Sigma Healthcare Limited (SIG) Earnings Call Transcript & Summary

Good morning, ladies and gentlemen, and welcome to our interim results presentation for the 6 months ending July 2022. I am Vikesh Ramsunder, the Chief Executive and Managing Director of Sigma Healthcare. Before I begin, I wish to acknowledge the Wurundjeri people of the Kulin Nation and acknowledge them as the traditional custodians of the land on which we meet today. I pay my respects to their elders past, present and emerging. I am joined here today by Nigel Simonsz, our new Chief Financial Officer, who commenced with the business last month; and Gary Woodford, our Head of Corporate Affairs. Together, we will take you through today's presentation. You are welcome to submit questions during the webcast using the tab at the right corner of the screen. Gary will then read out your questions at the end of the presentation for Nigel and myself to answer. In terms of today's presentation, I will review the key highlights for our first half. Nigel will then provide some detail regarding our financial performance, and I will conclude with the business performance strategy and outlook for the remainder of the year. Before proceeding, I would like to acknowledge our former Chairman, Mr. Ray Gunston, who sadly passed away in July this year. Ray was a Sigma Director for 12 years, including 2 years as Chairman. Ray was deeply respected and had a profound impact on Sigma and our people and will be dearly missed. In memory of Ray, we have renamed our Boardroom, the Ray Gunston Room, from which we are broadcasting our webcast today. I would like to begin with some opening remarks. My focus, since joining Sigma 7 months ago, has been on stabilizing our ERP systems, simplifying business processes, establishing a strategy for the future and assembling a leadership team that will be able to execute the business objectives. Prior to my appointment, it is well known that Sigma undertook a significant development program, covering both systems and distribution assets. This phase is almost complete, and we can now shift our focus on extracting commercial value from these investments. You will see elements of this begin to emerge as we discuss our half year results and our strategy today. Starting with a review of the first half. The ERP system implementation has been one of the most challenging times Sigma has faced as an organization. It has been a highly disruptive period for all our stakeholders. Pleasingly, following a period of targeted actions, our IT systems are now truly stable and working as designed. The financial challenge we currently face is that the implementation has brought an increase in license fees, IT support costs and more complex business processes throughout the organization. We are now reviewing our business processes, and the team has been established to fully extract efficiencies from the installation. With regards to operational performance, we see all of our DCs are now consistently achieving delivery in full metrics of around 97% and dispatch on time metrics of 99%. These metrics are measured across the 115 million units of product shipped to customers in the first 6 months of the year. A level of underperformance still remains with our new distribution center in Victoria, where we are the most impacted by shortage of skilled labor. Stock availability has also remained at an unacceptable level. Whilst a significant proportion of stock shortages relate to global supply chain outages and poor supply infill, there are internal stock planning and replenishment processes that require improvement. We will complete these in the second half of this year. The changes being made have also extended to renewing parts of the executive leadership team. We have a new CFO, who you will hear from shortly; a new Chief Logistics Officer, who joined Sigma 3 weeks ago, and we are currently in the market for a new Chief Commercial Officer. In addition, Mr. Michael Sammells, our newly appointed Chairman, will be bringing new Directors onto the Board with a relevant skill set to support our strategy. With renewal comes a blend of fresh ideas, broad experience and diverse thinking that will help guide Sigma's future. An important focus area for the first half has been to complete a rigorous whole of business review so that I could make recommendations to the Board with clarity and conviction. This review has seen us implement some changes to simplify and streamline our operations. We will continue to implement changes over the next 18 months. A pleasing outcome for the first half is a 43% reduction in net debt, down from $149 million at year-end to $86 million at 31 July. We also took a decision to write-off inventory to the value of $29 million in the half. This is disappointing, but necessary as we instituted best-in-class inventory management processes at our distribution centers and increased our provision for obsolete stock. As part of business simplification, we have taken an impairment and assets write-off charge of $9.7 million relating to Cura. Cura is a dispensing pharmacy business for which we own the contract rights. This arrangement has lost us around $2 million per annum and will be terminated in October this year. The combination of these activities has resulted in a reported first half loss of $1.5 million, enhanced by strong sales of rapid antigen tests. The Board remains confident in our long-term strategy and has approved a dividend payout of $0.05 per share for the first half. I will now hand over to Nigel to take you through the detail of our financial performance.

Thank you, Vikesh. Firstly, it is a pleasure to be here having joined Sigma only 4 weeks ago. By way of introduction, I was most recently the CFO for AACo, and prior to that, held various financial and executive leadership roles with leading international consumer goods businesses, PZ Cussons, General Mills and prior to that, BHP. I bring to Sigma a strong track record of financial delivery and strategy development and look forward to working with Vikesh and the Sigma team to support delivery against our strategy moving forward. I'd now like to run through some key highlights of our financial performance. Sales revenue was up 6% for the half. A major contributor to the growth was the high sales volume of rapid antigen tests. RATs sales ramped up in late December, contributing about 5-week sales volume growth in FY '22 and continued into FY '23 with a particularly strong period at the start of this half. This was partly offset by lower sales in the community pharmacy channel, including sales of PBS products, which were down 7.9%, which also led to a reduction in CSO income. Both of these are largely a reflection of the challenges experienced through our ERP implementation. Gross profit for the half was positively up 12% to $126.7 million. Again, a major contributor to the GP growth was the margin from the high volume of RATs sales. This contributed around $52 million in the half and went some way to offsetting the adverse stock adjustments taken in the half of $29 million. This largely reflects a provision for slow-moving inventory, including RATs, and provisions arising out of ERP implementation issues and DC transition. Operating costs were up 5.9% to $161.3 million, which I will expand upon further on the next slide. Depreciation and amortization has increased by 14.5% to $15.3 million, which is a reflection of the accelerated capital investment cycle that is now concluding. And net interest is up 24% due to higher average net debt levels during the period compared to the first half last year and higher interest rates. And turning now to the key drivers of operating costs. Employment costs were up 13.2% to $83.2 million. This increase is in part a reflection of the complex processes that exist within the business and is a key focus area to address. The increase has been amplified by the operational shift from the Rowville DC to the new Truganina DC. Increase in duplicate labor was required to manage the transition, shift significant volumes of stock and adjust to new practices, all through a period of COVID-19 challenges and labor shortages. With the team now gaining improved training and the stock transition now complete, we expect to extract some efficiency gains moving forward. And with the implementation of SAP also comes higher IT and support costs. Also impacting these results are higher recruitment costs for a number of roles that have been filled. Freight costs were up 11.1% to $23.5 million. This is due mainly to a combination of higher costs relating to increased sales activity during the period and also being impacted by some inefficient activity that was an outcome of the ERP challenges experienced in customer ordering and fulfillment. That will continue to improve as we progress throughout the second half. We have also seen an increase in fuel costs impacted by higher fuel prices. An important area for us to work on is with our logistics service providers to improve route optimization and to drive efficiencies. Other costs were down 5.4% to $54.6 million. This is despite a $9.7 million asset impairment and write-off charge related to Cura pharmacy operations, and a $4.9 million asset write-off as a result of warehouse and office relocations from Rowville and Mulgrave. The reduction reflects lower professional service and advertising costs, which were down $4.9 million and a lower SaaS expense in the year of $4.2 million, which was down $13.7 million on the first half last year. Cloud-based services can no longer be capitalized and amortized so are expensed in the year they are incurred. Separately, SAP software license costs increased by $2.1 million. And for noting, the implementation of SAP has increased the cost base in the business by approximately $10 million per annum through increased license support and headcount costs. Delivering efficiencies from this investment is an important focus area. Cash management has been a major focus for the leadership team this half, which has delivered an excellent result in terms of improving our net debt position. Net debt is down 43% from $149 million at 31 January year-end to $85.6 million at 31 July. This has been achieved through improved working capital management, including inventory as we complete the transition from Rowville to Truganina and is after $15 million capital expenditure incurred in the first half. We have also repaid a $70 million debt facility in July. That is now excess to our needs and is in the process of being canceled. The cash conversion cycle is 27 days at 31 July, close to the best level it has been for the last decade. This is an improvement from 31 days at the same time last year and 33 days at 31 January. The improvement is partly driven by low stock availability, which is impacting the industry. As we improve stock availability, we would expect our cash conversion days to shift back up closer to 30. And now turning to capital expenditure. As we have already mentioned, Sigma is nearing the completion of what has been a significant program to upgrade and renew our network. As you can see on this slide, it has been an accelerated program over the last 5 years, which largely comes to an end this year. With the exception of our smaller lease DCs in Darwin and Townsville, our entire DC network has been upgraded, providing a strong foundation for the business moving forward. Capital expenditure in the half was a total of $15 million. This included expenditure to double the size of the Truganina DC, to facilitate growth in the Victorian market as well as the fit out of the new Hobart DC and the move of our support center from Rowville to Clayton. The expansion of Truganina and the new Hobart DC is planned to be completed in the second half with half 2 CapEx of around $25 million. Beyond that, we anticipate ongoing maintenance CapEx to stabilize around $5 million to $10 million per annum. Return on invested capital is at the low point in the cycle. We have invested the capital and at the same time, disrupted ourselves through our ERP implementation that impacted sales and earnings. As we recover, we expect return on invested capital to rebound to improved levels. And with that, I'll now hand back to Vikesh. Thank you.

Thank you, Nigel. I will now take you through the operational performance of the business. As is common knowledge, our ERP implementation did not go to plan with many challenges emerging as the system went live. It adversely impacted our sales to customers, added to our operating costs and was a major reason for the stock write-off in this half. Since implementation, our teams have worked -- are working tirelessly to identify and rectify the causes of instability. As depicted on this slide, I am pleased to say that our systems are stable and working with limited outages. We have completed our post-implementation review to identify key learnings to carry forward, and our focus has now firmly shifted to optimizing the benefits an integrated ERP system can deliver. We are systematically adjusting processes and removing inefficiencies to improve our service levels to customers and enhancing our governance and control measures. A remaining issue continues to be stock availability. Global supply chain challenges mean that manufacturer out of stocks are at historically high levels, which makes demand forecasting very difficult. Out of stocks at Sigma have been further exacerbated by the ERP implementation module not working as planned. I've taken a decision to replace this module and the project will be concluded in the next 3 months. Finally, we will be progressively integrating our key subsidiary businesses onto SAP over the next 12 to 18 months. Turning to our wholesale business. Community pharmacies were the most impacted by our system challenges and the move from Rowville to the new Truganina DC in Victoria. The community pharmacy channel makes up 53% of Sigma's revenue and was down 7%. The overall decline was weighted towards sales of PBS products, which was down 8%, as pharmacists saw certainty of supply to service their customers during this period. Sales of [ franchise ] products were up 3%, supported by RATs sales. Hospital sales have continued to grow steadily, up 7%, maintaining a 10% share of this market. The other wholesale category experienced excellent growth, largely driven by high-volume sales of RAT. Sigma has an 18% market share of the community pharmacy market. Our market share has declined by 4% for the period, owing to the challenges previously described. I fully recognize the need for sales growth and scale in a low-margin business like ours, but it is important to note that I have requested our sales team to pursue only profitable market share growth. Importantly, the upgrade and renewal of our infrastructure provides us the foundation to grow wholesale with spare capacity of 30% to 40%. Sigma currently has over 520 franchise brand members operating across Australia, which combined, achieved 5% sales growth. This is a pleasing result considering how challenging this period has been. I take this opportunity to thank our members for their loyalty and commitment. With a continued focus on supporting professional services, over 560,000 vaccinations were administered in our franchise pharmacies during the first half, a fourfold increase on the same period last year. This is a combination of flu vaccines and COVID-19 vaccines and demonstrates the ability of pharmacists to support the health care needs of their communities. Pleasingly, our brands are being noticed and recognized by consumers with 3 of them winning awards in the previous year. We congratulate all our pharmacists and the teams for the high level of frontline customer care they provide. I remain committed to supporting and growing our franchise brand membership, and we'll take you through this later in the presentation. Strategically, we continue to focus on the growth of our Contract Logistics business. Growth in the first half was up 16%, and we now service to our clients with 1 additional client being signed in the period. An additional 20,000 pallet positions will come online in December upon the completion of our Truganina expansion, which we will use to target new 3PL customers. MPS Connect continues to play an important role in servicing age care facilities, providing dose medication management services with the highest standards available in the market. A continuous improvement program, as seen, MPS maintained world-class standards, recording just 1 error in 1 million dose packages. Packed patients is a lead indicator of sales growth with progress through the year leading to a 21% increase in the first half. In February this year, MPS launched a new MediSphere management system, providing personalized care and support to patients on an integrated platform. This has proven very successful, with over 3,000 patients already signed up to the platform. We also commissioned a new blister packing machine in New South Wales, which has provided greater efficiency in operations. MPS is on track to make a profit for the first time this year. That concludes the half year review. I will now take you through the strategy of the business. For the benefit of 7 months to understand the Sigma business and gain insight into the Australian market dynamics, I'm now in a position to articulate our strategy. As a Board, we are ultimately committed to creating long-term shareholder value. We will pursue this through our diversified health, beauty and wellness offering. Some elements we do at scale today, other aspects, we will focus on growing. And there are further vectors for growth that we will begin investigating. We will drive shareholder value through the following key objectives. Firstly, we will grow scale and profitable market share in the wholesale business. This is at the very core of what we do today. Secondly, we will consolidate and build our franchise brand network. Thirdly, we will diversify our streams of income through expanded offerings via health, beauty and wellness categories. Finally, we will simplify our business and divest noncore assets. I will now unpack each of these in a bit more detail. Over the past 5 years, Sigma has invested over $400 million to upgrade and renew our infrastructure and technology platforms. That phase has been very challenging as we have seen our market share decline through a combination of COVID execution challenges, ERP implementation issues and an increasingly more competitive landscape. This period also meant an enormous amount of our time has been spent focused internally, whilst competitors have actively targeted our customers. We are nearing the finish line of this investment cycle, and our focus will move to winning back customer confidence and trust by executing with excellence and efficiency. The upgraded infrastructure gives us a foundation from which to build. It enables us to reduce operating costs and free up cash through better inventory management and throughput philosophy. The community pharmacy and hospital markets are worth approximately $19 billion, of which Sigma currently accounts for around 17%. Thus provides us with sufficient headroom for growth. Turning to our franchise brand network. Sigma has for many years operated 5 franchise brands with over 520 members as of today. Whilst this strategy offers choice of brands to community pharmacists, it makes it very difficult to manage 5 brands with excellence and build consistent, recognizable consumer-facing offers. So we have made the decision to consolidate and focus our brand membership growth under the Amcal and Discount Drug Stores brands. Amcal has strong heritage as the oldest community pharmacy brand in Australia and is consistently acknowledged by customers as one of the most trusted brands in the country. Discount Drug Stores offers us a brand positioning focused on value. We will renew the Amcal value proposition to bring a reinvigorated front shop offering, focusing on preventive and curative care. The need for differentiation and value will see a major focus on private label and exclusive brands with a targeted 20% contribution to sales. With over 3 million loyalty members, the Amcal and DDS programs are at scale. We will be investing here to enhance data analytics and consumer targeting to drive footfall into our network. Finally, if we are to deliver long-term sustainable consumer demand, we have to improve franchise member compliance to enhance brand equity. I recognize that this will not be an easy transition. The process will take several years to complete, but it is an essential strategy to influence long-term demand creation. We have in prior years outlined a desire to diversify income streams, particularly in the medical consumables space via our MIA business. We will continue to focus on this strategy while simultaneously consolidating the MIA business into Sigma wholesale, which will assist us to broaden our ranges and increase our customer base. A key area of focus for the business moving forward will be to source and develop a pipeline of exclusive products in the health, beauty and wellness categories. This may take several forms, including expanding our product ranges within the Amcal and Pharmacy Care label as well as signing exclusive distribution rights for innovative products. The primary driver here is to enhance margin for both Sigma and our franchise brand members. Finally, we will also evaluate opportunities within the $4 billion beauty market, owing to its natural adjacency to health and well-being. Beauty, as a category, has been negatively impacted by COVID-19 in recent years. It, however, remains a resilient category, and we expect growth to normalize over the next few years. Our interest in beauty will be broad, including product sourcing and distribution. Finally, to our fourth strategic objective. As highlighted at our previous results presentation, work on the simplification of the business has begun and will continue over the next 18 to 24 months. My aim is to make Sigma easier to do business with, so it's frictionless for our customers and suppliers to engage with us. As part of the simplification, we are integrating businesses operationally. This will see the MIA business integrated into Sigma from November this year, essentially becoming a product category within our core operations. The integration of the CHS hospital and third-party logistics businesses will also occur over the next 12 months. A key dependency here is the ISO 9001 accreditation of the Sigma DCs. These businesses are currently not on SAP and maintain their own stock holding, warehousing, distribution routes and support. The integration will bring them all into a singular operating environment, leveraging group infrastructure and capability. We have also undertaken an evaluation of noncore assets that deliver limited commercial benefits [ all fit ] with our strategy moving forward. As previously mentioned, we have made a decision to end the Cura pharmacy dispensing operations with a write-off of $9.7 million in these results. Consistent with this approach, we will continue to divest further assets and a number of smaller noncore financial investments at the appropriate time and valuation. No significant write-offs are anticipated from these disposals. As you can understand, the process will not be rushed to ensure we maximize the benefits received, but the divestments are expected to conclude in the next 12 months. The simplification and disposal process, once concluded, is anticipated to release between $30 million to $40 million in cash without negatively impacting earnings. And now the outlook for the balance of the year. We have made significant progress in stabilizing our ERP systems and improving our operational performance. There has, however, been reputational damage to our company. So we have to work tirelessly to restore our customers' confidence and trust, particularly in Victoria. System design decisions have increased the cost of operating. A key focus for the balance of this year and into the new year will be on simplifying the business, reducing our operating costs and building our reporting capability. Implementing our franchise brand strategy will be a high priority in the second half. The program will begin with us engaging our Guardian members to convert to Amcal. The next few months will also see the completion of our Truganina and Hobart DC expansions and will bring an end to the significant spend on renewal of our infrastructure. The opportunity ahead for us is to better optimize these assets, to enhance customer service, capture efficiencies, grow volume and ultimately, improve shareholder returns. I will not be providing formal guidance today as the second half of the year will continue to be disrupted through necessary people, process and system changes. I am, however, confident that our most significant operational challenges are now behind us, and we can accelerate the turnaround process to achieve sustained profitability. Finally, I would like to close by thanking our people for their dedication and commitment to the organization through these very challenging and disruptive times. Thank you for listening, and we are now happy to take your questions.

We have a question from Ross Curran from Macquarie. You're stating your result, ERP implementation and distribution since the transition issues, which have largely been rectified. What do you mean by largely? What other issues still ongoing?

As I mentioned in my presentation, we have a challenge with the replenishment module that we implemented not working as planned, and we're currently in the process of replacing that module that will be completed in the next few months.

Follow-up question from Ross. Prior to the ERP issues, the medium-term earnings guidance was EBITDA $100 million. You state that the turnaround has 18 months to run. Where do you see medium-term earnings once we get through the turnaround process?

I would think a good target for EBIT in the medium term would be around 1.5% to 2%, and I'll certainly be aiming with the team to achieve that.

A similar question from Dave Stanton, Jefferies. Sigma's previously stated, it will hope to return to profit in FY '23. Is this still the case? I think you've just answered. Again, Dave Stanton from Jefferies. What were the reasons for the decline in Other revenue in first half '23? Obviously, Nigel?

Largely, the declining supply rebates and in -- largely the decline in the supply rebates and in marketing and promotional revenue.

We have a question from Gretel Janu at Crédit Suisse. How much market share have you lost during ERP implementation? How much do you think you can recover in both the short term and long term?

I think it's quite a difficult question to answer, but I can certainly confirm that we've lost around 4%. The good news is, actually, we've seen that the rate of loss slowdown, which is encouraging. But certainly, winning back the trust and confidence of customers is something very difficult to predict. But as our service levels have now improved and we have stability in the system, we will certainly be working very hard to win back the sale that we lost during the transition.

Another question from Ross Curran. Can you please talk us through the $29 million inventory write-down? What were you writing off? What caused the excess inventory? Why did it spoil?

So without a doubt, I think it's very important to ensure that your inventory is accurate. And we started accounting a cycle count process throughout our distribution centers, as you can imagine, the disruption when we switched over on to our new system. And as we start to count, we recognized that there was a lot of inventory that we had picked and dispatched to customers that we hadn't accounted for. So the inventory wasn't there, so we have written that off to ensure our balances were accurate. And taking to the account the dynamics around change in COVID, we actually have excess inventory predominantly in RATs, which we've conservatively taken a provision show before which we think is right. So that's really driven the bulk of the inventory provision and adjustment for the first half.

We have a few questions here from Mathieu Chevrier, Citi. You were previously targeting full optimization of the ERP system by January 2023. Are you still expecting this to be the case?

Yes, we are. When I talk about full optimization, it means the system is working as designed, but there will always be continuous improvement measures that we will take on an ongoing basis. Every single year, we will try to optimize the system, extract efficiencies and improve our execution. So although the bulk of it will be completed by the end of January next year, we expect this to be an interim process that continues into the future.

Part 2 of the question. You're saying the turnaround process has begun and is anticipated to conclude in the next 18 months. What metrics are you looking at to measure the turnaround? EBIT, EBIT margin, can you give us a sense of what to expect?

Yes, certainly. I think the first objective is to get to a reported profit. I think that would be good for all of us. And as I've just guided into the future, the medium term between a 1.5% to 2% EBIT margin.

Part 3 of the question. How is the pickup in inflation and higher operating costs impacted your views on the level of margin achievable once the turnaround is complete?