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Morningstar | Ebos' Investor Day Highlights Cost Efficiency as a Shield to Margin Pressure

Following our trip to narrow-moat Ebos' first investor day and the visit to its new Symbion distribution centre in Brisbane, we maintain our fair value estimate of NZD 20 per share (AUD 19 per share using the spot exchange rate of 1.07). Despite ongoing headwinds from the group's pharmacy distribution business, we believe improving cost efficiency and diversification into pet care and consumer brands will support overall profitability, and we expect Ebos' EBIT margin to remain at around 3.2% for the next five years. At current prices, the stock is modestly overvalued compared with our intrinsic assessment.

Ebos continues to operate in a highly competitive pharmaceutical distribution industry. The company is exposed to competition from its peers, particularly Sigma, which recently lost a major client and is likely to fight aggressively for market share, as well as threats from the direct distribution by pharmaceutical manufacturers. Therefore, managing cost efficiency has become even more crucial. To this end, our site tour of the highly automated new Brisbane warehouse reinforces our confidence in Ebos' ability to control costs, with significant reduction in manual handling. This is especially important as about 50% of warehouse/distribution costs are labour-related. We expect this improvement in cost efficiency and enhanced productivity to offset the inherent margin pressure in the underlying pharmaceutical distribution business, underpinning our stable margin assumptions over the next five years.

Because the distribution centre facilities and supply infrastructure are well in place, we are not concerned with Ebos' capacity to accommodate the recently secured Chemist Warehouse contract (starting in July 2019). This is especially true as Ebos will only distribute part of Sigma's supplies (mainly PBS ethical and scheduled OTC drugs) to Chemist Warehouse. The increased volume will also boost Ebos' Community Service Obligation funding from about 33% to over 40%.

Despite accounting for a smaller portion of group EBITDA, pet care and consumer brands reduce Ebos' reliance on the lower-margin pharmaceutical distribution business. We forecast the EBITDA margin for the pet care division to trend up from 12% to 14% in the next few years with more focus on premium brands with higher margins. During the investor day, management pointed out several potential opportunities for selected brands such as Red Seal and BlackHawk to expand in emerging Asian markets. However, it acknowledged the group’s primary focus will remain on the Australian and New Zealand markets and will likely to be conservative in allocating capital to higher-risk Asian markets.

Ebos' balance sheet position remains solid with cash conversion at 15 days for fiscal 2018. Healthy gearing ratio (net debt/EBITDA of 1.74 times as at June 30) positions the group well for further acquisition opportunities. The company has expanded its business rapidly over the past few years through multiple acquisitions, which offer cross-selling opportunities and leverage its extensive distribution network. Management's record in this regard is solid, delivering return on capital employed of about 16% over the past three years (above the ROCE target of 15%), which should provide investors with significant comfort.