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Morningstar | A Line in the Sand Established for Sigma's Sustainable Earnings Base

We cut our fair value estimate for Sigma by 3% to AUD 0.68 per share, reflecting marginal downgrades to our outer-year earnings forecasts. This follows the outcome of the narrow-moat group's business review, which projects a 10%-plus EBITDA CAGR from fiscal 2021 to 2023. This is a touch shy of our previous expectations but not alarmingly so.

The lack of details on how management plans to extract AUD 100 million of cost efficiencies (from an operating cost base of around AUD 290 million) over the next 18 to 24 months is disappointing. As such, execution risks associated with this transformation program, designed to prepare Sigma for an era without the My Chemist/Chemist Warehouse, or MC/CW, contract, will increasingly become the focus of investors.

Another focal point will be Australian Pharmaceutical Industries', or API's, next move. Sigma has now established what it believes to be its sustainable EBITDA base, of around AUD 80 million in fiscal 2023 versus our forecast of AUD 83 million. The onus is now on API to justify its merger price (announced in December 2018), of 0.31 API shares plus AUD 0.23 cash for every Sigma share and convince Sigma shareholders of its appeal. At the current API stock price, this initial merger offer equates to AUD 0.64 per Sigma share, above the current AUD 0.58 stock price but below our revised AUD 0.68 fair value.

The wild card is how the Australian Competition and Consumer Commission, or ACCC, will view the proposed merger. Back in 2002 and 2006, ACCC prevented these two companies from merging, as the combined entity would have commanded a significant market share. While the pending loss of the MC/CW contract by Sigma will reduce the combined share, it would still be significant. As such, there is considerable risk of ACCC resistance to the deal, a key reason we maintain our fair value estimate for Sigma on a stand-alone basis.

Sigma's near-term earnings expectations are broadly in line with our estimates. Management's fiscal 2019 underlying EBIT guidance is unchanged at AUD 75 million, consistent with our forecast. Fiscal 2020 EBITDA guidance (metric changed from EBIT to exclude impact of current distribution centre investment program) of AUD 55 to 60 million is lower than our previous AUD 64 million forecast. However, we now expect fiscal 2020 EBITDA of AUD 57 million, and growing from that base at a CAGR of around 12% from fiscal 2021 to 2023, versus management's guidance of "over 10% per annum". Assuming no future acquisitions, we expect negligible net debt from fiscal 2020, in line with management guidance.

While losing the former largest client has materially reduced the business' revenue, the company gains some flexibility on the cost and working capital side. Sigma's operational review and earnings guidance, together with its intention to further engage with the review process, should provide API with greater information to assess Sigma's intrinsic value and the adequacy of the proposal. More updates are expected to come in Sigma's fiscal 2019 results on March 21.