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For Sigma, Time is Running Out

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	Peter Jackson articles by this author...
Peter works in the pharma industry and has a specialty interest in pharmaceutical supply systems and logistics. He is based in Sydney with his wife and two children.

Siege mentality seems to have paralysed senior managers and executives at the troubled Sigma Pharmaceuticals, the Melbourne based pharmaceutical wholesaler.

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* The collapse of Allco Finance, the company involved with Sigma’s customer rewards program.

* Inflated goodwill values listed on the Sigma balance sheet, particularly the amount attributed to the purchase of Arrow Pharmaceuticals, the generic drug manufacturer originally owned by the Duchen family.

* Special deals made with some of its clients, notably Chemist Warehouse.

In mid-August 2007, the first clouds began gathering inside Allco Finance Group.
In just two days, its share price had fallen from $9.42 to $7.69.

An email was sent at 7.45am on August 16 discussing the market volatility and the company's share price, and a board meeting was convened at 4.15pm in such haste that all the directors, except for managing director David Clarke, attended by telephone.

But it was not the news of Allco's share price that would surprise some directors. Rather, it was the revelation that one of the company's most important managed funds, the Allco Principals Trust (APT), was facing margin calls.

One of APT's subsidiaries held 13 per cent of Allco's stock, and another held assets that were earmarked for the Singapore Investment Fund (SIF), whose float on the Singapore stock exchange had been delayed, but was still expected.

The market did not know too much about APT but, incredibly for such an important fund the Allco directors didn't appear to know that APT had been funding itself through taking out margin loans over Allco stock it held.

Allco subsequently collapsed in November 2008, and the fallout is still being felt by companies such as Sigma, Qantas, Audi, BMW and ANZ Bank.

Sigma's board is yet to disclose whether the drug maker has taken over responsibility for any Allco-related loans or liabilities under deals it had with the failed finance company.

The loans and liabilities run into hundreds of millions of dollars and have the potential to boost Sigma's net debt by more than $500 million.

It is believed that Sigma has been in talks with ANZ, Westpac and other banks on refinancing at least $40 million of loans that Allco provided the company.
These loans, known internally as the Gateway program, were used by Sigma to deliver ``competitive funding'' for pharmacists to expand their businesses.

The loans were not included in Sigma's last reported balance sheet because the company's board judged that Allco "bears the majority of the risk".

The Gateway loans were first disclosed in notes to the Sigma interim accounts issued on September 14 last year - the same day the company mailed information to shareholders about a $297 million capital raising.

But the fallout of Allco's collapse may be even more profound for Sigma.

Uncertainty surrounds the future accounting treatment of another "off-balance sheet'' deal between Sigma and Allco relating to the former's customer rewards program.

According to disclosures made by Elmo de Alwis in a presentation to investors on September 7, the rewards scheme owed 1500 pharmacists about $518 million worth of points.
It is one of the biggest business-to-business rewards programs in the country, with pharmacists receiving one point for every dollar they spend on Sigma products.

In 2009, the program generated $1.3 billion of sales for Sigma.

Sigma directors also classified these rewards liabilities as ``off balance sheet'' because Allco had maintained an investment in the rewards program.

There are significant business risks for Sigma if the program stopped honouring points.
If the program became unviable, Sigma would run the risk of losing the support of pharmacists who sell its products.
In notes to the interim accounts, the board acknowledged the prospect of taking over Allco's financial obligations relating to the rewards scheme and Gateway.

"In the event that Sigma purchases Allco's investments, this would trigger consolidation of the underlying trust that carries the Sigma Rewards debts and/or the trust that carries the loans receivable from individual pharmacists,'" Sigma stated in the first-half accounts.

The company told investors last year that group debt would be about $89.6 million following the capital raising.
But this would rise above $600 million if the rewards points were brought on to the balance sheet.

As a result of an earlier merger with Arrow Pharmaceuticals Sigma is expected to unveil a full-year loss of up to $280 million after acknowledging it paid too much for its 2005 merger with Arrow Pharmaceuticals and writing down its underperforming healthcare brand Herron.

Herron, which makes over-the-counter vitamins, cold and flu treatments and wellness products, has encountered slowing earnings, especially in the grocery sector, and recently closed its Brisbane plant, triggering redundancies and a picket by workers.

Sigma bought Herron for $123 million in May 2003.

As directors prepared to sign off Sigma's year to January 31 accounts long-serving chief executive Elmo de Alwis still had boardroom support to remain head of the prescription drugs manufacturer, marketer and pharmacy banner group.

However, immediately after the meeting rumours began to circulate of his intention to resign.
Shares in Sigma have been in a trading halt since February 25 and the company has informed the market it will release its delayed 2009-10 result by Wednesday 31st March 2010.

At the heart of Sigma's woes is the more than $1 billion in goodwill created by its $2.2 billion merger with generics drug company Arrow Pharmaceuticals five years ago.
Sigma could announce that it will write down roughly $320 million in goodwill flowing from the Arrow Pharmaceuticals deal. Although a non-cash item, it will wipe out Sigma's second-half profit and cause the company to report a bottom-line loss for the year to January 31, 2010. It will also probably skip its final dividend payment.

Sigma has encountered other pressures to its business including the global economic slowdown and regulatory changes that have squeezed margins on its generics drugs business. The expected loss has also forced Sigma to renegotiate more than $380 million in debt as the write-downs threaten loan covenants.

Disturbing to the pharmacy clients of Sigma was a recent revelation that larger pharmacy groups, principally Chemist Warehouse were being offered very generous terms for placing large orders for six months of requirements.

The margin on such orders was 0.5% and it was whispered that payment of these invoices could extend for 6-12 months.

When news of Sigma’s difficulties first broke, pharmacy clients surmised that this was the major cash flow problem. However, it pales into insignificance when compared to the items mentioned above.

Pharmacies that have been unable to negotiate similar terms feel doubly aggrieved because their major supplier differentiates product prices so that they are hurt in the market place and then discriminates in trading terms by having them pay up in full on the 25th of each month, or incur financial penalties.

Client anger has been growing for some time, well before Sigma’s internal problems began to be publicised. Many will march with their feet, particularly if they feel they will be further disadvantaged by having an unstable supplier.

And many of these clients are shareholders (some major) in Sigma, and their voices will be collectively felt if client imbalances in price and terms are not corrected.
This could have a flow on effect for Chemist Warehouse because any loss of financial benefits here could destabilise their own business activity - not that much sympathy would be evoked by the general pharmacy population if that happened.

While Sigma is electing to get everything out in the open in one hit, it allows internal reforms to occur and a general tightening of management processes.
However, fallout will still continue to surround Sigma for some time to come.
At the time of writing, Elmo de Alwis still seemed to have board support, but his tenure is definitely weakening.

Clients of the calibre of Chemist Warehouse will lose a large percentage of privilege that they have enjoyed, and it will cost dearly to replace it.

It seems a more level playing field is emerging in the community pharmacy market place and the advertising around “save up to 50% on your prescriptions” may need to be reviewed.

Meanwhile, all investors await the formal accounts due out on the 31 March 2010.

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