as a standalone entity will see earnings undergo a step change in the 2025 FY with the CWG prescription drug distribution contract from 1 July 2024. This contract is independent of the proposed merger and will proceed regardless of ACCC determinations.

The CWG contract delivers around $2 billion of revenue with no additional capex and a limited lift in operating expenses (opex) driving high incremental margins. The combined CWG supply contract (SIG already distributes about $1 billion in non-prescription items into the CWG network) gives SIG exposure to the fastest growing element of the Australian pharmaceutical industry.

Whilst this is incrementally positive, if the CWG deal does not proceed, SIG is worth substantially less than the current share price implies.

Investment view

We commence coverage of SIG with a sell rating. The proposed merger with CWG is a transformational deal and gives shareholders access to a growth business. The current share price implies a about 20 times enterprise value to earnings before interest and taxes (EV/EBIT) 2026 FY end for the merged entity.

The company faces several hurdles which could derate the stock. It will need ACCC approval, continued elevated like-for-like sales growth, seamless integration of the CWG contract and signs of success in newer offshore markets. We see strong earnings growth in the merged entity over the next five years but would like to see a cheaper entry point that gives some margin of safety. We see fair value closer to 17 times EV/EBIT.

Merger rationale

The transaction is effectively a reverse takeover of Sigma by Chemist Warehouse. Under the terms of the agreement (subject to ACCC approval), SIG will acquire all shares in CW via a scheme of arrangement for a cash consideration of $700 million and 9.91 billion shares. The resulting entity will be owned 85.75% by former CW shareholders and 14.25% by former SIG shareholders.

Transaction synergies

Sigma has forecast $60 million of annual synergies available from the merger. Full synergy run rate is expected to be achieved in the fifth year after transaction completion. The target $60 million of synergies entirely relate to warehousing and delivery expenses and the cost savings available from the rationalisation of logistic footprints.

Considering the scale of the operations to be consolidated, $60 million appears a realistic target. Much of the SIG distribution network has been operating at low utilisation rates with significant residual capacity to absorb the CWG contract from July 2024, and much of the $2 billion in stock that CWG self-wholesales currently.

The immediate exception is the Queensland DC which currently has insufficient capacity and will depend on the use of CWG infrastructure which is 25 kilometers away.

Additional synergies

The $60 million in target synergies does not include any buying synergies. CWG and SIG are individually amongst the biggest buyers of certain categories of fast-moving consumer goods (FMCG). Together, they will likely be the largest domestic buyers of certain products with the ability to achieve favourable pricing.

Will the ACCC approve?

The ACCC is testing the proposed acquisition against substantially lessening competition in a market. The ACCC sought public/industry views on the following issues:

• How closely CWG and SIG franchised community pharmacies compete and the likely impact of the proposed merger on retail prices and service quality
• How closely CWG and SIG compete to supply brand and support services to community pharmacies
• The likely impact of the proposed merger on the wholesaling and distribution of products from manufacturers to community pharmacies.

Competition concerns raised

SIG and CWG have argued that the proposed merger will not lessen competition. The basis of their argument is that the addition of the CWG banner group to the SIG corporate structure does not differentiate it from other wholesalers with multiple retail banner group offerings.

This position appears to be in line with the industry structure that the ACCC outlined in the original document that requested submissions in March 2024. We note that CWG is listed alongside other banner groups implying that it was no different in structure or function to competitor-owned banner groups.

Sandstone viewpoint

Our view is that the transaction will ultimately succeed but will almost certainly end up in court. At face value, the merger does impact the competitive landscape of either pharmacy or pharmacy wholesaling. We note that wholesalers routinely operate multiple banner groups simultaneously with largely undifferentiated offerings. For example, API (owned by Wesfarmers) operates the Priceline and Soul Pattison brands. We don't expect that CWG plus Amcal/Discount Drug Stores put together would create a materially different competitive dynamic to that in similar structures elsewhere.

Can Sigma get it done alone?

SIG's market position has been weak for several years, following the loss of the CWG prescription drug supply contract in June 2019 to competitor EBOS, and a series of self-inflicted wounds from poor execution. At this time, SIG lost significant scale which resulted in a loss of scale with suppliers and less certainty of supply with customers which drove further minor market share loss.

ERP rollout issues

The poorly executed Enterprise resource planning (ERP) rollout in FY 2022-2023 resulted in further losses. Customers either re-contracted with an alternate wholesaler permanently or temporarily switched to a back-up wholesaler. Simultaneously, SIG decided to consolidate banner groups and many members of the banners to be closed went to groups outside of SIG.

At the lowest point, SIG market share reached as low as 11% for brief periods. By the end of half 2023 FY, SIG reported that the ERP had been stabilised and was functioning correctly with 97% delivery in full and 99% dispatched on time. Market share recovered to about 14-15%. We also note that SIG recently re-contracted with the largest pharmacy buying group in the country, Pharmacy Alliance. While this was almost certainly done at sharp pricing, the deal helped put a floor under SIG market share and provided valuable volumes.

Prospects for market share recovery

The outlook though sharply improves from July 2024 as the CWG contract returns and execution is corrected but the wholesaling industry remains under pressure, which is the core driver of SIG earnings. We believe that SIG can grow its market share back up to around 30% by 2030, though would see a significantly improved ramp-up if the CWG transaction goes ahead.

SIG revenue projections with CW contract, limited growth to follow

Margin projections, remain <2% without merger synergy benefits

Valuation considerations

For a combined CWG and SIG group, we view a group EV/EBIT multiple at 17x as fair value, which includes the uplift from synergies. There are four key peer groups that we look at to derive this multiple:

1. Global pharmacies: In offshore development markets like the US and UK, there is less regulation around pharmacy dispensing and the major players are typically vertically integrated. They also face more competition in front-of-store categories. Companies such as Walgreens-Boots and CVS operate with low to mid-single-digit EBIT margins and limited growth in stores. Smaller player Ulta Beauty has higher margins and a higher EV/EBIT of 11.1x.
2. Domestic retailers with strong market positions: In Australia, successful retailers tend to have high market share and superior sales productivity compared to their rivals. In Australia, JB Hi-Fi, Reece, and Wesfarmers all have strong market positions. The average EV/EBIT for this group of retailers is 18.4x.
3. Retailers with store rollout: Chemist Warehouse has scope to almost double its store count over the next 12 years. This will include global growth and there is potential for additional countries such as the USA. Australian retailers with strong store rollout include Lovisa and Nick Scali. Lovisa is the most well-advanced with its global rollout and trades at an EV/EBIT of 21.7x with EBIT margins of 33%.
4. Franchise businesses: The two major franchise businesses on the ASX are Domino’s and Harvey Norman. Domino’s also has global growth opportunities and has a slightly higher EBIT margin than Chemist Warehouse. Domino’s trades at an EV/EBIT of 17.8x.

Fair value estimation

We place a 17.0x EV/EBIT multiple on Chemist Warehouse based on 2025 FY end earnings. Our enterprise value includes the value of the synergies that would be extracted from the merger with Sigma. This premium multiple places the stock at a valuation similar to Wesfarmers but below Lovisa, where the store rollout is a more proven model offshore.

We estimate the combined group will earn2026 FY end EBIT of between $750-775 million. Applying a 17x multiple gives a group EV of between about $12.8-$13.2 billion. Adjusting for net debt, this would imply a valuation of around $1.03 to $1.08 per share. With a current price of about $1.25, this valuation underpins our sell recommendation.

Sigma as a standalone

We view 11x EV/EBIT as an appropriate multiple for SIG without CWG. This is lower than key peer EBOS, given that it is a more diverse business, with about 45% of earnings from medical devices and animal health, as well as a stronger track record than SIG. This would see valuation fall to below ~$0.90 per share.

Investment view

The merger between SIG and CWG clearly has some significant synergies on offer for the group and is a transformational deal. CWG adds much-needed growth for the group, expands the network distribution capabilities and gives SIG exposure to the fastest growing segment of the pharmaceutical industry.

CWG growth though is not without risks, and meaningful acceleration in store rollout is unlikely in the short term in our view, given that profitability in new markets will take time to build. The growth therefore relies on strong execution in the face of slowing like-for-like sales. All of this is before factoring in the potential for the ACCC to delay or not approve any merger, adding significant risk to the group.

The standalone SIG entity will see a significant step up in earnings from the CWG prescription drug distribution contract, effective 1 July 2024 which is independent of any ACCC determinations. Without adding the synergies from the CWG deal, the SIG share price materially overvalues the stand-alone entity. Trading on ~20x EV/EBIT, we view the share price as more than factoring in all the positives from the CWG deal, without any of the risks, with fair value likely closer to ~17x on a merged entity.

Without the benefit of synergies, we believe SIG alone would be valued closer to ~11x. We therefore commence coverage on SIG with a sell rating, given the current share price implies benefits above our estimates, inclusive of a seamless integration.

Risks to investment view

The key risks for Sigma include regulatory changes, such as government decisions on pharmacy and wholesaler remuneration, which can impact revenue and earnings.

The impending transition of prescription drug distribution from EBO to SIG on 1 July 2024 poses significant disruption risks, exacerbated by limited support from EBO. Retail earnings may be affected by slowing sales at Chemist Warehouse due to inflation and currency fluctuations on imported products. Additionally, SIG management faces challenges in recovering from an IT crisis, reforming the business, and planning a merger, which may stretch their capacity.

The merger itself involves integrating two different management teams, which could be difficult. Finally, the transaction requires approval from the ACCC, which is not guaranteed.

Share price against S&P/ASX 200 chart

• _{The information provided by Sandstone Insights does not constitute investment advice and does not have regard to the specific needs of any person who may receive it. No warranty is given as to the accuracy or completeness of the information and any person acting on it does so entirely at their own risk.}