On the surface, there’s no comparing these two stocks. Primary Health Care looks like the Rolls Royce of the health care sector. In 2010, the business generated a return on tangible assets (EBIT/tangible assets) of 40%. Its pathology division generated a return on tangible assets of an astonishing 76%.
Sigma Pharmaceuticals, on the other hand, is the Hyundai Getz of the industry. The return on tangible assets for its wholesaling division (the only bit that’s left after the recent sale of the manufacturing business to Aspen Pharmaceuticals) was about 5% for the past year – worse than bank interest.
The two businesses do have something in common, though. Primary’s pathology division and Sigma’s wholesaling business both have the Government as their main customer. And that customer is hell bent on reducing its costs.
Here’s where things get interesting. Sigma’s appallingly low returns give it substantial leverage at the negotiating table. If the Government tries to squeeze any more margin out of Sigma, the directors can and should take the company’s assets and leave the industry. Returning capital to shareholders is a much better option than leaving it in a business earning substandard returns on capital. And, given the assets are predominantly receivables, inventory and cash, that should be relatively easy to do.
Primary, on the other hand, doesn’t have the luxury of walking away. Even if the Government were to halve its earnings, the business would still be obscenely profitable. That’s a very difficult position to negotiate from, especially given the returns are published for all to see.
Long-suffering Sigma shareholders have been twelve brutal rounds with the Government but have likely weathered their last punch. For Primary shareholders, the traumas of the past year might only be round one.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.