Shares in pharmaceutical distribution company Sigma Healthcare Ltd (ASX: SIG) were on the move in December, rising 45% following the news of a potential $9 billion merger with Chemist Warehouse Group. SIG shares are in the spotlight again today, up a further 7% today.
The merger is making headlines given the size of the deal and the relative dearth of capital markets activity over the last 18 months, where the ASX IPO window has been dubbed to be ‘closed’.
Sigma Healthcare share price
Will the deal go through?
The merger is still pending clearance from the Australian Consumer and Competition Commission (ACCC). We think this is exactly the kind of deal that the competition watchdog may look to block, given the already anti-competitive dynamics of the pharmaceutical industry and the high-profile nature of the case in the media, which could be used to ‘make a statement’. Chemist Warehouse dominates the market, with ~50% share. At a minimum, the group may need to divest non-core pharmacy brands, such as Amcal for the regulator to allow the deal to complete.
Sigma had recently emerged with the $2 billion Chemist Warehouse distribution contract in June 2023, before the merger announcement in December 2023. The contract gave Chemist Warehouse a 10% equity stake in Sigma. On top of its distribution capabilities, Sigma operates its own pharmacy brands including Amcal, Discount Drug Stores, Guardian, and PharmaSave. Prior to Wesfarmers Ltd (ASX: WES) buying out Australian Pharmaceutical Industries (API), Sigma tried and failed to merge with API after the ACCC blocked the deal on the grounds that it would reduce the number of full-line pharmaceutical wholesalers from 3 to 2.
Chemist Warehouse founders Jack Gance and Mario Verrocchi have grown rapidly since opening the first store in Melbourne in 2000, operating over 500 stores today. The group generated $3 billion in revenue and $460 million in earnings before interest and tax (EBIT) in FY2023. According to its latest filings, Chemist Warehouse makes $603.5 million in revenue from “marketing, advertising and other”. So 20% of its revenue comes from selling targeted ads to suppliers utilising customer data, and it is high-margin revenue.
The meteoric rise of Chemist Warehouse as a volume-driven, low-margin business model has been good news for the consumer, offering low-priced pharmaceuticals. It is a business model that has been successful offshore as seen by the likes of Costco Wholesale Corporation (NASDAQ: COST), Home Depot Inc (NYSE: HD), and discount supermarket Aldi.
Chemist Warehouse also has reportedly creative corporate structures for franchises, which may be a reason for the ‘backdoor listing’ rather than pursuing a straight IPO to avoid the extra compliance burdens from the S&P/ASX 200 (INDEXASX: XJO). We see franchisee structuring as a governance risk to monitor going forward.
Valuation – what’s SIG worth?
On top of the deal uncertainty, we think the implied valuation is on the expensive side. Chemist Warehouse Group will end up with 85.75% of the merged Sigma entity.
Initial investor enthusiasm saw SIG open up +60% $1.35 when it recommenced trading after announcing the proposed merger, before fading to +40% ~$1.05. At the current SIG share price of $1.06, this equates to an EV/EBIT multiple just north of 27x for the merged group on our estimates.
This is on the high end of peers such as Woolworths Group Ltd (ASX: WOW), Coles Group Ltd (ASX: COL), and Bunnings Warehouse owner Wesfarmers Ltd which all trade on 15-20x EV/EBIT. BWS and Dan Murphy’s operator Endeavour Group Ltd (ASX: EDV) trades on 14.5x, although its multiple has compressed down from 18x due to concerns with its lucrative pokies earnings coming under further regulatory scrutiny. On the more expensive side is Domino’s Pizza Enterprises Ltd (ASX: DMP) on 25x and on the cheaper side is JB Hi-Fi Limited (ASX: JBH) on 11x.
Even considering the high-quality nature of Chemist Warehouse which enjoys strong bargaining power with suppliers, the current share price seems a rich price to pay given where similarly high-quality peers trade.
Are Sigma Healthcare shares a buy today?
While it may seem like a ‘free hit’ to buy SIG shares before the merger so that you get Chemist Warehouse shares upon listing, the lack of certainty on the deal structure and the high implied valuation makes SIG shares unattractive at these levels, in our view.
We think the bulk of the value created by the transaction has accrued to existing SIG shareholders, who not only made a 40% stag profit on the day of the deal announcement but also had the opportunity to buy new shares in the 1 for 1.85 entitlement offer at the pre-deal price of $0.70 per new SIG share, a 25.5% discount to the current share price of $0.94.
What to buy instead?
We have just released our top 3 ASX dividend shares to buy in 2024, hot off the press. Free for the Rask Media community, our top picks for this year have an average dividend yield of 6.4%. We’ll give you a hint, it’s not BHP Group Ltd (ASX: BHP) & Commonwealth Bank of Australia (ASX: CBA).
