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Pharmacy wars heating up, shareholders risk getting burnt

By Graham Witcomb, analyst with Intelligent Investor

It's a battleground and Professor Ian Harper found himself caught in the middle of it. Earlier this year Harper led the Competition Policy Review, which examined, among other things, the level of competition within Australia's $12 billion pharmacy industry.

He didn’t have many nice things to say.

In March, the Review recommended that the Government overturn a set of archaic restrictions that protect pharmacists from competition. Harper, as well as last year’s National Commission of Audit, found that the restrictions are anti-competitive and not in the public interest. He recommended deregulation, which the Government promptly ignored.

In May, it signed a sixth Community Pharmacy Agreement, leaving pharmacy location and ownership rules unchanged for a five-year period beginning 1 July 2015. The Pharmacy Guild of Australia knows how to twist an arm.

Its power has been a blessing for Australia's 5,450 community pharmacies and the distributors who service them, the largest of which are Sigma Pharmaceuticals and Australian Pharmaceutical Industries (API).

Until recently, the industry enjoyed fairly stable conditions and steadily rising drug prices. But the glory days seem numbered. Shareholders in both companies should be worried.

An aging population has caused unprecedented growth in healthcare costs. Government health spending has risen 74% over the past decade and now accounts for 19% of the Australian budget. Quite simply, it’s getting too much to bear.

While the Pharmacy Guild successfully haggled for ownership and location rules to remain in place, it hasn’t been able to stop the Government taking an axe to the Pharmaceutical Benefits Scheme (PBS), the Government’s program of subsidised prescription medicines.

PBS prices are under increasing scrutiny as the Government tries to find savings in its budget. Growth in funding has declined materially over the past five years, with many drugs receiving price cuts. While great for the taxpayer, the reforms are eroding sales at pharmaceutical wholesalers – Sigma estimates PBS price reductions cut 4% from revenue in the first half of 2016.

With an estimated $7.8bn in cuts to the PBS over the next three years, price deflation throughout the supply chain is here to stay. This isn’t good news for either API or Sigma.

As income from the PBS makes up more than half of Sigma and API’s revenue, it isn’t too surprising that both have been quick to talk up their non-PBS revenue streams, focusing on growing sales of over-the-counter medicines and private label products.

Sigma has been relatively quiet about how the new strategy is faring but non-PBS revenue now accounts for 43% of sales, up from 40% a year ago. Management hopes to increase this figure to 50% over the next two years.

API’s same-store sales grew 4.5% in 2015, with most of the growth coming from cosmetics, skincare and fragrance sales. That’s an impressive result given that half the business is experiencing significant pricing pressure and most general retailers are having a hard time; something seems to be working.

Nevertheless, pharmaceutical distribution is a commodity business running on very low margins. API’s average earnings before interest and tax (EBIT) margin over the past five years was 1.5%; At 2.2%, Sigma’s wasn’t much better.

Both are well-managed companies with dominant market shares and government protections. But when you have businesses that make a 1–2% profit margin, there’s little margin for error. Industry regulation is in flux and the Government seems hell-bent on lowering prescription prices, which is going to anchor API and Sigma’s revenue growth.

This is reason enough to avoid both stocks. The possibility of drug makers eventually choosing to distribute directly (with Pfizer leading the way a few years back) or supermarkets eventually muscling in on API and Sigma’s turf are two more.

None of these risks seem to be accounted for in the respective company’s share prices. Sigma trades on a PER of 19 whereas API has a PER of 23. Best to AVOID both and if you’re a current shareholder, think carefully about staying aboard.

This article contains general investment advice only (under AFSL 282288). Authorised by Alastair Davidson. To unlock Intelligent Investor stock research and buy recommendations, take out a 15-day free membership.

 

Comments

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