No-moat Sigma (ASX:SIG) agreed to acquire Chemist Warehouse via a scheme of arrangement, for $700 million in cash and Sigma shares that result in Chemist Warehouse shareholders owning 85.75% of the potential merged group. A new $1 billion debt facility will primarily fund the deal as well as refinance existing Chemist Warehouse debt of $300 million.

The acquisition is subject to several conditions including Chemist Warehouse and Sigma shareholder approval, and regulatory approvals from the Australian Competition and Consumer Commission, or ACCC, and if required, the New Zealand Overseas Investment Office. Particularly uncertain is the ACCC’s view of the transaction, given a merger of Chemist Warehouse and Sigma would create Australia’s largest pharmacy retailer. With Sigma’s Amcal and Discount Drug Store pharmacy chains, we estimate it would command over 50% market share.

As such, we think the ACCC will likely reject the deal and do not yet factor in a merger in our base case. The Pharmacy Guild of Australia also made a statement saying the merger poses significant questions and risks. The proposed merger is also aiming to be completed in second half 2024, suggesting a potentially lengthy review process.

Separate from the merger, Sigma is also raising $401 million from an underwritten entitlement offer, representing 573 million new shares or 54% of existing shares on issue. Sigma intends to primarily use the proceeds for the working capital required to supply the prescription medicine Chemist Warehouse contract it won back from Ebos commencing July 2024. We recommend participating in Sigma’s raise subject to individual investment goals.

It also safeguards ownership of its key distribution centers and progresses business initiatives including Sigma’s private label range and investment in its pharmacy brand strategy. We decreased our fair value estimate for Sigma by 3% to $0.78 largely due to raising equity at a dilutive price.

Pharmacy industry dynamics

There is no escaping Pharmaceutical Benefits Scheme, or PBS, price reform, which is challenging industry profitability and leading to subpar returns for Sigma. We estimate about 50% of Sigma’s revenue is reliant on PBS.

Although government PBS spending is notionally uncapped, the overall quantum typically barely grows due to ongoing PBS price reform and the Australian government having significant negotiating power in allowing new drugs onto the PBS schedule. As such, we forecast typical industry revenue growth in line with population growth of 1.5%.

The ongoing financial impact of the PBS price reform and increasing operational costs represent significant challenges to Sigma’s earnings growth. The wholesale margin earned on PBS medicines is regulated to a 7% for community pharmacy, leaving the distributors to absorb operating cost inflation and resulting in downward pressure on operating margins.

However, there are positive key strategic initiatives Sigma is in the process of completing to become more efficient. The business aims to use excess warehouse capacity to grow its non-PBS-related revenue streams, particularly third-party logistics. While we don’t believe Sigma to be the lowest cost operator, there is low marginal cost to housing new customers in existing facilities, and so we expect it will make small inroads into these markets. The firm also completed its cost-savings program, Project Pivot, and upgraded its enterprise resource planning system and distribution centers, which we expect to contribute to long-run efficiencies.

At an industry level, our long-term stance remains cautious. The nondiscretionary nature of pharmaceuticals and other health-related products, coupled with ageing of the general population, implies defensive earnings streams. However, earnings growth remains challenged given current government PBS policies.

Economic moat

Due to Sigma’s relatively smaller scale and significant revenue exposure to highly regulated pharmaceutical distribution, we do not award the company an economic moat. We estimate over 90% of Sigma’s revenue is earned from the distribution of pharmaceuticals and front-shop items to community pharmacies, the highest proportion of the three major industry players.

Although wholesale gross margins are regulated to 7% for community pharmacy on the PBS portion only, which is undisclosed but we estimate to be over half of distribution revenue, competition amongst the three players is intense as they vie for distribution contracts with pharmacies. We do not believe the requirement to hold a drug wholesaling licence enables the industry participants to earn excess returns.

Within community pharmacy distribution, EBOS has a scale benefit over its two peers. The benefit of EBOS’ scale advantage results in the company earning a superior operating margin and returns in excess of its cost of capital, while we do not believe Sigma earns an economic profit on PBS distribution.

Pharmaceutical distribution is specialized as it involves picking and packing small quantities of small, high value items. All three of the pharma distributors have invested significantly in warehousing systems and goods-to-person automation in order to try and be profitable within the regulated margin environment.

These outlays have the effect of increasing capital invested and lowering ongoing variable labor costs. Sigma has recently consolidated a number of regional warehouses but still has excess warehouse capacity.

While this leaves significant space for growth without further investment, and it is the company’s stated strategy to expand into outsourced logistics, its supply chain would likely only be competitive for other small, high value items.

Moreover, outside of pharmaceutical distribution, competition is open to other logistics providers where barriers to entry are low. While we expect Sigma to leverage its capital investment in its infrastructure and generate economic profits near term, competitive forces and its current scale disadvantage to EBOS prevent us from awarding an economic moat.