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Morningstar | API Executing Playbook to Defend Against Pressure from PBS Reform

There is a playbook being followed by all three major Australian pharmaceutical distributors, in a bid to offset margin pressures from Pharmaceutical Benefits Scheme, or PBS, reforms. Australian Pharmaceutical Industries', or API's, fiscal 2019 first-half result shows that management is admirably executing on this playbook, with EBIT up 6% to AUD 44 million and interim DPS increasing 7% to AUD 0.0375, fully franked.

The narrow-moat-rated group is redirecting cash flow from its core Pharmacy Distribution to higher-margin businesses which are all showing promising progress. Priceline Pharmacy (almost 30% of group revenue) returned to like-for-like growth of 0.3%, a solid recovery from negative 1.1% in fiscal 2018, as solid foot traffic is converted to sales. While Consumer Brands sales account for just 2% of group total, its first-half EBIT of AUD 2 million (up 28%) represented 5% of group total and growth outlook remains positive. Contributions from recently-acquired Clear Skincare are also starting to flow, with the first full six-month revenue of AUD 22 million under API's ownership, up 21% from a year ago on a pro forma basis.

However, there is no escaping the pressure facing Pharmacy Distribution where first-half revenue fell 3% to AUD 1.4 billion (70% of group revenue). PBS reform-led price deflation, rising operating costs and intense competition show no signs of easing. Still, excluding the PBS reform and the impact of Hepatitis C sales, adjusted distribution revenue was up 8.8%.

We have cut our EBIT forecasts by an average of 6% over the next three years, reflecting the impact of PBS reform-related pressures on the Pharmacy Distribution unit. However, our longer-term forecasts are largely unchanged and we maintain our AUD 1.80 fair value estimate. Shares on API remain at an attractive 16% discount to our intrinsic assessment, as the market continues to underestimate management's strategic initiatives to offset pressure from PBS reform.

The most audacious way API tried to address PBS reform pressure was to merge with Sigma. While this proposal was rejected last month, logic of the combination is too compelling to ignore, as it would strengthen both groups and eliminate duplications in the industry. This at a time when both are suffering from not only PBS reforms but also by the static Community Service Obligations, or CSO, funding pool. This may well explain why API is keeping its options open with respect to the 13% shareholding in Sigma, a strategic stake that was built ahead of its tilt at the peer pharmaceutical distributor.

In terms of API's first-half result details, revenue fell 2% to AUD 2.0 billion. Excluding the impact of Hepatitis C medicine sales and PBS reforms, adjusted group revenue was up 7% to AUD. Group EBITDA grew 3% to AUD 61 million. Due to the financing cost impact of the Clear Skincare acquisition, investment in working capital and the purchase of the 13% shareholding in Sigma, net profit after tax, or NPAT, was flat at AUD 25 million.