Elmo's Fire

Elmo de Alwis: Sigma has two major divisions. One is a pharmaceutical business, which manufactures and markets our own brands and is the largest contract manufacturer of pharmaceuticals in the country; and our health-care business, which comprises our wholesaling activities as well as the management of three banners: the pharmacy banners Amcal, Guardian and the most recent one, Amcal Max.

JK: How long have you been managing director and how long might we expect you to remain in the top job?

EDA: I've been in this job for nearly five years; as for how long I will be in this role, I guess that's not a question that depends entirely on me but I certainly have no intentions to leave.

JK: Looking at your industry, the Pan Pharmaceuticals affair [Pan products were withdrawn from the market and its manufacturing licence was revoked in 2003 in response to health concerns] was said to have damaged the image of your sector, but you have a price/earnings multiple that is at a 50% premium to the rest of the market. Were you affected by that scandal?

EDA: I think that incidents of that magnitude don't just disappear overnight without leaving a fairly strong imprint on the industry. The good that's come out of that is that we have today an industry that is regulated; in which it has been proven that people who habitually ignore the rules don't prosper and don't survive. That whole process should have given more confidence to consumers that there are regulations and laws in the country that protect them.

JK: You've based yourself out here in the Dandenongs, on the south-eastern outskirts of Melbourne. Is there any reason you choose to work far from the investment markets?

EDA: There is a simple reason: it's less expensive to maintain an office in an outer suburb of Melbourne than right in the heart of the city. I don't think we would be adding value for shareholders if we increased overheads by moving to some expensive part of Melbourne; so this [location] is consistent with the approach we want to see the business take, where we seek value and we look for the least costly way of doing it. Having the corporate office being consistent with those philosophies is very important.

JK: What sort of stake or interest do you have in the listed company?

EDA: I have a fairly small stake in the company; as the annual report shows '” about 150,000 or 160,000 shares. I've got probably another 250,000 options and a million performance rights options. The performance rights haven't matured to date and accessing them would rely on the performance of the business, which is in line with a principle that Sigma endorses: that executives should not be rewarded unless we can demonstrate that the shareholders have been rewarded even more. If the performance of Sigma continues, then I would have access to those options as well as the performance rights.

JK: What is your background? Are you a scientist or were you in business?

EDA: I joined Sigma 28 years ago. My background is finance; I'm an accountant by profession. I joined Sigma as cost accountant and have moved through various roles.

JK: So you've been here all your working life, effectively?

EDA: I hope not. I hope I've got a few more years to go.

JK: The business that you work in has changed substantially in scale over this past year when you acquired Arrow Pharmaceuticals. Can you tell me about that takeover and how it is coming along in terms of the merger of the two enterprises?

EDA: It's a merger between the two entities and it is going along according to schedule. We hope that we would be sending out the scheme booklets to our shareholders in the next couple of weeks. We expect to have a shareholder meeting by the end of November and a court hearing in the first week of December. Everything is on track at the moment and we are very pleased with the progress. It is only the Sigma shareholders who would be voting on this transaction. There will be a vote of Arrow shareholders, but that's not to endorse the transaction; that is to approve the change of name from Arrow to Sigma Pharmaceuticals and also the change in the composition of the board.

JK: You have a market capitalisation of something over $1 billion at the moment. What would the combined market cap be when the deal is completed in December?

EDA: Sigma's current market cap is just about $1.8 billion and Arrow's is over $800 million, so if we just simply add the two together it would be $2.6 billion.

JK: How dependent will the new merged entity be on the Federal Government's pharmaceutical benefits scheme (the PBS, which subsidises a range of prescription medicines)?

EDA: The merged entity will still be impacted by regulations that affect the pharmaceuticals industry, but the merger broadens our offering in terms of products and services to community pharmacists. Arrow has a 36% market share in the generic market and, what it does is give Sigma exposure to what will be the fastest-growing segment of the pharmaceutical market.

JK: Could you just explain what the generic drug market is?

EDA: Currently it is worth about $700 million. Australia extended patents for five years, which meant that in the past five years there have only been four products that have come off patent. In the next five, in contrast to that, there would be more than 50 products coming off patent, so there's a big opportunity coming up. These are products that have been proven to be identical in terms of their therapeutic effectiveness and their mode of activity. Generics are equivalent to the more expensive branded products coming off patent, so pharmacists and consumers will have a choice.

JK: Strategically, apart from the Arrow takeover, that would mean you are going to shift substantially from contract manufacturing '” making well-known pills from well-known manufacturers to perhaps making your own branded products '” is that the future direction?

EDA: Yes. That increases our reliance on our own brands compared to what we do for outside companies. Now contract manufacturing is a very important part of Sigma's business; it's not just an adjunct we engage in to use up factory capacity. It's a very important part of our core business, but there are benefits of having your own brand in terms of permanence, reliance in the future, and being able to impact the market to sell more product, which is not available to you with a contract brand.

So our strategy is about increasing the proportion of profit. We want to increase Sigma's profit on its pharmaceutical business as compared to its wholesaling business, which is very profitable but is more exposed to regulatory changes and affected by things like the PBS. Within the pharmaceutical business [we want to] shift our reliance to our own brands and products that we own and control.

JK: For a long time, investors have been attracted to the consistency of earnings per share growth at Sigma and the stock's 100% franking. Your dividend yield of course traditionally has been on the low side, in the order of 3%. Will you continue to be primarily a growth stock?

EDA: Yes, that is certainly what we see for the future. We have a dividend payout ratio of 60–65% of our profits. The business generates a strong cash flow so there is certainly plenty of cash to pay those dividends. You spoke about a price/earnings multiple that's higher than the market and I guess stocks such as that, even if they have a payout ratio of up to 60–65%, are going to result in a lower yield.

Obviously yield is important for shareholders but the price is, too, and we feel that if we can continue to deliver consistent earnings growth then shareholders would be rewarded in terms of total returns.

JK: You have given guidance to date that net profit after tax growth in the year to January 2006 would be in the order of 15%. Now in the first half you came in with a net profit growth of something in the order of 20% and so the market is saying that those estimates are perhaps conservative. Could you comment on that?

EDA: I'm aware that some analysts say they are conservative but we believe that there are some factors that are impacting are likely to impact the second half '” like some of the changes in the PBS that we have factored into our forecast. We are confident of delivering the 15% guidance number but as always we would be looking to improve on that and that's been Sigma's strategy over the past five years and what we want to provide in terms of guidance is a number that we are very confident in. That is still 15% and, you know, shareholders should rest assured that if you can do better than that we certainly will be doing our best to do that.

JK: And in terms of getting that growth, will there be further consolidation in your industry and will you be a player perhaps in the breakup of Mayne Health?

EDA: I think managements have a responsibility to make sure they identify opportunities to increase efficiency in their business and pursue them vigorously. Acquisitions, consolidation '” they're all things that provide the potential to increase the efficiency of the business, the profitability of the business and they will continue to remain the key focus of Sigma. Now if after the demerger of Mayne there was an opportunity for us in line with that principle to acquire, to merge with, to basically take part of that business and combine it with Sigma's and create a more profitable more efficient business than we have today, we would certainly be very interested in playing a role there.

JK: Elmo De Alwis, thanks for taking the time to talk to Eureka Report.

Disclosure - Carnegie Wylie, a shareholder in Eureka Report, has acted as an adviser to Sigma.