Other Revenue Sources Underpin Sigma

By Eva Brocklehurst | More Articles by Eva Brocklehurst

Sigma Pharmaceuticals ((SIP)) is broadening its horizons amidst a challenging operating environment. The company will automate its distribution centres, expand relationships with generic manufacturers and extend its reach in China.

The company’s FY17 results were in line with Citi’s expectations and the underlying operating environment is forecast to remain challenging, given the poor prospect for improved Pharmaceutical Benefits Scheme (PBS) revenue and the end of working capital benefits from the pulling back of customer credit terms. The company has indicated there is limited scope to reduce terms to customers beyond this year.

Growth is expected to come from a share of the $3bn Australian hospital distribution market and fast-growing, high-margin over-the-counter (OTC) products, as well as the leveraging of existing and new infrastructure with third-party distribution. As the PBS market is flat the company is investing to maintain its margins and diversify its revenue sources.

The company is embarking on a multi-year capital expenditure program for new distribution centres with around $100m allocated in FY18 and around $65m in FY19. This excludes any investment in a new ERP (enterprise resource planning) system, which would allow the company to fully benefit from its investment in distribution centre automation. Management is yet to disclose the expected expenditure.

Sigma has also launched an Amcal website aimed at the Chinese market in partnership with a local operator. A deal with generics manufacture Arrow has also been signed. Citi believes these sorts of deals with third parties are a natural extension of the company’s existing business and should allow it to leverage distribution infrastructure.

The category of other revenues, which include supplier rebates and merchandising income, is probably accounting for a large proportion of profits but Citi has very little visibility on this and remains wary of long-term sustainability.

The company has guided to earnings growth of at least 5% for FY18 and Citi suspects Sigma will improve guidance, as it upgraded guidance throughout FY17. The broker is confident in management’s ability to deliver, given its history, and this could provide upside to forecasts. Meanwhile, the stock is considered fairly valued relative to the broader market.

While the company has maintained growth expectations for FY18-19 and organic growth trends are expected to improve across the business, a material ramp-up in capital expenditure is needed to invest in growth, Morgan Stanley observes. This will have implications for debt, depreciation and interest.

The broker believes there is little room for upside surprises and, while the company has maintained its momentum, the outlook is more than captured in the share price. Morgan Stanley retains an Underweight rating as, at current levels, longer term risk is not being reflected in the multiple. On a sector relative basis, the broker prefers to hold the IVF names.

Pharmaceutical Benefits Scheme

Citi observes the PBS base business is the largest component in the company’s revenue (64%) and is generating very thin margins which are unlikely to get better over time. Australian government estimates for the PBS show a -7% year-on-year decline in FY17 to $10.4bn, which UBS notes was caused by the slowing take-up of hepatitis C drugs.

The PBS is expected to return to 1.9% growth in FY18 and 4.9% growth in FY19. The growth may be predominantly in hospitals, which the broker believes is a positive for Sigma’s expansion strategy. That said, UBS acknowledges non-PBS revenue will continue to be the main driver of revenue for the company, along with extending its presence in Asia.

New HCV drugs were listed on the PBS in the March quarter 2016 and the company benefited in terms of sales by around $687m in FY17, although Morgan Stanley observes this was considerably more modest at the earnings level. Management has indicated that peak sales for these drugs in other developed countries were reached at 12-18 months after launch.

The rise in the provision for doubtful debts disappointed Credit Suisse but additional costs are not expected to emerge in the near to medium term. The main highlight for the broker was a material decline in working capital.

With PBS revenue to remain under some pressure, higher growth of non-PBS revenue, as well as a potential winding back of remaining trade discounts to pharmacy, should sustain gross profit throughout FY18, the broker believes. Beyond this, Credit Suisse expects incremental wholesale opportunities in hospital pharmacy, as well as procurement cost savings, should underpin medium to long-term earnings growth.

An un-geared balance sheet and a focus on managing working capital has put the business in a strong position, the broker contends, to fund the first material step-up in capital investment over the next two years as ageing distribution centres are replaced. Credit Suisse retains a Outperform rating.

FNArena’s database shows two Buy recommendations (Credit Suisse, UBS), one Hold (Citi) and one Sell (Morgan Stanley). The consensus target is $1.26, suggesting 1.7% upside to the last share price. Targets range from $1.15 (Morgan Stanley) to $1.40 (UBS). The dividend yield on FY18 and FY19 forecasts is 4.9% and 5.0% respectively.

Eva Brocklehurst

About Eva Brocklehurst

Eva Brocklehurst started her journalistic career in 1993 as a financial reporter with RWE Australian Business News covering money markets and economic reports. She moved to Australian Associated Press (AAP) in 1998 as a senior financial journalist to cover money markets, economic analysis, Reserve Bank and Treasury. Eva became deputy finance editor at AAP in 2003. Started working online as a reporter on ASX-listed companies for RWE Australian Business News in 2005. Eva joined FNArena in 2012 and has been covering stockbroker analysis of ASX-listed companies since, as well as writing general news stories.

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