Medici Capital > Articles > Buying a Pharmacy

Article By:

Frank Sirianni BEc(Hon) MEc

Buying a Pharmacy - Is Now the Right Time?

Friday, 4 August 2006

Pharmacy affordability, if you don't do your homework, can be very low. That is, the amount of profit used to repay the average pharmacy loan has now reached almost 100%. All of the profit is going to pay debt and interest - and that's before taxes!

Medici Capital research indicates that:

the current average actual market capitalisation rates are above 17% for metropolitan pharmacies in Sydney and Melbourne (and above 18% in other states)
the effective rates of return, including capital gains, remain well above those of alternative uses of capital (alternative investments) and recognise the implied and known risks of pharmacy ownership/investment; and
declining returns and increases in interest rates have made the affordability of pharmacy the least that it has been in the data history and provided a basis for further risk (aside from high interest rate periods of the late 80's).

Pharmacy Prices and Effective Returns

Using pharmacy business sales which took place in the 2004 calendar year, the implied capitalisation rates (broker's return on investment) are listed in Table 1.

Table 1: Average Capitalisation Rates (ACR) based on the location of pharmacies

	Implied Capitalisation Rate based on Adjusted net Profit For Valuation purposes	Range
Metro	17.35%	12.99% to 21.71%
Rural	20.91%	15.08% to 26.74%
Total Sample	18.27%	13.28% to 23.26%

Range determined by Average +/- 1 Standard Deviation
Table 1 presents the Average Capitalisation Rates for metropolitan pharmacies, rural pharmacies and the total sample. It highlights that, on average, rural pharmacies have higher Capitalisation Rates than metropolitan pharmacies.

Table 2: Average Capitalisation Rates based on the state and location of pharmacies

	Implied Capitalisation Rate based on Adjusted net Profit For Valuation purposes	Range
VIC Metro	15.64%	12.43% to 18.85%
VIC Rural	18.38%	10.90% to 25.86%
NSW Metro	16.89%	12.35% to 21.43%
NSW Rural	19.56%	16.73% to 22.39%
Others Metro	19.56%	15.18% to 23.94%
Others Rural	25.55%	21.45% to 29.65%
Total Sample	18.27%	13.28% to 23.26%

Range determined by Average +/- 1 Standard Deviation
Table 2 presents the Average Capitalisation Rates for metropolitan pharmacies and rural pharmacies[1] in Victoria, New South Wales and all other states, and also the total sample.

On average, Victorian metropolitan pharmacies are valued at and sell at higher prices than other metropolitan pharmacies. The situation is the same when comparing rural pharmacies.

Similar results are observed for rural pharmacies in these states. That is, Victoria has lower rates than NSW, however, this difference is not as large as it is for metropolitan areas. Both Victoria and NSW also have lower rates than all other states for pharmacies in rural areas.

Victoria and NSW are the largest pharmacy markets in Australia and are highly populated with brokers. As a result there is more liquidity in these markets as brokers facilitate the purchase situation and act as 'market makers'. This in turn lowers 'sale' risk for pharmacy buyers and so helps to explain why capitalisation rates are lower in these states.

On average, both metropolitan and rural pharmacies in Victoria and NSW attract lower capitalisation rates.

Effective rates of return

Even though capitalization rates may be as low as 15% for the most sought after pharmacies, which are generally in Victoria metropolitan or NSW metropolitan areas, the effective return on investment will be much higher. The reason for this is that Adjusted New Profit (ANP) can be considered as a dividend yield and to obtain the effective rate of return, capital gains need to also be accounted for. Capital gains come in the form of changes in the value of the pharmacy as a result of growth. Table 3 lists the effective rates of return when both cap rates and growth rates are taken into account.

Table 3: Effective Rates of Return given Capitalisation Rate and Growth Rate[2]

	Growth Rate
Capitalisation Rate	0%	5%	10%	15%	20%
15%	15.0%	21.5%	28.1%	34.7%	41.4%
16%	16.0%	22.6%	29.2%	35.8%	42.5%
17%	17.0%	23.6%	30.2%	36.9%	43.6%
18%	18.0%	24.6%	31.3%	38.0%	44.8%
19%	19.0%	25.7%	32.4%	39.1%	45.9%
20%	20.0%	26.7%	33.4%	40.2%	47.1%

Table 3 presents effective rates of return calculated for different Capitalisation Rates and Growth Rates. It can be seen that a Capitalisation Rate of 17% where 5% Growth is being achieved actually gives an effective rate of return of 23.6% compounded per annum. This is relatively high in comparison to returns for alternative investments.

If we compare an effective rate of return of 23.6% p.a. against annual returns for six of the major investment sectors over the ten-year period, we observe some very interesting results. The six alternative investment sectors include:

Australian equities;
Australian residential property;
Australian listed property;
Domestic fixed interest;
Domestic cash; and
Overseas equities (unhedged).

Figure 1: Comparison of Gross Returns for different investment classes[3]
Figure 1 presents a comparison of investment returns for a pharmacy with a Medici Capital Capitalisation

Rate of 17% (VIC Metro average is 16.93%) and a conservative Growth Rate of 5%, and the six alternative investment sectors. From this figure, it can be seen that pharmacies produce a gross return that is almost double any other conventional investment class.

Note that the investment returns shown in Figure 1 are gross returns. Nonetheless, our research shows tax does not influence the rankings. This shows that pharmacies are experiencing relatively good returns compared to other conventional investment.

Pharmacy Values and Affordability

Figure 2: Trends of growth in Sales, FME[4] and Value over the period 1972-2004

Figure 2: Trends of growth in Sales, FME1 and Value over the period 1972-2004

Figure 2 presents the trends of growth in Sales, FME and Value over the period 1972-2004. The most distinctive feature of this graph is that pharmacy values continue to grow at a substantially faster rate than either Sales or FME.

There are a number of drivers of this growth, including the robust pharmacy growth relative to the economy, other retailers and other professions.

Our research show, pharmacies have been experiencing relatively good returns, though returns are declining. Despite the fact that pharmacyreturns are declining, it should be emphasised that they still compare very well against the other conventional investment classes.

Affordability

The affordability of pharmacies can be calculated by finding the proportion of FME taken up by debt repayments (principal and interest). The higher the proportion of FME taken up by debt repayments, the less affordable is a pharmacy.

To calculate debt repayments, we assume a seven year period of monthly repayments and a 3% premium on the 30 day Bank Accepted Bill rate (or the 90 day Bank Accepted Bill rate, for dates prior to July 1992, since the 30 day rate was not available). In addition, we assume that 80% of value is being borrowed.

Figure 3: Trends of FME and Average Annual Debt Repayments over the period 1972-2004

Figure 3: Trends of FME and Average Annual Debt Repayments over the period 1972-2004

Figure 3 presents the trends of ANP and the Average Annual Debt Repayments (AADR) over the period 1972 - 2004. It is noticeable that around the time when the limitation of the number of pharmacies was imposed, the AADR was actually higher than ANP. This is due to the increase in value of pharmacies and more prominently, the historical highest interest rates in the 22 year period.

Figure 4: Affordability (Proportion of FME taken up by Average Annual Debt Repayments) over the period 1972-2004

Figure 4: Affordability (Proportion of FME taken up by Average Annual Debt Repayments) over the period 1972-2004

Figure 4 presents the proportion of FME taken up by Average Annual Debt Repayments, or Affordability, over the period 1972-2004. A sharp decrease (increase in the portion of Debt Repayments to FME) in Affordability can clearly be seen around the time of very high interest rates and the limitation of the number of pharmacies being proposed (around 1986).

In terms of today, this graph illustrates that, on average, 100% of ANP is currently being used to pay off debt.

Call for comment

I would welcome comment and feedback to me at fsirianni@medici.com.au or fax 03 9853 7990. Medici Capital is currently preparing detailed analysis on the pharmacy trends and outlook.

1 The sample size for rural pharmacies was too small to warrant general conclusion by state.
2 The calculations are for illustrative purposes only. Full analysis can be provided to support these calculations.
3 Alternative Investment Returns obtained from ASX Media Release: Towers Perrin, ASX Investments Report, December 2001
4 Future Maintainable Earnings = Adjusted Net Profit for Valuation purposes.

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