Sigma's pulse strengthens

The past few months have been difficult for Sigma Pharmaceuticals (SIP), to say the least. The healthcare stock, a long-time favourite of retail investors, lost its momentum earlier this year and the news has been relentlessly negative ever since. A failed bid for Symbion (SYB) health in June, two profit downgrades and the introduction of a fourth player to the Community Service Obligation (CSO) pool has taken its toll on the manufacturer, wholesaler and distributor of over-the-counter (OTC) pharmaceutical goods.

The slide appeared to begin when Symbion rejected an offer from Sigma, although the ensuing story of Healthscope's marathon effort to secure Symbion suggests Sigma may have sidestepped a minefield there. Nevertheless, the failure to acquire Symbion provided analysts with their best opportunity to properly scrutinise Sigma's ongoing operational performance. They were not inspired by what they saw. Two profit revisions later and speculation of a third has so far proved the critics to be right on the money.

The Sigma share price slide began in earnest back in May after Symbion Health (SYB) rejected Sigma’s offer for the company of $1.085 billion. Less than two weeks later, Sigma announced what would be the first of two profit downgrades within the space of three months. Original market guidance of 10–15% profit growth vanished as the company announced flat performance expectations on 2006-07’s $101 million result, and then downgraded that revision to $88–93 million. The market reacted savagely, wiping almost 38% off the company’s share price.

What went wrong? Clearly, the company needs to improve its bottom line and it also needs to win back the respect and confidence of the market. Increasing its sales performance may be the easy part. Winning back the market is another thing altogether, but Sigma’s refreshingly accessible chief executive, Elmo de Alwis, believes it can be done.

He believes the worst is over. “Things can’t get much worse,” he says. “I think that the negatives have been absorbed by the business and a number of the initiatives that we were looking at putting in place have now happened. We have more products coming out in the second half and we released products that didn’t impact the first half at all – products launched right at the end of the first half that are now going to give a full second half benefit.”

De Alwis is also keen to detail the cost-cutting measures Sigma has implemented, and is confident those reforms will make an immediate impact and help win back market confidence. “Cost reductions that we did in terms of finance, customer service, duplicated administrator roles, and issues like closing the Sydney office – they’re all things that we did in the first half, that are delivering benefits in the second half. It’s a combination of reduced costs, increased revenue and increased profitability.”

One central plank in Sigma’s strategy is the 'Embrace’ program, which offers substantial discounts to pharmacists through its wholesale distribution arm. Several brokers, including Deutsche Bank and Morgan Stanley, are sceptical about 'Embrace’, but de Alwis believes it can deliver better results. “It’s very much win-win” he says. “We make more money out of doing business with them and they make more money because we give them preferential trading terms. We have the opportunity to earn more profit from those customers.”

In the July–October period, 'Embrace compliance’ – the ability of Pharmacists participating in 'Embrace’ to reach minimum performance benchmarks – has shown a healthy increase. “When we started in the first half we had 350 Embrace customers. Now we have nearly 1200 customers.”

De Alwis believes growth prospects have improved since the courier company DHL withdrew from the CSO program. One less player claiming credits from the CSO as a result of legislative changes means Sigma is eligible to claim a greater share of the $144 million pool, boosting its bottom line and erasing some of the doubts that set in when DHL entered in July. “DHL don’t qualify under the new criteria, but they’re making a virtue of their withdrawal,” de Alwis says.

A Citigroup analyst, who asked not to be named, was not convinced the worst is over for Sigma. “If you look at Sigma’s result from 2007 to 2008, they’ve got a 20% drop in net profit. It doesn’t look great.”

Matthew Prior, an analyst with Merrill Lynch, believes Sigma still has some work to do to win back confidence. “The current share price for Sigma is pricing in a degree of risk associated with the potential for another downgrade to earnings,” he says. “There have been two to date and the risk of a possible third.”

Fresh assessments of Sigma from UBS and Wilson HTM have seen its share price start an upward trend, currently trading at $1.68. A report issued by Wilson HTM on November 14 indicated that Sigma may be winning back some market confidence. A senior analyst with Wilson HTM, David Arter, says Sigma shares were undervalued at about $1.64 (a price/earnings multiple of about 15 times) and that given the strategies embarked upon by Sigma, a rise to about $2 is not out of the question over time.

Although known for his optimism, de Alwis is keen to rule out any further downgrades. “Based on the way the company is performing at the moment, I can certainly do that. Unless some catastrophe takes place, we would deliver.”

The days of Sigma’s $11 share price are long gone. With structural reforms in place such as cost cutting measures, improved sales through 'Embrace’ compliance and OTC performance, and a number of brokers now prepared to ask them for another dance, investors prepared to ride out volatility within the sector will find a healthy upside in Sigma and be just what the doctor ordered.