Morningstar analysts say Sigma's proposed acquisition of Priceline owner Australian Pharmaceutical Industries faces significant hurdles and will likely attract resistance from the competition watchdog.

In a research note, Shane Ponraj estimates the market share of a merged Sigma/API entity would be roughly half of Australia's pharmacy distribution network, ringing alarm bells at the Australian Competition and Consumer Commission's (ACCC) who blocked a similar deal two decades ago.

Sigma's (ASX: SIG) network of 1,200 stores includes brands Amcal, Guardian and PharmaSave while API's (ASX: API) brands include Priceline and Priceline Pharmacy franchises and the Clear Skincare network.

"The ACCC prevented a Sigma API merger in 2002 as it would have commanded over 60% of the pharmaceutical wholesaling market in Australia's eastern states and over 50% in others," he says.

"Since 2002, Sigma has lost a material Chemist Warehouse contract to EBOS Healthcare, and competitors DHL Pharmacy Supply and Clifford Hallam Healthcare have a greater presence in the space."

"However, we still estimate that the current market share of a merged entity would be roughly 50% of Australia's pharmacy distribution.

"As such, there is considerable risk of ACCC resistance to the deal."

Sigma Healthcare jumped into the race for API on Monday, outbidding Wesfarmers (ASX: WES) by a small premium.

The pharmacy group made a nonbinding offer to acquire no-moat API for 35 cents in cash and $2.05 Sigma shares per API share, implying a $1.57 consideration (based on Sigma's closing price on 24 September 2021). The API board has since deemed it superior to Wesfarmers' September 16 bid of $1.55 cash per share and allowed Sigma to undertake due diligence in parallel with Wesfarmers.

Wesfarmers had initially bid $1.38 cash per cash in July. At the time, Morningstar analyst Johannes Faul described the bid as "opportunistic", coming as lockdown restrictions led to the temporary closure of 75% of Clear Skincare clinic and about one-fifth of Priceline's network.

Ponraj says Sigma's API bid could struggle to gain necessary approval given Wesfarmers' capacity to block to deal in the event of lower shareholder turnout.

"Wesfarmers made an agreement with Washington H. Soul Pattinson that if its bid was to go to a shareholder vote, WSP would vote in favour. WSP has a 19% ownership in API. In the event of a competing offer, Wesfarmers would have the option to acquire WSP's holding.”

"For a successful bid, Sigma must secure at least a 75% 'yes' vote from API shareholders. However, not all shareholders need to be present for the vote, as long as half are represented.

"It's unlikely all the shareholders would attend the vote. If 80% turn up, this would allow Wesfarmers to block the acquisition using its 19% interest from WSP."

Cost savings

This is far from the first time Sigma has attempted to acquire API. Bids were made in 2002 and 2006, the former failing due to competitive concerns and the latter on valuation. API sought to acquire Sigma in 2018.

Ponraj says a Sigma/API tie-up would offer the merged entity greater buying power to negotiate terms from drug manufacturers and allow it to find efficiencies in its logistics operations.

Sigma estimates $45 million in potential cost synergies but Ponraj says there are risks in its ability to execute in full.

Morningstar's Faul says a Wesfarmers/API deal is "far from transformational" for the conglomerate due to the relatively small size of API – $0.8 billion compared to WES' market capitalisation of over $65 billion.

"The potential addition of no-moat API to the conglomerate's stable is too immaterial to impact Wesfarmers' competitive advantage," he says.

"The balance sheet is capable of much larges moves, which could have the potential to add greater value for shareholders."

Since Coles demerged from Wesfarmers' in 2018, management has overseen several smaller acquisitions including Catch Group, Kidman Resources and Geeks2U.

Morningstar is maintaining its $1.55 fair value for API, $0.69 fair value for Sigma and $39.50 fair value for Wesfarmers.