Sigma Healthcare (SIG.AX) – Merger Arbitrage – 14% Upside

Current Price – A$0.56

Merger Consideration – A$0.63

Upside – 14%

Expiration Date – TBD (expected mid 2019)

This idea was shares by Ilja

 

This is a combination of non-binding acquisition proposal and expected outcome from the ongoing strategic review within Australian pharmacy market.

Sigma Healthcare has seen its share price drop by 70% since the relationship with their biggest client (42% of the revenues) crumbled in mid 2017. As a result, its peer Australian Pharmaceutical Industries (API), which owns 13% of Sigma, got interested and made an offer of A$0.23 in cash and 0.31 in API shares. Sigma has agreed to proceed with the talks and apparently will grant the due diligence soon. However, the company also stated that before engaging they want to finish their ongoing business review and potentially restructure operations in light of the client loss (the contract ends in mid 2019).

Regulatory approval is also a big question mark. This is a deal between a 2nd and a 3rd largest players in Australian pharmacy market and antitrust issues have already killed the merger between them once (17 years ago, when Sigma tried to acquire API). Nonetheless, I believe it should be different this time, as after the loss of a major client Sigma is significantly weakened. If the deal goes ahead, antitrust clearance is expected in mid 2019.

Downside to unaffected price is quite limited. On top of that, as Sigma’s business review should be concluded in Q1 2019 (annual report should be out in March) + API should start the due diligence soon, we can expect some positive announcements in short future.

 

Background

Current situation was caused by major client loss. In May of 2017 Sigma’s largest client My Chemist/Chemist Warehouse has announced that they are considering to switch to another wholesaler (Chinese EBOS Group). To prevent this from happening, Sigma has started a legal dispute, but after a few months dropped it and so the companies started the negotiations. Unfortunately, the negotiations were not successful and the in July 2018 the end cooperation was announced, with EBOS Group securing the previous place of Sigma. The contract will last until the July of 2019. Sigma expects that the termination of contract will free up A$300m cash, which the company plans to use in restructuring the remaining operations.

API has started buying Sigma’s shares in September 2018 and has gathered under 5% before coming up with an indicative proposal in October. Sigma has responded positively and was ready to continue the talks, but reportedly API went quiet for a few months. Then in December API has raised their ownership to almost 12.95% by acquiring half of the largest shareholder Alan Grey’s stake (South African billionaire, previously owned over 17%). The initial 5% were acquired between A$0.53 and A$0.64 and the 8% from Allan Grey were acquired for A$0.64 (higher than the value of the current offer). Given that Allan Grey (still holds over 9%) agreed to sell to API, I assume that it shouldn’t be too hard to persuade him to liquidate the rest of his holdings and vote for the transaction.

Companies have already tried to combine couple of times before.

• Sigma has tried to acquire API in 2002, however the deal was blocked by ACCC (Australian Competition and Consumer Commission) due to antitrust concerns.

• Sigma has tried again in 2006, however this time the offer was rejected by API as undervaluing and opportunistic.

 

Thoughts on shareholder approval

From bigger picture perspective the price API is offering seems to be in line with its own valuation in terms of EV/Revenues. However, such calculation assumes that any lost revenues from My Chemist are compensated by management’s estimated A$300m of freed up capital. On top of that API’s Gross and EBITDA margins are almost double those of Sigma.

This obviously resulted in some negative reaction from API shareholders. For example, Andy Gracey (holds 3%) has commented that this is not a good deal for them and he would prefer an all stock deal with a lower implied valuation of Sigma. He also noted that Sigma’s position is currently quite weak and Sigma’s management is overstating the potential revenue growth (without My Chemist) and the value of A$300m of freed working capital.

Despite that, API management remains positive on the deal and talk about the expected A$60m in synergies, which are needed in the time when the pharmacy market leader My Chemist/Chemist Warehouse has turned to the largest distributor EBOS Group.

 

Regulatory Approval

The biggest concern is still the antitrust. As I’ve mentioned earlier in 2002 ACCC has blocked the merger between these companies due to market concentration:

The merger would create a company with 60% of the pharmaceutical wholesaling market in NSW, Victoria and Queensland and more than 50% in other States. With Mayne, the only other major wholesaler, it would account for almost 90% of the market.

Today the combined company would have 45% market share (compared to the market leader EBOS with 36%). Thus even-though ACCC can still block it, the chances are definitely better now.

In the annual shareholders’ meeting on the 23rd of January, API’s chairman has also hinted at possible better trading terms for the pharmacy industry if the merger goes ahead.