Chemist Warehouse & Sigma Healthcare – a very special situation

(SIG.AX, market cap USD1.4bn today / USD9.5bn implied post-merger, USD8.2m ADVT, free float 100% today / 47% post-merger)

Chemist Warehouse is a big box discount pharmacy retailer in Australia with a track record of rapid and profitable growth. It is also an institution, a part of the Australian zeitgeist which has its own Bluey episode. In a few months’ time, it is on track to become a listed company for the first time, with a c.USD10bn pro forma market cap. And its proxy stock, Sigma Healthcare, already trades today.

If CW nails its Australian rollout and its international expansion, it could even turn into a contender to join the retail greats: the Costcos, the Inditexes and the Actions of the world.

CW’s chosen route to market is a backdoor IPO, via a merger with its small cap pharmaceutical wholesaler Sigma Healthcare. This eccentric decision has postponed the exhaustive disclosure and forecasts that accompany a full Australian IPO.

The deal announcement in Dec’23 kickstarted an entertaining dynamic whereby Sigma has stopped trading on its own fundamentals, and instead already trades as a proxy for the CW business, adjusted for the probability of deal completion.

Price discovery for the CW backdoor IPO will be a long and messy process, replete with game theory between existing Sigma holders, would-be CW investors and the wall of passive money that will be required to own the name post-merger.

For the time being, the CW-Sigma special situation is virtually unknown outside of Australia. (The FT has written absolutely nothing about it, for example.) I would expect a discovery phase as international and global fund managers learn of the pending IPO, subject to ACCC clearance. (An international roadshow by the combined management team would be a significant moment, but is likely to take place only after ACCC approval.)

I am not aware of any broker estimates for the combined business. Sigma consensus is currently still struck on a standalone basis. My own rough estimates suggest a pro forma valuation of c.25x June 2026E P/E, falling to c.19x June 2028E, which I find to be cheap, even allowing for deal completion risk.

I would expect many institutional investors to stay on the sidelines with a bucket of popcorn for now, but positive ACCC news could trigger a stampede into the stock.

I have bought a starter position in Sigma Healthcare at AUD1.26, sized appropriately for the volatile and speculative pre-completion risk profile.

As always, feedback is very welcome. What have I missed about this situation that is important?

The full post is laid out as follows.

·       I introduce the Chemist Warehouse business, and try to explain why it is special enough that international investors should care.

·       I briefly profile Sigma Healthcare, and the potential benefits from the merger and integration of Sigma and CW.

·       I outline the transaction structure itself, as well as corporate governance details and concerns.

·       I set out an illustrative forecast and valuation scenario for the merged company.

·       Finally, approval from the ACCC antitrust regulator is the key hurdle to deal completion. I provide details about this process with relevant precedents in the annex.

What is Chemist Warehouse?

Chemist Warehouse (CW) is an Australian discount retailer combining a wide range of health and beauty merchandise with dispensing pharmacies. Its c.550 stores in Australia are organised as a franchise network due to local regulations preventing direct corporate ownership of pharmacies. Overseas, CW owns pharmacy stores in the deregulated markets of New Zealand and Ireland, as well as a China business focused on vitamins and supplements via a Tmall shop and physical duty-free stores.

CW was founded by brothers Jack and Sam Gance and Mario Verrocchi, all qualified pharmacists. The partners came together in 1980 and opened a number of traditional community pharmacies in Victoria where they were based. In 2000, joined by Sam’s son Damien Gance (also a qualified pharmacist), they experimented with a discount format, asking themselves the question “What would happen if I drop the price on everything by 25%?”. The first Chemist Warehouse store was opened.

After a process of trial and error to get the format right, they found that the very low prices and a huge range led to dramatically higher sales per square foot, sharply reducing rent costs and staff costs as a percentage of sales.

They started a rollout across Australia. Total domestic store numbers rose from 58 in FY04 to 549 in FY23. Since 2018 they also opened 54 offshore stores in New Zealand, China and Ireland. See chart below.

Almost all stores use the Chemist Warehouse brand, except 21 community pharmacy stores in Victoria branded as My Chemist.

The Chemist Warehouse format is like a Walgreens or Superdrug store on steroids.

·       Average store size of 540 sqm is far larger than rival chemists.

·       21,000 SKUs are stocked across all health, wellness and beauty categories. The emphasis is on fragrances, vitamins, beauty and skincare products, along with discounted prescription pharmaceuticals.

·       67% of store revenue is from “front-of-store” sales, vs 27% on average for other pharmacies.   

·       Prices are low, with colourful tags to prove it.

·       Customers describe experiencing a hypnotic compulsion to spend far more than they intended. This article provides vivid colour:

You pop in to grab a single item and leave with $50 worth of stuff you didn’t really need. Every. Single. Time. What has Chemist Warehouse done to us all?

A sample of social media customer reaction is shown below.

Australian history and rollout

In Australia the pharmacy sector is highly regulated. The Pharmacy Guild of Australia has been described as the country’s most powerful lobby group. They are responsible for restrictions against non-pharmacists owning pharmacies, and limits on how many pharmacies an individual can control. To this day, the Pharmacy Guild has kept supermarkets out of the sector. Chemist Warehouse is itself a member of the Pharmacy Guild, although resented by small pharmacists.

The CW founders’ genius has been to find workarounds and loopholes in order to build a giant and commercially powerful pharmacy chain in a field of pygmies. In the early days they “bought the shell of a friendly society and began exploiting a loophole in Victorian law that placed no limit on how many pharmacies a friendly society could own”, according to the AFR.

That loophole closed in the mid-2000s, after which the founders switched to the franchised model. Initial franchisees were the founders and management themselves and their family members, many of whom are qualified pharmacists. Today, CW selects its franchisee partners from within the group, according to a structured recruitment process.

·       Each year the group takes on 500 pharmacist trainees, for the one-year traineeship as part of their course.

·       The top 25% of trainees are retained by CW as employed pharmacists within the system.

·       The best of these employed pharmacists progress to area manager, before being offered a franchise partnership.

·       They have to buy in with their own cash or parents’ support, giving them meaningful skin in the game.

Another key restriction in Australia is around the locations of pharmacies. The Pharmacy Location Rules handbook states:

“To ensure new approvals granted to address community need remain in that area of need, an approval granted following an application made under Item 130 must stay within a 1 km radius of the premises in respect of which the approval was originally granted, for a period of 5 years.”  

CW is expert at establishing or acquiring community pharmacies, and then relocating them to commercially viable premises within a 1km radius within the rules. This explains the otherwise strange existence of 24 so-called Pipeline stores, which are “Unbranded stores included in total network with plans to be converted into Chemist Warehouse stores.”

New Zealand expansion

Chemist Warehouse first opened in New Zealand in October 2017 with just AUD5m of initial capital. By June 2023 they reached 42 stores. This rollout was self-funded by revenue from existing New Zealand stores. CW has done well in New Zealand, with higher than average sales per store, according to Jack Gance. Incumbent chemist chains had high prices. CW disrupted the market with its discounted front-of-store products, and also by offering free prescriptions, waiving the usual NZ$5 per item pharmacy prescription charge.

New Zealand’s rules around pharmacy locations are liberalised compared to Australia, and CW has enjoyed the freedom to open stores of any size in any location it chooses. (In Australia, by contrast, the 1km-radius relocation rule limits site choice, resulting in smaller-than-desired stores in many cases.)

The pharmacies are majority controlled by pharmacists, as required by NZ legislation. CW owns 43.3% of Class A voting shares and 60% of Class B income shares in each pharmacy. CW also charges service fees to the pharmacies. The business is equity accounted. Equity method profits were AUD13m in FY23, up from FY8.2m in FY22. This likely understates the total contribution from New Zealand, given the existence of service fees on top.   

Ireland and possible UK expansion

CW opened their first store in Dublin in October 2020, and reached six stores by June 2023. Today they trade out of ten stores, mainly in Dublin and Cork – see my map below.  

CW in Ireland is structured as a 70:30 JV with local partner Colin Galligan, a pharmacist and entrepreneur who has taken on the CEO role of CW Ireland.

Accounts are available for the business from Ireland’s company register, with a time lag. Results so far are encouraging. Revenue was €4.8m in the year to June 2021 and €19.3m to June 2022. Gross margin was 18% in FY21, rising to 21% in FY22. The net loss was around €2m in each year, not surprising given store opening costs and lack of scale. Accounts for FY23 are due to be published imminently.

I reached out to my network in Ireland. I received notably positive feedback from a teacher in Cork.

“Asked my colleagues about Chemist Warehouse. They all love it. All have gone there for beauty products and vitamins only. No one has got medicine, besides the odd pack of Panadol. They love the range of products. The vitamins, make up, perfumes, baby products and gift sets are cheap and big range. The only thing they don’t get are hair products because the Boots 3 for 2 offers make it cheaper there. Some exclusively get products there over other places.”

Other responses mentioned “not as convenient as pharmacy beside doctors” and “we go when we are looking for specific items/brands we can’t get at our local chemist”. 

Jack Gance has described Ireland as a stepping stone to the UK in two podcast interviews. He wants to check they have the model right first. They are specifically conscious of Bunnings’ expensive failure in the UK with the Homebase acquisition, where arrogance led to humiliation.

The UK would be a highly attractive market for CW. UK’s population of 67m is twice as high as Australia and New Zealand combined. The UK incumbents, Boots and Superdrug, are potentially complacent and undermanaged.

If CW does launch in the UK then it will be joining Lovisa, Premier Investments’ Smiggle, Harvey Norman and Nick Scali on a well-trodden path for Australian retailers.

Additional future growth drivers.

CW has launched two recent brand extensions.

·       Ultra Beauty is a luxury brand beauty retail format co-located within CW stores. 17 have opened since 2018.

·       Optometrist Warehouse is a new discount optical retail concept. Two stores were opened in 2023. It may be rolled out on a standalone or co-located basis. Specsavers is the incumbent discount-coded optician chain in Australia. CW think they can beat Specsavers on both price and on superior healthcare credentials. JV partners are two former Specsavers individuals.

Existing rollouts are in Australia, New Zealand, China and Ireland. The UK is signposted as the next major destination.

Jack Gance has also spoken about Israel and the US as attractive locations for Chemist Warehouse in future. However, he is conscious of the prohibitive import restrictions that prevail in Israel, and would not expand there unless the government first changed the law in CW’s favour to allow parallel imports, which seems unlikely. As for the US, he is conscious of the unique PBM system and its complications for retail pharmacists.

I assume no international expansion beyond the existing countries and the UK for the next five years or so. In the longer term, and assuming good progress with the current rollout, then entry into additional countries does look likely.

Chemist Warehouse financials

CW’s track record of network sales growth is excellent. My chart below shows a 14% CAGR in the last ten years.

This has been driven both by new store openings and by strong same store sales growth. We lack an explicit disclosure of SSSG, but my chart below shows a 6% CAGR in average system sales per store, a close proxy.

CW’s long-term growth is impressive. They reached network sales of over AUD1bn in FY10, and have increased sales by more than sixfold since then.

The chart below is borrowed from European retailer Action’s recent capital markets presentation. I have drawn on the Chemist Warehouse sales growth. CW is so far tracking along a similar growth trajectory to some world-class retail success stories. Its pace is not quite best-in-class, given the speed bumps posed by pharmacy ownership regulations and due caution in entering new markets.

Profit and cashflow data has been provided only for the last four financial years, and only on a statutory basis with no adjusting factors provided. COVID produced a windfall for CW, both in direct pandemic-related sales and also because the stores were designated as essential services and stayed opened throughout the tough and lengthy lockdowns in Australia and New Zealand, unlike many general retailers.

The available data show CW to be highly profitable and cash-generative: see my table below. In particular, the ability to grow rapidly with low capex, while also generating significant free cash flow that can be paid out to shareholders, is an unusual and attractive feature.

Advertising and marketing revenue is significant. CW feature top brands and are proud of their strong relationships with the likes of Unilever, Colgate-Palmolive, Reckitt Benckiser and the other health and beauty FMCG giants. As part of these relationships, they sell gondola-ends and other in-store promotion opportunities. The line item ‘Marketing, advertising and other’ was AUD603m in FY23.

The table shows EBIT of AUD460m in the year to June 2023, which management were happy to endorse on the call as a representative profit level after the prior year COVID benefits had dropped out.

CW’s CFO provided an H1 update for the period to December 2023 within Sigma’s recent FY results presentation. It was a solid update, with 13.5% network sales growth, 9% LFL growth in Australia, and 29% PBT growth. 18 stores were added to the network in the period. A change to Australia’s PBS pharmaceutical reimbursement scheme (the ‘60-day dispensing rollout’) has had no negative impact so far.

Sigma Healthcare background

Sigma is one of three Australian pharmaceutical wholesalers, and also a franchisor to around 400 pharmacies. On a standalone basis, Sigma has been uninteresting for shareholders, with a mediocre track record of low growth, low profitability and low returns on capital. Its market cap averaged AUD600m in the five years prior to the CW merger announcement. Adjusted net profit after tax averaged AUD24m in the five years to Jan’24, and reported NPAT averaged just AUD6m in those five years.

Chemist Warehouse has been Sigma’s largest customer for at least 15 years, through a series of wholesale supply agreements. My chart below shows that in the year to January 2019, Chemist Warehouse accounted for 43% of total sales, as Sigma benefited from CW’s rapid growth.  

However, CW brutally leveraged their power over Sigma by exacting thin margins, extended payment terms and brinksmanship on contract renewals. This culminated in the non-renewal of the pharmaceutical supply contract in June 2019, as CW awarded Sigma’s rival EBOS the contract for the next five years to summer 2024.

Subsequently, in November 2019 CW awarded Sigma a new contract to supply FMCG products, worth half the previous one – another example of CW’s divide-and-rule approach to its wholesalers.

In June 2023, CW switched the pharmaceutical supply contract back to Sigma commencing July 2024. This unified the FMCG and pharmaceuticals contracts with a combined AUD3bn annual value. With hindsight we can see that this award laid the groundwork for the merger and vertical integration of CW and Sigma.  

Sigma earnt AUD31m of adjusted EBIT in the year to January 2024. Consensus expects a step-up to AUD70m in the current year.

The merger agreement

In December 2023 trading in Sigma’s stock was halted. The company announced its merger with Chemist Warehouse in a joint analyst meting hosted by CW and Sigma management.

In nominal terms, Sigma is to acquire CW in exchange for Sigma shares and AUD700m cash consideration. CW shareholders will own 85.75% of MergeCo on completion, and Sigma shareholders will own 14.25%.

In an instant, Sigma shares were transformed from representing a 100% interest in a stodgy and uninspiring wholesaler to a minority stake in a fast-growing and profitable discount retailer. (Conditional on deal completion which is subject to regulatory risk.)

Sigma also announced a AUD400m equity raise. This is intended to fund additional working capital required for the new CW supply contract announced back in the summer. It may also be used to help fund the AUD700m cash consideration to CW’s shareholders, with the balance to be funded by debt.  

Cost synergies of AUD60m were announced as part of the merger, to be realised four years post completion. That feels like a bit of an afterthought. The main headline of the deal is that it serves as a backdoor IPO route for CW.

Shareholder structure and free float

Mario Verrocchi, Jack Gance and Sam Gance will own 49% of the merged company on completion. They will be subject to a 12-month lock-up on 10% of their shares and a 24-month lock-up on the other 90%. They have suggested they have no plans to sell and are in it for the long haul. Another 4% of shares will be owned by other directors and officers (likely to be Damien Gance, Danielle Di Pilla and to a lesser extent CFO Mark Davis).

Free float is estimated at 47% on completion. This includes the 14.25% of existing Sigma shares which is “genuine” free float, but also c33% of shares held by around 200 other shareholders, most of whom are CW’s franchisees. These individuals will not be subject to any lock-up, and the extent to which they will want to sell down their stakes post completion, and at what price, is a complete unknown in the process that could create extremely volatile post-completion dynamics. The direct listings route seen occasionally in the US might provide a useful parallel, with the lack of a formal book-building process.

Sigma Healthcare was added to the ASX200 index on Friday May 10 2024, without undue drama. If and when the deal completes, and if the merged stock gets added to global indices with a c.USD10bn market cap and a c.50% free float rating, then passive funds would have a lot of buying to do, which would contribute to the volalility.

On the existing Sigma register, the largest holder is David Di Pilla’s HMC Capital. He sold AUD52m on Tuesday April 2, cutting his stake in Sigma from 19% to 15%. The price of AUD1.255 was a 4% discount to closing. David Di Pilla is brother of CW director Danielle Di Pilla. Both are cousins of Mario Verrocchi.

Leadership and governance

On completion, the key CW business will continue to be run by founder and CEO Mario Verrocchi (age c.66), with Jack Gance (age c.78) and Damien Gance also becoming Executive Directors. The group CFO, Mark Davis, will also come from CW. I consider the Chemist Warehouse founder / management team to be highly committed to the business. They have spoken about their hundred-year vision for further growth. I expect them to keep on running the business for decades to come.

However, Sigma’s CEO Vikesh Ramsunder is due to stay on as overall group CEO. This is a potentially unstable structure.

Ramsunder joined Sigma in 2022, having previously been CEO of Clicks Group in South Africa. Clicks is a USD3.9bn market cap health, beauty and pharmacy retailer with over 900 stores and a strong track record. As such, Ramsunder has greater credibility to play a meaningful role in the CW business than one might first assume. Nonetheless, he can hold no real power or authority over the Verrocchi and Gance families, who will own around 50% of MergeCo between them.

In short, it is unknown whether or not CW will deliver sound governance as a public company for minority shareholders in both form and substance.

Jack Gance (left) and Mario Verrocchi (right)

Lack of financial detail is another significant issue. We do not currently have a full prospectus on Chemist Warehouse. This will be published just prior to deal completion, as required by ASX.

Instead, for now we have private company accounts for FY21, FY22 and FY23. These lack any Management Discussion & Analysis, segment breakdown or explanation of exceptional items. We also have the 80-page merger presentation deck, which contains selected and limited information and disclosure about Chemist Warehouse.

Hence the Sigma stock – while already trading as a proxy Chemist Warehouse stock – is flying blind until the prospectus is published.

Related party disclosures will be key, along with any steps taken to mitigate conflicts of interest. As a private company, CW used structures such as directors and extended family members serving as franchisees. 158 of the CWG franchisee pharmacies are controlled by Mario Verrocchi, Jack Gance, Damien Gance, Danielle Di Pilla and Sam Gance. An undisclosed additional number of pharmacies are controlled by other family members including Adrian and Marcello Verrocchi, Mario’s younger brothers who are both qualified pharmacists.

CW also leases real estate from principals and purchases goods from related company suppliers. In the prospectus, such arrangements will have to be fully disclosed, and preferably rectified where possible.

Forecast and valuation scenario

Given the large uncertainties around deal completion and true financial shape of CW, I provide a forecast scenario that should be regarded as indicative only. See my table below.

At the current Sigma Healthcare price of AUD1.26, I see the pro forma mergeco stock as trading at multiples well south of 30x P/E, falling to below 20x four years out. This strikes me as relatively cheap.

ACCC deal completion risk is real. However, if the merger does go ahead as planned, then I would expect the stock to trade at considerably higher multiples given the potential for sustained and self-funded mid-teens earnings growth.

I have started a modest position in Sigma on the strength of this upside potential. Feedback on my estimates and assumptions is very welcome.

Acknowledgements

This post is a form of cross-border arbitrage. Chemist Warehouse’s pending backdoor IPO is as familiar to investors in Australia as the business itself. Both are largely unknown to the international investor community. The story deserves to be told. To my Australian readers, I owe apologies for giving them old news, and thanks for the helpful feedback they provided me in writing this post.

Annex – ACCC approval process

The Australian Competition and Consumer Commission (ACCC) launched an informal review of the merger in March. It consulted with industry participants. On June 13 it will announce its findings – likely to be a Statement of Issues rather than a final decision.

There are two likely areas of contention.

First, the combination of c.600 CW-franchised pharmacies with c.400 Sigma-franchised pharmacies could lead to substantial lessening of competition in particular neighbourhoods. This will be tested with a postcode-by-postcode analysis, and could require divestment of specific stores where local monopoly situations would otherwise result.  

Barrenjoey analysts ran their own version of this analysis on 827 pharmacy postcodes. They found only ten suburbs in which the merger would lead to ownership of over 50% of pharmacies. In their analysis, this could be rectified by divesting only 13 stores, of which five in Victoria. If the ACCC requires a similarly low number of pharmacy divestments then this would be seen as an extremely benign result. (I have not seen the Barrenjoey note itself. I have relied on the AFR’s summary for the above.)

A recent relevant precedent is Viva Energy’s acquisition of OTR Group. Viva had 1,300 retail service stations and OTR had 189 service stations. The ACCC approved the merger with the divestment of just 25 sites. The timeline was July to December 2023. However, this was a smaller deal in a less politically sensitive category.

The second likely area of ACCC scrutiny is the vertical integration of Sigma’s wholesaling with CW’s retail pharmacy supply operations. If the ACCC finds that wholesale competition would be substantially lessened, then it could either block the merger outright, or accept undertakings that customers supplied by Sigma will continue to be served on equal or better than existing terms.

A precedent of this type is Metcash’s acquisition of Home Timber & Hardware in 2016. The ACCC accepted court-enforceable undertakings from Metcash, with ongoing monitoring by an independent auditor.

Of course the specifics are different in each situation. For example, in the hardware market Bunnings is a giant whose power to restrain Metcash was reassuring to the ACCC. They might take a different and stricter view in the case of CW-Sigma, where no such giant constraining power exists.

A possible drawn-out scenario is for CW and Sigma to take legal action following an initial negative response by the ACCC. This could arise if they block the merger outright, or if they require an unpalatable number of disposals.

A recent major precedent in which an ACCC decision to block a merger was overturned on appeal was ANZ’s acquisition of Suncorp’s banking division. In this case ANZ first press-released the acquisition in July 2022. The ACCC announced a decision to block the transaction in August 2023, and ANZ won an appeal in February 2024. This illustrates the extended period of uncertainty that this scenario could create: CW and Sigma might only receive an appeal decision in July 2025 on a similar timeline.

ACCC decisions can also be appealed in Federal Court: the TPG-Vodafone merger was authorised in this way in February 2020 after ACCC initially refused to sanction it. That merger had first been announced in August 2018 – another lengthy timeline.

Sigma itself has a negative history with the ACCC. Way back in 2002, Sigma’s proposed merger with API was blocked. The deal would have reduced three main pharmaceutical wholesalers to two. The ACCC refused to accept Sigma’s proposed undertakings.

In 2018, API once again proposed to merge with Sigma, which would have set up a rerun of the battle with the ACCC. Sigma rejected this proposal in 2019, and the ACCC issue was not tested.

In 2021, Sigma tried yet again to merge with API. But Wesfarmers swooped in and acquired API, a deal that finally completed in 2022 and was not opposed by the ACCC.