The Health Minister said that Pharmaniaga’s concession to distribute drugs and medical supplies for the Health Ministry will end, and a new open tender system would be introduced. While we are negative on the news, there is some saving grace for Pharmaniaga from (i) the migration to open tender will take time and its services will still be required during the transition and (ii) it has the upper hand to participate in the open tender given its experience and incumbent position. We downgrade to HOLD with lower TP of RM2.14 based on FY19 earnings pegged to P/E multiple of 9.3x (-2SD below 5 year mean).

NEWSBREAK

Health Minister, Datuk Seri Dr. Dzulkefly Ahmad said that Pharmaniaga’s concession to distribute drugs and medical supplies for the Health Ministry will end and there will no longer be concessionaire for logistics and distribution services, but an open tender system would be introduced instead. Pharmaniaga has been the sole concessionaire providing these services and its concession will end on 30th Nov 2019. To ensure the medical supplies and health services are not disrupted, Pharmaniaga’s services will be extended until the Cabinet decides on the mechanism to manage the open tender.

HLIB’s VIEW

No overnight migration. We view this news negatively; however Pharmaniaga should be unaffected in the near term as the migration to an open tender method will not occur immediately. A great deal of matters needs to be ironed out, such as the overall framework of the new model, as well as tender and evaluation before the winning bid is decided. Until all this is resolved, the Government is likely to extend the logistics and distribution services of Pharmaniaga beyond 30 Nov 2019 (official concession expiry date); this has been echoed by the Health Minister.

Takes time. During the last concession cycle which ended in Nov 2009, the renewal only happened in March 2011 (i.e. a gap of 1.5 years). Another pertinent historical example we can consider is the concession to maintain public hospitals by Faber Medi-Serve (subsidiary of UEM Edgenta). The 15-year concession first expired back in Oct 2011 but extensions were granted for it to continue its services until the new agreement was inked in Mar 2015. The point to note from these 2 examples are, despite them being concession renewals (which arguably should be less cumbersome vs. changing an entire model), it took 1.5-3.5 years to iron out. If these were used as anecdotal evidence on the possible timeline, then perhaps, Pharmaniaga’s near term earnings (i.e. FY19-20) are arguably intact as it continues to operate under the current terms.

Still the ideal choice. When the open tender is called, we believe Pharmaniaga will have the upper hand for the job due to having a competitive advantage of being the expert in cold chain pharmaceutical logistics and distribution, with a historically proven track record of 25 years, supplying drugs and medical items to over 148 government hospitals and 1,300 government health centres encompassing urban and remote areas. Pharmaniaga has successfully reduced the delivery period of pharmaceutical supplies from 60 working days to just within 7 in Peninsular Malaysia and 10 for East Malaysia. In addition, Pharmaniaga already has its existing systems and infrastructure in place, while potential new entrance would need to upfront a substantial amount of capex to build up the capacity, especially to cater to East Malaysia. As we understand margins from L&D business is not attractive enough (c.1-2% at the PBT level) to invite newcomers to embark into the journey. Also, Pharmaniaga has collaborated with the Health Ministry to develop, implement and maintain the Pharmacy Information System (PhIS), an optimal inventory management system used by all government hospitals and health facilities. Hence it would be harder for a new comer to integrate its system into the government’s existing inventory management systems. Our point here is that, there will be no margin for error allowable for a new player as it could cost the Government dearly. Healthcare is a sensitive topic and execution is key; failure to deliver due to a disruption of an existing order could result in lives and as well as negative political ramifications.

Earnings impact. In the past 3 years, on average, logistics and distribution segment contributed 60%-62% to revenue and 7%-10% to PBT (margins are thin).

Forecast. At this juncture, we believe that the earnings projection under our forecast horizon is still insulated from the propose model change (or at least for FY19-20 as elaborated above). Numbers are maintained pending further clarity from the Government on the rollout timeline and framework.

Downgrade to HOLD and lower TP of RM2.14. Despite our take that near-term earnings will be unaffected, we cannot discount the fact that uncertainty arises once the open tender model is implemented. Although we reckon that Pharmaniaga could retain its services in an open tender, margin erosion is inevitable with competition in the picture. In a nutshell, the reduced earnings clarity under the new model (vs. the existing concession), prompts us to take a more bearish stance on our valuation parameters. As such, we cut our PE target from 15x to 9.3x, which is -2SD below 5- year mean. We downgrade to HOLD (from Buy) with lower target price of RM2.14 (from RM3.45).

Source: Hong Leong Investment Bank Research - 1 Nov 2019