We  came  away  from  Pharmaniaga’s  company  visit  feeling  positive about  its  prospects  going  forward.  The  key  take-aways  include:  (i) Indonesian unit PT ERRITA expected to turn around in FY15, (ii) recent supply agreement with three teaching hospitals to boost revenue, and (iii)  PHIS  system  is  only  expected  to  be  implemented  nationwide somewhere in FY15 and FY16. We maintain OUTPERFORM call on the stock with a higher TP of RM6.95 to reflect our higher revised earnings forecast  and  PE  target  of  16.5x  compared  to  14.5x  previously,  and rolling  forward  our  valuation  from  FY15E  to  FY16E.  Although Pharmaniaga’s  share  prices  have  been  performing  well  since  our initiating  coverage  back  in  Nov  2014,  rising  36%,  we  believe  that  the stock has further upside.

New  supply  agreement  with  three  teaching  hospitals  could  raise  revenue. Recall,  Pharmaniaga has over the past few months signed exclusive agreements to solely undertake the services of purchasing, storing, supplying and delivering drugs and non-drugs to three teaching hospitals namely Hospital University Sains Malaysia,  Hospital  University  Kebangsaan  Malaysia  and  Hospital  University  of Malaya.  All  three  agreement  concessions  will  end  in Nov  2019.  We  expect  the three  teaching  hospitals  to  contribute  RM160m  per  annum  or  7%  to Pharmaniaga’s  topline.  We  expect  topline  contribution  to  double  from  the  low base  of  which  we  have  yet  to  factor  into  our  earnings  model.   However,  gross profit margins are expected to be lower by 2-3ppts  compared to the Government hospitals' concession. We are not overly concerned  as the higher volume would make up for the lower margins.

Pharmacy  Information  Systems  (PHIS)  to  only  be  fully  implemented nationwide  somewhere  in  FY15  and  FY16.  We  understand  that  the  PHIS system  is  only  expected  to  be  rolled  out  nationwide somewhere  between  2015 and 2016. As such, we believe the higher cost from  the PHIS implementation is expected  to  hit  Pharmaniaga  in  end  FY15  or  starting from  FY16.  However,  the slack from lower margin in the logistics & distribution division (PHIS system cost incurred in this division) will be more than taken  up by the manufacturing division. We have sufficiently factored in this cost into ourearnings model. PHIS plays a vital  and  integral  role  in  ensuring  the  dispensing  of  drugs  to  patients  and management of stock levels under the concession agreement.

Indonesia  unit  PT  Errita  Pharma  expected  to  turn  around  in  FY15. Pharmaniaga’  75%-owned  Indonesian  manufacturing  based  PT  Errita  Pharma, which suffered a loss in RM2.9m in FY14 is expectedto turn around in FY15. The reasons are: (i) the low utilisation rate of 50-60%in FY14 was due to delay in the registration of ten new products, which was rectified and approved in end 2014, and (ii) absence of kitchen sinking or provision made in FY14.

Separation  of  drugs  prescription  and  dispensing  could  pose  risk  to earnings? Speculation is rife that the Health Ministry may soon prohibit doctors from  dispensing  drugs  to  their  patients  and  hence  diminish  their  roles  to  only prescribing.  It  was  also  reported  in  the  media  that organisations  representing doctors and pharmacists have agreed, in principle,  that dispensing be left to the pharmacists. Pharmaceutical players are unlikely tobe affected since they still be supplying to the dispensers (whoever they may be) and consumption of drugs are essential for healthcare reasons. Specifically, revenue generated by Pharmaniaga (under our coverage) is supported by government concessions, non-government purchasers and exports to a smaller extent.

Raising our FY15E and FY16E net profit by 2-3%  Overall,  we are raising our FY15E and FY16E net profits by 2-3% as we assume higher revenue contribution from the new supply agreements with the teaching hospitals. Correspondingly, we raised our TP from RM5.45 to RM6.95. Apart from thehigher earnings forecasts, the upgrade in our TP also reflects a higher 1-yearforward PER rating of 14.5x to 16.5x and rollover in valuation from FY15E to FY16E.

Maintain OUTPERFORM. We continue to like Pharmaniaga for: (i) its defensive earnings  being  a  prime  beneficiary  as  the  sole  concession  holder  to  purchase, store, supply and distribute approved drugs and medical products to Government hospitals  and  clinics  nationwide,  (ii)  its  growth  exposure  in  the  healthcare  and pharmaceuticals  industry  supported  by  an  ageing  population,  and  (iii)  decent dividend yield of 5%.

Source: Kenanga Research - 24 Mar 2015