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Morningstar | Sigma Not Keen on Marrying API at First Sight

Sigma's rejection of Australian Pharmaceutical Industries', or API's, merger proposal is not surprising to us. Having unveiled last month what it believes to be its sustainable "post-Chemist Warehouse" earnings base, narrow-moat Sigma was never going to meekly accept API's initial merger terms without some haggling.

Granted, at our AUD 1.80 fair value estimate for API, the 0.31 API shares plus AUD 0.23 cash offer values Sigma at AUD 0.79 per share, 29% higher than the AUD 0.61 Sigma price before today's event and 16% above our AUD 0.68 stand-alone fair value estimate. However, the reality is, at the API stock price of AUD 1.40 before today's event, the merger offer was just AUD 0.66, much closer to the Sigma stock price before today's event. The lack of a juicy premium presented an easy basis for Sigma to shun narrow-moat API's overture, one that has summarily dismissed Sigma's recently-announced business review.

API's response to Sigma's rejection is terse, even threatening to sell its 13% shareholding in Sigma. Whether the deal is dead, or this is just part of negotiation battle, only time will tell. The 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 constant Pharmaceutical Benefits Scheme, or PBS, reforms are putting pressure on industry revenue which is exacerbated by the static Community Service Obligations, or CSO, funding pool. This much was confirmed by Sigma itself when it agreed API's estimate of AUD 60 million in synergies from the combination is realistic.

In the meantime, the uncertainty and the threat of stock overhang have driven shares in Sigma to 25% below our AUD 0.68 fair value estimate. Shares in API are also now trading at a similar discount to our AUD 1.80 fair value estimate. Despite the volatility caused by the corporate manoeuvres, both stocks show good value relative to their fundamental, stand-alone intrinsic worth.

We note that Sigma, as part of its justification for rejecting API's merger offer, highlighted the execution risks relating to the combination. We agree. While API estimates the gross synergy to be AUD 60 million, the net synergy could be lower. There are risks of revenue leakage from independent pharmacies churning out of the combined group, and securing another entity as a second-line distributor. There may be other costs, such as lease contract breakage from consolidating the two companies' distribution centre infrastructure. The fact the proposal was conditional and subject to ACCC approvals raised further uncertainties.

Judging by its response, API appears to believe these execution risks are such that it is not willing to table a better merger offer. On the other hand, API's statement does not appear to completely rule out further development, only that it is unable to pursue a merger based on the current merger proposal as tabled before Sigma. As such, there may be more water to flow under this bridge in due course.

Sigma cited a few rationales for rejecting the initial offer from API. Under the scenario of Sigma continuing as a standalone business, Sigma estimates cost efficiencies of over AUD 100 million over the next 18 to 24 months, and expects the EBITDA for fiscal 2023 to recover to the fiscal 2019 level. It also touted its solid balance sheet with investment cycle largely completed and minimal debt. Despite this and the share price movements since October last year when the proposal was initially announced, API did not change the terms on its merger offer. And since API's proposal, API's declining share price essentially lowered the value of the initial merger offer, which made the proposal less attractive for Sigma and its shareholders.

API, on the other hand, has argued that Sigma's business review, planned restructure and the claimed AUD 100 million in cost efficiencies are all devoid of details. Consequently, API did not alter its initial merger terms and the discussions in relation to the merger proposal with Sigma have been terminated.