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This moated pharma stock's earnings may be on the rise

Glenn Freeman  |  23 Dec 2016Text size  Decrease  Increase  |  

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As the largest pharmaceutical wholesale distributor in New South Wales, and third-largest nationally, this is the most vertically-integrated of the three operators in this space.

 

This national pharmacy wholesaler has seen impressive growth in earnings over the past two years, suggesting the scale benefits of Australian Pharmaceutical Industries' 442-strong distribution network are starting to emerge.

Morningstar initiated coverage on Australian Pharmaceutical Industries (ASX: API) earlier this week, with a fair value estimate (FVE) of $2.15 and a narrow moat rating.

"API is unique in the Australian context, given the degree of vertical integration and targeting of the mass-market health and beauty segment through its corporate-owned Priceline and franchisee-held Priceline Pharmacy stores," says Morningstar healthcare equity analyst, Chris Kallos.

The API business is significantly different to those of its two close competitors, Sigma Pharmaceuticals and EBOS Healthcare. According to Kallos, while there are a number of commonalities across all three, API is distinguished by its combination of a higher margin mass-market retail operation alongside the pharmacy distribution business, and its Priceline branded stores transition to a partial franchise model.

These attributes now appear to be bearing fruit for API.

"The company's full-year dividend for the past two years has equated to a payout ratio of approximately 51 per cent and 57 per cent, respectively.

"This, in our opinion, is illustrative of improving earnings quality and stability, driven by the critical mass gained in the Priceline Pharmacy franchise network. Our model assumes a 60 per cent payout ratio for the next five years," Kallos says.

API has made substantial improvements to API's financial health in more recent times, after a difficult operating period characterised by several years of one-off adjustments, high levels of debt and margin pressure as a result of regulatory challenges.

"Management has done a good job of de-leveraging the balance sheet through a combination of disciplined supply-chain cost-management initiatives and the conversion of corporate-owned Priceline stores to Priceline Pharmacy franchisee stores," Kallos says.

While Morningstar views the API's business model as holding stable economic moat, underpinned by a retail services that is not focused around the Pharmaceutical Benefits Scheme (PBS), regulatory risk remains an ever-present threat.

"Regulatory risk related to further reform of the PBS remains high for API and for pharmaceutical wholesalers in general, despite the significant cost savings delivered to the government since 2007 by the market-based price-disclosure initiative," Kallos says.

However, the risk is offset by strong synergies between API's mainstream retail offering and traditional pharmacy-focused model, which "adds to the operating leverage of the logistics/distribution business."

API holds a solid market share of Australia's pharmacy retail sector, with around 26 per cent.

"Competition in the domestic health and beauty market segment remains intense, with new entrants expanding footprints in Australia and ongoing strong promotional pricing across all participants. These include the pharmacy industry, specialist retailers, discount department stores, and grocery," Kallos says.

"We consider pharmaceutical wholesaling and distribution to be a relatively mature industry, and forecast modest growth for the next decade, given the Australian government's determination to contain Pharmaceutical Benefits Scheme costs.

"Nonetheless, continued expansion into the highly competitive health and beauty category is generating scale benefits and forging an attractive franchise model for community pharmacies seeking a stronger retail-facing business. We also believe diversification into non-PBS-related manufacturing revenue will support margin improvement, given vertical integration into corporate-owned retail stores and banner group channels."

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Glenn Freeman is Morningstar's senior editor.

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