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Morningstar | API Proposes to Sigma but Consummation Could Take Time

Impetus for consolidation in the pharmaceutical distribution space has been brewing for some time, given the challenging top-line conditions and the regulatory environment. Against this backdrop, Australian Pharmaceutical Industries, or API, has seized on Sigma's loss of the Chemist Warehouse contract (and its subsequent weak stock price) as a catalyst to kick-start the consolidation.

At API's current price, the merger offer of 0.31 API shares plus AUD 0.23 cash for every Sigma share equates to a value of AUD 0.73 per Sigma share, close to our unchanged AUD 0.70 fair value estimate. API shares have responded positively to the deal, now trading at AUD 1.62, 10% below our unchanged AUD 1.80 fair value estimate. As the non-binding, indicative proposal is still subject to due diligence and clearance by the competition regulator, we recommend shareholders in both narrow moat-rated companies sit tight, pending the release of further information.

The strategic merits of the tie-up are compelling. It strengthens both groups at a time when there are constant Pharmaceutical Benefits Scheme, or PBS, reforms putting pressure on industry revenue which is exacerbated by the static Community Service Obligations, or CSO, funding pool. All this amidst rising volume throughput and input costs. While all the distributors have been stepping their efficiency drives to combat these headwinds, the next step is consolidation and elimination of duplications in the industry. And a merger between API and Sigma is an obvious transaction to begin such consolidation, one that also allows them keep up with Ebos which is now the industry leader with its upgraded distribution infrastructure and the Chemist Warehouse contract.

The projected AUD 60 million synergy from combining API and Sigma demonstrates the benefits from such duplication elimination in the industry, in areas such as distribution infrastructure rationalisation and support function expense cuts.

Granted, the net synergy could be lower as there are risks of revenue leakage from independent pharmacies churning out of the combined group, and securing another entity as a second-line distributor. API management estimates this could lop AUD 10 million from the gross synergy benefit figure. There may be other costs, such as lease contract breakage from consolidating the two companies' distribution centre infrastructure. All these figures are, however, just numbers on a paper and subject to due diligence. Such is the uncertainty that API management itself appears not to have a handle on what the earnings accretion would be from combining with Sigma, at least not at this preliminary stage.

What is equally uncertain is how the Australian Competition and Consumer Commission, or ACCC, will view the transaction. Back in 2002, the regulator prevented these two companies from merging, as the combined entity would have commanded 50% to 60% of the pharmaceutical wholesaling market, depending on the state. With the pending loss of the Chemist Warehouse contract by Sigma, the combined market share of API and Sigma is rubbery, but it would still be significant, perhaps around 40%, despite the presence of two new players (DHL, CH2) since 2002 in the space. As such, there is considerable risk of ACCC resistance to the deal, and that is one key reason why we are maintaining our fair value estimates for both companies on a stand-alone basis.

We are unperturbed by Sigma's lack of detailed engagement with API, even though it received this proposal on Oct. 11, 2018. It would be bordering on irresponsible on Sigma to make a call on the adequacy of API's proposal, when the board/management is in the process of determining what Sigma's intrinsic value is post the Chemist Warehouse contract loss. We expect details on this internal review will be unveiled in the new year and could well lead to some changes in API's merger terms--another reason for us to maintain our current fair value estimates of both companies at this stage.