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Morningstar | Ebos Group Meets Expectations but Chemist Warehouse Potentially Negative for Margins Ahead

We reaffirm our NZD 20 per share (AUD 18.00 per share using an Australian dollar/New Zealand dollar exchange rate of 1.09) fair value estimate for narrow-moat Ebos Group after the company met expectations with net profit after tax for fiscal 2018 of NZD 152 million up 10% in constant currency terms. This compares with our forecasts of NZD 154 million.

The highlight of the result was the incremental EBITDA margin expansion in both the Australian healthcare and smaller animal care divisions, leading to group margin uplift of 43 basis points to 3.75%. At current levels, we consider shares in Ebos as slightly overvalued and think the market is underestimating the potential risk to margins the Chemist Warehouse, or CW, contract commencing in July 2019 represents.

As the major driver of earnings representing 70% of group EBITDA in fiscal 2018, we support efforts by Ebos to build scale and diversify distribution channels in the Australian healthcare division. We expect positive contribution of HPS, acquired in June 2017, in the hospital channel to continue, driven by growing volume of higher-priced PBS-approved medicines targeting complex indications such as cancer in these settings such as Keytruda and Opdivo.

On the franchise front, we think the additional 80 stores managed by the Venture management company acquired in April 2018 will complement the Terry White franchise operations totaling 400 stores and increase efficiencies along with growing the opportunity to market proprietary lines such as the Red Seal products to a larger client base.

In terms of the traditional community pharmacy distribution business, and notwithstanding the commencement still 12 months away, we think winning the CW contract, representing around 400 MC/CW stores, raises potential downside risk to margins. While we expect the CW contract to add approximately AUD 1 billion of revenue in fiscal 2020, driving a CAGR of 6% for the segment, up from 3% previously, we lift our divisional margin forecast beyond 2019 only slightly to 3.2% from 3.1% rather than fiscal 2018 levels of 3.35% to reflect margin concerns relating to the CW contract.

Nonetheless, we're encouraged that Ebos is managing to successfully deploy acquired branded products such as Black Hawk and pivot away from low-margin agency generic products in both Australia and New Zealand. We expect this momentum to continue given the company's focus on differentiation, through new product development, and targeted marketing. Ebos branded animal care products now represent 37% of the divisional mix, up from 29% in fiscal 2017, contributing to 151 basis point expansion of EBITDA margin to 12.1% in fiscal 2018. We expect mix shift to continue and remain comfortable with five-year revenue CAGR of 5% for the division in both geographies. On a combined basis, we anticipate EBITDA margins rising, averaging 12.8% over our five-year forecast to reflect margin expansion through higher proportion of Ebos brands in the mix.

Ebos Group's balance sheet strengthened slightly in fiscal 2018, with uptick in cash flow from operations leading to net debt/EBITDA of 1.74 times down from 1.85 times in the previous corresponding period. This represents headroom of around NZD 160 million for acquisitions given management's net debt/EBITDA targeted range of between 1.7 times and 2.3 times. We expect any such purchases could be made in healthcare consumer products and specifically OTC lines for community pharmacies, similar to Red Seal. We see these as adding upside risk to our earnings forecast given the opportunity to leverage growing base of community pharmacy clients. Ebos declared a full-year dividend of NZD 0.685 equating to a payout ratio of 69% and reiterated its targeted payout ratio of 70% which we believe is sustainable.