The Australian Competition and Consumer Commission has approved Sigma Healthcare’s SIG proposed acquisition of Chemist Warehouse, or CW, largely based on Sigma’s proposed remedies. Despite the ACCC delaying its decision twice, opposition from pharmacists and major bodies including the Pharmacy Guild and Ebos, and admitting the acquisition is a major structural change for the pharmacy market, it concluded the proposed remedies would assuage the initial competition concerns raised in June 2024.

We are surprised, given Sigma’s remedies didn’t address the significant structural advantages it would gain. Given significantly superior scale and likely efficiency gains in its supply chain, we think it allows the merged group to potentially offer a lower wholesale markup to independent pharmacies and its own stores than competitors can afford. The Pharmacy Guild agreed, noting the merger sets a new precedent for a vertical integration model, and the other two major wholesalers, Ebos and API, would need to follow suit to compete effectively. Nonetheless, with ACCC approval, we raise our fair value estimate for no-moat Sigma by 99% to AUD 1.55 per share with the largest merger hurdle cleared. The deal is still subject to customary conditions and shareholder approval, but we have no remaining concerns and assume a six-month earnings contribution from CW in fiscal 2026, which ends in January 2026.

However, Sigma shares are materially overvalued, trading at a 57% premium to our revised fair value estimate and an implied market cap bigger than Coles of over AUD 28 billion. While our earnings per share forecasts for fiscal years 2027 to 2029 increase on average by 67%, the current share price implies a P/E of 36 for our fiscal 2029 forecast, bringing risk of earnings disappointment if there is a failure to achieve expected growth in store rollouts.

Business strategy

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.

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Terms used in this article

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.