Sigma Healthcare Ltd

ASX:SIG

Earnings Call Transcript 2019-Q2

[Operator]

Thank you for standing by, and welcome to the Sigma Healthcare Conference Call. [Operator Instructions] I'd now like to hand the conference over to Mr. Mark Hooper, CEO and Managing Director. Please go ahead.

[Mark Hooper, CEO, MD & Executive Director]

Thank you, and morning, everyone. So I'll get straight to the chase, as I realize there's a lot of questions there. So, obviously, this morning, we've put out a market update on both the Chemist Warehouse contract and our earnings outlook for 2019. So I'll deal with them in that order. So we've announced to the market that we're no longer in discussions with Chemist Warehouse on a contract renewal, and some of you will have seen it for at least for part of the business there's been a subsequent announcement about signing with EBOS. I guess, from a Sigma perspective, we've been very consistent all along. The objective was to sign a new contract and I think we always felt reasonably confident that was the most likely outcome, but the terms required to renew the deal unfortunately wouldn't -- weren't acceptable for Sigma. Chemist Warehouse is quite entitled, obviously, to test the market on those sorts of things. But if we had signed a new contract on the terms required, we would have been announcing halving of our EBIT still with the $300 million of capital tied up. So whilst it wasn't the objective of the exercise, we felt on balance if we couldn't generate any rate of return from the business, we were better to have the $300 million of capital back. And the medium-term objective for us is to get the business to a similar level of earnings and have the $300 million in our pocket rather than as I say have that earnings impact in the medium term and still have the $300 million tied up. So there's a series of initiatives that we'll start working on from today. And I guess, one of the few advantages of having early notice of this decision is, we now get the chance to put some planning in place for what that means. That will be around, obviously, cost out. There's fixed cost in the business that the Chemist Warehouse business absorbed that we will now start working on trying to remove. We won't get all of those out, but we believe there's a reasonable proportion we can remove. There is revenue opportunities that we think are now there, and indeed there are other M&A opportunities now that potentially come on to the table with this decision.So as I say, not the original objective that we had, but we have been very consistent all the way through, and unless we can generate an acceptable level of returns for Sigma shareholders, then we wouldn't enter into a new contract. And as I say, I just can't imagine anyone would applaud a decision where we announced we had a new contract, and we'd halved our earnings in the process. So if Chemist Warehouse is able to find someone else willing to do it on that basis, fine. But it wasn't one that we were prepared to move forward with. I guess, on the earnings side, we had sort of flagged at the AGM that trading conditions in the first 3 months of this year were a little softer than we had been expecting. But I think, on balance, we still felt comfortable that the previous guidance of underlying EBIT of $90 million was something that was achievable. We had a very weak month of trading in May. I think, originally, we thought that might have been because of the previous reform adjustments that kicked in on June 1. So for those of you who aren't aware, the government's introduced additional PBS reform measures for drugs that have been on the PBS for 5, 10 and 15 years, that kicked in on June 1. And we thought maybe there was a wind down in ordering by pharmacies while those price changes worked their way through, but we've not seen the rebound in June. So we've seen a very weak period of trading in May and June. And I guess, we're also being hit with the fact that those PBS price adjustments on June 1 were much bigger than what we thought. So for Sigma, there's probably on an annualized basis about a $5 million EBIT impact from those adjustments. So when you combine that with the weak May and June trading performance, we felt we better go back into a review of what we expected for the balance of the year. So we've taken a fairly conservative approach, we've basically assumed current run rate for the rest of the year because I'm keen not to go through this process twice, and we start to rebuild from here. So I understand the magnitude of that -- that change is perhaps bigger than people might have thought. But I do think the impact of the new PBS adjustments and, as I say, particularly a weak May and June trading performance have impacted that. So we will start to build on both the cost and revenue side to address that. But as I said in the release, that's not going to be enough to offset the impact inside this year. We've also given some guidance for 2019-20 on the basis that Chemist Warehouse stops trading with Sigma in June next year. So basically, you've got 5 months of trading in next year's results, 7 months where they'll disappear. In 7 months, where we're effectively wearing the fixed cost that was previously absorbed by the Chemist Warehouse contract. So we're talking about a, sort of, a circa of $40 million to $50 million underlying EBIT for next year, which as I say is not too far of where we'd have been reporting we'd signed a new contract. So in one sense, we're in a slightly better position, albeit that in the following year, we still got to offset the contribution that we've had from the 5 months, but it does give us that run rate to be able to do that.So that's probably the only comments I'll make by way of introduction, and I'm happy to take any questions.

[Operator]

[Operator Instructions] Your first question comes from Tom Godfrey from UBS.

[Thomas Godfrey, Analyst]

Can you hear me, okay?

[Mark Hooper, CEO, MD & Executive Director]

Yes, fine. Thanks, Tom.

[Thomas Godfrey, Analyst]

Well, Mark, firstly, I just wanted to touch on the working capital relation. You've mentioned a few times the $300 million. Now I'm just wondering if you could sort of step us through in a bit more detail the mechanics of that, both from sort of a timing perspective and also how it translates through to debtors' inventory and creditors'?

[Mark Hooper, CEO, MD & Executive Director]

Okay. So I mean, that's a net working capital across both the receivables, the inventory we've invested and the terms we get from suppliers. I think the easiest way to think about it is if they stop trading with us in June, that money would naturally release over July, August and September next year. So that's why we said in the release effectively by the end of -- the end of next calendar year, we would have the return of the $300 million. But it'll effectively occur across a 3-month period.

[Thomas Godfrey, Analyst]

Okay. And just in terms of how the actual net impact of $300 million translates through to the 3 separate accounts?

[Mark Hooper, CEO, MD & Executive Director]

It's probably -- off the top of my head, it's probably slightly higher than that in terms of the receivables. And then there's a slight positive funding we get from supplies. It's less so in the case of Chemist Warehouse because they've got a higher percentage of FMCG supply, that tend to be on shorter payment terms. So it would be maybe sort of $325 million to $350 million in receivables offset by -- I don't have the inventory and creditors' figures, but probably a net $25 million to $50 million of funding that disappears from those guys -- from those lines, rather.

[Thomas Godfrey, Analyst]

Okay. That's great. Very helpful. Next, I just wanted to quickly touch on the DC expansion program, and whether today's announcement impacts any of those investment cases, especially sort of Kemps Creek, which was meant to be $110 million this year, I think?

[Mark Hooper, CEO, MD & Executive Director]

Yes, I mean, look, obviously, as we went through that -- those decisions, we thought about the possibility of the Chemist Warehouse business not being there. So I guess, for Queensland and WA, we needed to build new DCs anyway. So there's probably a slightly slower payback on those 2 DCs. But otherwise, there's no particular impact on the economics. Kemps Creek, we will now sort of look at from a point of view of -- from a sizing perspective, we've talked about the ability to sort of lease out the other half of the DC. One of the challenges over the next 12 months will be, I guess, seeing what opportunities come our way as a result of this decision. There will be some thought-out for EBOS from a customer perspective. There'll be other opportunities that come our way. So we think, this -- I guess, this process we've got to go through of adjusting our infrastructure to suit the fact that Chemist Warehouse is no longer there without sort of removing capacity to take on new business. So the Sydney market is one where we saw, in particular, 3PL, 4PL opportunities, so we'll -- we just need to work through that over the next 6 to 9 months and work out whether the best option is to significantly resize that particular DC or there's enough opportunity we see in 3PL and 4PL to leave it like it is.

[Thomas Godfrey, Analyst]

Okay. Thanks very much. And if I can just squeeze in one more. Just around your FY '20 guidance. So if we annualize sort of the step down in EBIT there, we're sort of landing at $50 million to $51 million in terms of the loss. Is the right way to think about that to attribute it all to Chemist Warehouse? Or are there are other moving pieces there you can take us through?

[Mark Hooper, CEO, MD & Executive Director]

Without sort of understanding exactly how you've done the math there, some of that would be a sort of step down from the change in guidance we've given for this year, and some of it would be from Chemist Warehouse, right, because the step down in guidance for this year, obviously, has some impact on next year as well.

[Operator]

Your next question comes from Philip Pepe from Blue Ocean Equities.

[Philip Pepe, Senior Industrials Analyst]

Just, I guess, obviously, disappointing to see impact seems a bit larger. So if you take the -- you mentioned the FY '20 guidance of $40 million to $50 million has 5 months of Chemist Warehouse in there listed at the bottom end that suggests that was well over 50% of FY '18 EBIT?

[Mark Hooper, CEO, MD & Executive Director]

No, no, because what's happening there, Phil, is you're wearing the -- because, I guess, you get a -- what you get from all your customers is a fully absorbed EBIT and you have a contribution of fixed costs, right? So in terms of the incremental -- the fully absorbed EBIT, it's significantly less than that. But what you've no longer got is the coverage of the fixed cost, because, obviously, your infrastructure is set up to be able to service in those months. That's what I was talking about earlier we'll need to sort of address that fixed cost back as a part of the action plan over the next 12 months.

[Philip Pepe, Senior Industrials Analyst]

Got you. Okay. And I guess, secondly, your theoretically $300 million in working capital can be returned. Presumably, you would have been doing the numbers since the first signs of trouble raised its head. How comfortable are you that will be the full $300 million and not a portion of it?

[Mark Hooper, CEO, MD & Executive Director]

Very, very, right? I mean, Chemist Warehouse has always been extraordinarily good on the payment front, so I don't -- they're very financially strong, so I don't have any doubts about getting that $300 million of working capital back. So look, the first signs of trouble makes it sounds like it's been a long drawn out process that really sort of came to a head late last week. Because we -- and you've got to remember we've been through -- well, I've been through 3 negotiations with those guys where quite often they go to the edge, you still find a way to do a deal. And being asked I thought that was probably the way this one was likely to pay out. But they have, obviously, been given a very, very sharp deal. Let's not forget there will be friction costs in moving this business. It's not easy to pick up $1.7 billion of business and shift it. So despite the offer we put to them and the friction cost, there's enough benefit for them to be able to move it. So they've, obviously, been given a very sharp offer. And good luck to them, right? They're quite entitled to go and seek that in the market. But from my perspective, as I say, you won't come out to the market and say, "Good news, everyone, I've signed a new contract, but by the way my EBIT's halved." I'm not sure there would've been a warm round of applause. So whatever your views on Sigma, I think we've been always good allocators of capital. And I'm not tying up $300 million to make no return.

[Operator]

Your next question comes from Carolyn Holmes from Shareclarity.

[Carolyn Holmes]

Just to make it maybe just clearer for the analysts, maybe you could just touch on the top line. We've talked a lot about EBIT. You've talked about the reduction in guidance for the current year, which has nothing to do with the contracts being down about 18% on the $90 million. So what's really happening at that top line? And if you take us through the FY '20 guidance, of the guidance that you've given, how much is split between just weakness in the current market versus the contract? But maybe just touch on that top line -- that revenue line, what's really happening there?

[Mark Hooper, CEO, MD & Executive Director]

So what we're saying is -- well, it is exactly what I described before, it's been a pretty weak market circumstances over in May and June. And I guess, because it's a more competitive market, generally at the moment, the ability to pass on previous price reform has been compromised as well. So I think, when we came into this year, we were probably expecting growth of about 3% to 5% overall, so that would have been PBS pretty flat, OTC probably growing by 3% to 5% and a little extra growth because we have Chemist Warehouse as a customer. I think our expectation now is we're probably broadly flat across the 2 years. So given Chemist Warehouse is growing slightly more strongly in the market, that means the balance of the portfolio is going backwards. And within that, our brands are still performing fine, so the brands are still growing. So the 5 brands, we've got Amcal, Guardian, DDS, PharmaSave and Chemist King are all still growing quite reasonably. Where we're seeing the real weakness is in the independent market, which is where people, I'd say are very much still most aggressive. So we've not seen the growth in that independent space that we would have hoped for. So that's what's driving that result. And if we roll that forward in the next...

[Carolyn Holmes]

If I just ask that in terms of the current year then, so and -- do I take from that, that revenues might be down slightly, but it's more of a margin type of impact to the profit? Or...

[Mark Hooper, CEO, MD & Executive Director]

It's both.

[Carolyn Holmes]

It's both. Okay.

[Mark Hooper, CEO, MD & Executive Director]

It's both. So revenues -- say, revenue is probably flat year-on-year, right? So you're, obviously, absorbing increased costs on the way through. So that impacts your earnings. But the impact of the previous reform [ picks ], which quite frankly, we hadn't picked. I don't think anyone had expected those June adjustments to be quite as big as what they were. And the inability to recover that in the current market circumstances means that's effectively flowing straight through to the bottom line.

[Carolyn Holmes]

Okay. So last year, you had the top line number of about $4.2 billion.

[Mark Hooper, CEO, MD & Executive Director]

Yes.

[Carolyn Holmes]

So if we said that it was down say, 5% or 10% in the current year, would that sound, okay? So that's -- what's that? $420 million, so somewhere between $200 million or $300 million top line softness?

[Mark Hooper, CEO, MD & Executive Director]

From a retail pharmacy point of view, ignoring Hep C, it will be that flat. Hep C will be down a little bit again because it's -- that's flattening out. But if you just look at it from a retain pharmacy point of view, it's reasonably flat.

[Carolyn Holmes]

Okay. And then moving to FY '20. So how much of the -- yes, so how much of that was actually the contract? So EBOS have come out and said in the first full year they're talking about $1 billion. I briefly caught -- my ear caught the $1.7 billion that you referred to, so what are we talking about in terms of an annualized revenue impact on the contract versus just, again, just current weakness and the PBS adjustment coming through next year?

[Mark Hooper, CEO, MD & Executive Director]

So $1.7 billion is the number we've got, so, obviously, that disappears. So, obviously, Symbion has not taken on all of the business. My guess is they haven't taken on the FMCG piece. And so there's, obviously, someone else who might be taking on the FMCG piece. So -- but for Sigma, obviously, the whole $1.7 billion disappears. And in terms of the guidance -- I mean, we've not previously given any guidance for '19 and '20. The only reason we've given you guidance for '19 and '20 is because everyone's going to ask what it means to lose the Chemist Warehouse contract.

[Carolyn Holmes]

Absolutely, yes.

[Mark Hooper, CEO, MD & Executive Director]

And so that's our best guess basically assuming little or no earnings growth next year and 5 months of contribution from Chemist Warehouse. So it's our best guess at the moment is the way we think that's likely to land.

[Carolyn Holmes]

Okay, okay. And just talking about the cost reductions. What -- you've talked a little bit, obviously, about the warehousing and et cetera, but what can you do in terms of some of the other major cost components?

[Mark Hooper, CEO, MD & Executive Director]

Well, there's a program at the moment to review all of our cost because we have invested in quite a bit in the business over the last couple of years. So not all of that has given us the return that we would have liked. So we're wanting a bit of that. But, I guess, in terms of the Chemist Warehouse piece, it's going to be mainly around the DC structure. So we'll work our way through that over the next 6 to 12 months.

[Carolyn Holmes]

Okay. And my final question. Your -- in prior releases you talked about the legal dispute, et cetera, with Chemist Warehouse. Is there any further abnormals that we should be taking into consideration in the current year and also next year?

[Mark Hooper, CEO, MD & Executive Director]

No. Not in terms of that. That was all settled. So, no...

[Carolyn Holmes]

That's all settled?

[Mark Hooper, CEO, MD & Executive Director]

Yes.

[Carolyn Holmes]

Any other abnormal type of costs in terms of others?

[Mark Hooper, CEO, MD & Executive Director]

Only the sort of the transition and redundancy costs out of the DC program, which we've flagged to the market before.

[Operator]

[Operator Instructions] Your next question comes from David Stanton from CLSA.

[David Andrew Stanton, Research Analyst]

Look, I just want to confirm -- pretty simply for me, just want to confirm '19, you've given CapEx guidance of $120 million and in '20, you've given CapEx guidance of around a $55 million number. Is that still holding as it stands?

[Mark Hooper, CEO, MD & Executive Director]

Yes, look, I mean, in terms of the balance of work that we need to do to finish WA in New South Wales, that -- though that stands, we'll -- in terms of CapEx beyond that point, I mean, if we don't have Chem Warehouse, then we would significantly review any other CapEx plans that we had. So just to the extent it relates to the finishing off of WA in New South Wales that would continue, but beyond that we'll be reviewing all of that, obviously.

[Operator]

Your next question comes from Nick Cameron from Watermark.

[Nick Cameron]

So just one quick one. Just want to understand the leverage, and you got appointed from advisers on, I guess, how to deploy capital going forward. Just want to understand what the revised guidance and your current net debt position. What the -- I guess, the outlook for your net debt-to-EBITDA position is? And what kind of headroom upon return of the $300 million-or-so in working capital in FY '20. What kind of war chest position that gives you in FY '21 so that's all settled down?

[Mark Hooper, CEO, MD & Executive Director]

Well, on the basis of sort of we can probably gear it at about 3x to 3.5x EBITDA. We're probably sitting in sort of capacity of $200 million of debt and post-Chemist Warehouse, I'm [ wondering ] we're probably sitting on $50 million to $100 million of cash. And so it's a reasonably significant sort of piece of capital what we have to employ there.

[Nick Cameron]

Okay. And anything that changes or anything strategically that you're looking at now that Chemist Warehouse has gone without opening up other opportunities?

[Mark Hooper, CEO, MD & Executive Director]

[ I don't think ] there's a raft of things that's sort of come because we've, obviously, got significant capacity sitting in the DC network to look at other things. So as I said in my opening comments, I guess, your M&A changes slightly because of that.

[Operator]

Your next question comes from Saul Hadassin from UBS.

[Saul Hadassin, Executive Director & Research Analyst]

Can you hear me? Just very briefly, I just want to step through the math again as to what this does to your group return on invested capital. So getting roughly and maybe a $40 million reduction to your EBIT from the loss of the contract, if I just supply a group EBIT margin to the revenues you lose, excluding the recent downturn that you talked to, but with that $300 million release, if I just sort of adjust your fiscal '18 ROIC, the [ debt ] turn up to around 20% group return. Does that sound correct?

[Mark Hooper, CEO, MD & Executive Director]

Yes, without having done the detailed math broadly, I mean, a lot of it sort of depends on how quickly you wind out the fixed costs that they used to absorb, right? Because on a straight EBIT to cash, your ROIC would go up. If all you were doing was saying the fully absorbed EBIT disappears, and you get the cash back, then your group ROIC would go up, right? So it's a case of how quickly you can wind out both fixed costs. As I've said in my opening comments, you won't be able to wind out all of the fixed costs, right? And to some extent, you need to sort of work through it in a way that's also cognizant of the opportunities that come up, which there will be opportunities along the way. So I would think it's slightly accretive for ROIC, but I guess, to pick up the line I used before there's no point having an ever-shrinking profit and ever-increasing ROIC. The idea is to grow both.

[Saul Hadassin, Executive Director & Research Analyst]

And any more color you can add on the -- in terms of those key cost buckets for your business? And when you say, it'll take time, where do you see those costs coming from?

[Mark Hooper, CEO, MD & Executive Director]

Which is basically -- look, it's basically there's the infrastructure. We've now got a DC infrastructure. And as I've said to people at previous briefings, the bulk of the Chemist Warehouse volume went through Sydney and Melbourne. So that's where your biggest opportunity is to pull out fixed cost. Now we had to make a decision on Sydney because of the timing of the exit from the current site. We've got -- now we've got a pretty good runway at Melbourne, so we can take out significant costs on Melbourne. We can take out some costs on Sydney, probably not quite as much because it's -- we had sort of opted for slightly bigger site, but I do think there's revenue opportunities now on the 3PL and 4PL side that will hopefully make that still quite a sensible decision at the end of the day. But most of it is going to come out of that rationalization of the DC network.

[Saul Hadassin, Executive Director & Research Analyst]

And just very finally, the working capital slide from your full year '18 results. I think it showed net invested capital position of about $360 million. So effectively, again, what you're saying is that would fall to $60 million, all else equal?

[Mark Hooper, CEO, MD & Executive Director]

Without -- again, without doing the math, yes, that would be right. Yes.

[Operator]

There are no further questions at this time. That does conclude our conference for today. Thank you for participating. You may now disconnect.