Revealed: Sigma's big write-offs

Herron, which sells a range of over-the-counter products, has encountered slowing earnings, especially in the grocery sector, and recently closed its Brisbane plant, triggering redundancies and a picket by workers.

Sigma purchased Herron for $123 million in May 2003.

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

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.

At the heart of Sigma's woes is the more than $1 billion in goodwill created by its $2.2 billion merger with the generic drug company Arrow Pharmaceuticals five years ago.

Sigma could announce as early as today 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 likely skip its final dividend payment.

Sigma has encountered a number of pressures to its business, including the global economic slowdown and regulatory changes that have squeezed margins on its generic drugs business. The expected loss has also forced Sigma to renegotiate its more than $90 million in corporate debt and $500 million in off balance sheet funding as the write-downs threaten loan covenants.

There is also continued speculation about the nature of revenue booked in the final few months of its financial year, with industry whispers centred on rumoured approaches to pharmacy wholesale customers asked to buy up to six months of products in advance.

It is understood that once a decision was taken by the Sigma board earlier this year to tackle the carrying value of goodwill, it was also thought prudent to trim other valuations in the business, such as Herron, allowing all the bad news to come at once rather than expose shareholders to a death by a thousand cuts.

But most of the pain will come from its Arrow Pharmaceuticals merger. Excited investors jumped on both companies in late 2005 when Sigma's merger with Arrow Pharmaceuticals was announced. By the time the all-scrip deal was approved by shareholders their combined scrip had risen by more than $300 million in value, leading Sigma to book the inflated valuation as extra goodwill on the newly merged company's balance sheet.

Fresh analysis of the 2005 merger deal shows a massive amount of goodwill was ultimately dumped on Sigma's balance sheet - a fact that shareholders were warned about in the scheme booklet.

KPMG noted in its independent experts' report at the time that "the merged group is forecast to increase the book value of intangibles significantly, relating to the recognition of goodwill and other identifiable intangibles on the effective acquisition of Sigma by Arrow".

Buried deep in the 229-page scheme booklet is the forecast that the tie-up would see Sigma's intangible assets more than triple to $1.05 billion. According to the document, Sigma's intangible assets on the eve of the merger were only valued at $233.5 million.

The accounting group also warned shareholders that the combined company's total liabilities to total tangible assets would increase from 86.1 per cent to 103.3 per cent.

Pharmacy insiders have also raised new concerns about the valuation placed on Arrow Pharmaceuticals' in-house sales team in 2005. Sales for this business unit rocketed in the year that Arrow Pharmaceuticals was sold to Sigma and was responsible for nearly 30 per cent of total EBITDA.

The 2005 KPMG report prepared for Sigma shareholders noted that Arrow Pharmaceuticals' "rendering of services to pharmaceutical companies" had doubled to $9 million for the first six months of 2005, making up more than one-third of Arrow Pharmaceuticals' gross profit for the half.

The stunning growth was tipped to continue. Revenue from these services was forecast to jump to $21.3 million in 2006, representing just under 50 per cent of gross profit and EBIT for that year.

One pharmacy industry insider said this contracted sales force, a type of "guns for hire" for large pharmaceutical companies, had a growing but highly volatile earnings history.

"They paid over the odds for the generics business, but a good chunk of the earnings on the year that they bought it was based on medical representative income," the insider said.

"Arrow basically had a field force that pharmaceutical companies would pay to have their products sold to doctors. They weren't generic drug earnings, they were a contracted force that didn't have anywhere near the growth profile of generic earnings.

"I was always amazed that no analyst ever asked Sigma why they were paying an exorbitant multiple on earnings that didn't relate to generic pharmaceutical sales because they don't have the same profile. It's just a cash flow which you should be paying six times not 25 times earnings."

Sigma has continued to grow revenue from the sales force over the past five years, but it is understood to have not maintained the double-digit trajectory witnessed in the year of the merger.

Founded by David Duchen in 1999, Arrow Pharmaceuticals rode a wave of booming generic drug sales which by 2001-02 was recording sector growth rates of 20 per cent-plus.

Growing consumer acceptance of generics and prodding by government helped Arrow Pharmaceuticals accelerate its sales from zero to more than $280 million in only four years - at which time the business appeared on Sigma's radar.

The Duchen family would later sell the bulk of their inherited Sigma shares at prices around $2.30 to $2.40 a share to raise more than $200 million. The Duchens' exit price is a far cry from Sigma's share price of 90? when the trading halt was placed on the stock last month.