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Edited Transcript of API.AX earnings conference call or presentation 23-Oct-19 11:30pm GMT

Full Year 2019 Australian Pharmaceutical Industries Ltd Earnings Presentation

Syney, NSW, Nov 2, 2019 (Thomson StreetEvents) -- Edited Transcript of Australian Pharmaceutical Industries Ltd earnings conference call or presentation Wednesday, October 23, 2019 at 11:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Peter Mendo

Australian Pharmaceutical Industries Limited - CFO

* Richard C. Vincent

Australian Pharmaceutical Industries Limited - MD, CEO & Executive Director

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Conference Call Participants

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* Gretel Janu

Crédit Suisse AG, Research Division - Research Analyst

* John Deakin-Bell

Citigroup Inc, Research Division - Director & Head of Healthcare in Australia and New Zealand

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Presentation

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Richard C. Vincent, Australian Pharmaceutical Industries Limited - MD, CEO & Executive Director [1]

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Well, good morning, ladies and gentlemen, to those in the room and for those listening online. Welcome to API's financial results presentation for the year ending 31st of August, 2019.

As per our standard practice, I will provide a quick overview of the group performance; and our CFO, Peter Mendo, will take you through the financial performance before I finish up with an operational summary and perspective on the coming year. We will then take any questions that you may have.

I'm pleased to say that today's financial results were in line with market consensus. This was achieved despite tough conditions in Pharmacy and more generally in retail. The results reinforce the fact that we have a portfolio of complementary health and beauty assets that are valued by our customers and are capable of delivering sustained returns for shareholders. The strategy remains simple: it's leveraging our existing infrastructure, market expertise and financial strength to optimize returns from Pharmacy Distribution and Priceline Pharmacy as well as our newer assets, Clear Skincare and our Consumer Brands portfolio.

So to our results for the year. The group's total revenue was $4 billion, and excluding the impacts of PBS Reforms and hepatitis C medicine sales, this represents a 4.1% increase on the prior year.

Reported EBIT was $94 million, up 14.1%, and reported NPAT was $56.6 million, up 17.4% on the prior year. However, you need to bear in mind that last year's results included the impact of $6.6 million in one-off costs associated primarily with the Clear Skincare acquisition and business restructuring to lower the ongoing cost base of our business. And therefore, on an underlying basis, EBIT was up 3.9% on the prior year, and underlying NPAT was up 3.2%.

The highlights in this result are that we were able to restore same-store sales growth in the Priceline Pharmacy brand; continue the expansion of our Consumer Brands business; develop and scale Clear Skincare for network growth; while managing the structural issues prevalent in the Pharmacy Distribution sector.

Pharmacy Distribution continued to deliver increased underlying revenue in a highly competitive environment. Pleasingly, like-for-like sales at Priceline Pharmacy strengthened during the second half of the year, and we ended up at 0.7% up on the prior corresponding period despite ongoing deflation caused by increased promotional activity across the sector.

Consumer Brands continued to exceed our expectations, with gross profit up by 24.7%. Revenue at Clear Skincare was up 20% on the prior year, and the expansion of the clinic network has now accelerated.

Our balance sheet remains in good shape, with basic earnings per share of $0.112, and our financial strength is reflected in the Board's decision to declare a fully franked dividend of $0.04 per share, bringing the full year dividend to $0.0775, an increase of 3.3% on the prior year.

I'll elaborate more on our operational performance, but first, over to Peter to take you through our financials in more detail. Peter?

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Peter Mendo, Australian Pharmaceutical Industries Limited - CFO [2]

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Thank you, Richard, and good morning, everyone, here or via the webcast. To recap on the key financials. FY '19 saw another solid operational performance. Reported EBIT was up 14.1% to $94 million, and reported NPAT rose 17.4% to $56.6 million. On an underlying basis, EBIT rose 3.9% and NPAT, 3.2%. The result for FY '19 has us reporting in line with consensus. Richard will go into greater detail about each business unit in his operational review.

From a CFO's perspective, it's pleasing to see the success of the strategy reflected in the key financial metrics. Before I get into the numbers though, I should note that there is a different flavor to our accounts this year. They include the first full year of Clear Skincare with the associated acquisition debt and treatment of future acquisition-related payments.

Secondly, we have classified and measured the investment in Sigma at fair value through the consolidated statement of comprehensive income in the 4E. This is because these shares are not held for trading, but rather, they were purchased as a strategic investment.

And lastly, for the accountants, as I mentioned at the half, there have been changes in accounting standards that we have been required to adopt: AASB 9 Financial Instruments; and AASB 15 Revenue from Contracts with Customers. The related disclosures have been incorporated in note 25, providing an overview of the impacts of the adoption of the new standards. Further, the estimated impact of AASB 16 covering leases, effective from the 1st of September, has also been included in note 25.

Right. With that out of the way, let's unpack the results.

Firstly, revenue. After adjusting for the continued reduction in hep C sales and PBS price reductions, total revenue has increased by 4.1%, noting that, for the first time, Clear Skincare added $45.6 million.

You will notice in the P&L that other income is higher than last year. Referring to note 3, changes in fair value of financial liabilities, you will see we have reduced the provision we hold for future payments and dividends to the minority shareholders of Clear Skincare. This reflects the commercial likelihood of having to make payments relating to performance targets for the existing network agreed with the founders at the time of acquisition. The value we expect to extract from expanding the network and its profitability using API's existing skill set and infrastructure remains undiminished. Richard will talk more to Clear Skincare's performance and growth potential.

In relation to cost management, you'll see that the group's underlying cost of doing business has increased this year to 10.9%. That is because of the addition of a full year of operations of Clear Skincare, which has a different cost profile when compared to our other businesses. If the impact of Clear Skincare is excluded, the result would have been 10.3%, the same as last year.

Included in the sales and marketing line of cost of doing business is trade receivable provisioning. You will see in note 8, the value of our noncurrent trade receivable has increased. We are comfortable that we have sufficient provision to address any potential exposures, whether current or noncurrent.

You will note that the 2 substantial items that I've highlighted, the Clear Skincare contingent consideration provision and the trade receivables provision, effectively offset each other.

You may recall that at the half, we reported that working capital had increased as a result of investing in inventory to ensure that we optimize retail sales opportunities through the Christmas period. The increases in both overall sales and like-for-like sales at Priceline Pharmacy suggest that this was a successful tactic. However, as advised at the time, this move negatively impacted upon cash conversion days and debt levels at the half.

With the exception of an increasing Consumer Brands inventory, which is a natural outcome of the business growing, cash conversion days reduced almost to prior year's levels and we witnessed a solid cash performance in the second half.

Following on, reported net debt has reduced by $63 million from the half to $199.1 million. Compared to the $55.9 million at the end of FY '18, the difference is primarily driven by our shareholding in Sigma Healthcare of $86 million; the previously noted investment in Consumer Brands' inventory of $22 million at the year-end; an increase in our CapEx spend of $10 million relating in part to the spend on Clear Skin clinics; and the balance is made up of a range of small items.

It is well worth noting again that the financing cost of our investment in Sigma had been offset by dividends during the period.

Talking about interest costs, not financing costs which include the API rewards program, our interest expense for the period was $15.7 million. When normalized to take account of the costs of both Clear Skincare and the Sigma Healthcare share acquisition, interest costs were actually $9.9 million.

Given the interest rate environment and our strong focus on debt management, we expect further reduction in the cost of debt, albeit at a higher debt level while we maintain our Sigma Healthcare shareholding.

In relation to our effective tax rate of 23.3%, this is mostly as a result of the fully franked Sigma dividend, along with the Clear Skincare fair value provision adjustments which are not subject to tax.

On a further positive note, underlying return on equity increased from 10.29% in the prior year to 10.96% in FY '19, reflecting the results from our growth businesses, Consumer Brands and Clear Skincare.

While return on capital employed remained strong, it declined slightly to 16.29% from 16.54% in the prior year. This was due to the inclusion of the Clear Skincare debt for a full 12 months and the working capital investment in the first half.

I am confident of further improvements in our key financial metrics as a result of a combination of our focused financial management, strong cash flows from Pharmacy Distribution business and further growth from our Priceline Pharmacy, Consumer Brands and Clear Skincare businesses.

Based on this performance, the Board has declared a final dividend of $0.04 per share, fully franked, which means that the payout ratio has risen from 66% to 70% over the last 3 years.

As always, we remain committed to disciplined capital management. We are currently reviewing our capital expenditure requirements for all our businesses, including assessing the Sydney Distribution Centre and the potential impacts of newly available technology. We will provide an update when we have any news in relation to the Sydney DC as any potential investment would be over and above normal CapEx levels.

Our Clear Skincare capital management plan also includes the second and third acquisition tranches in September 2020 and 2021. Those payments are $32.9 million each.

As any shareholder would, with interest, we continue to assess ongoing our investment in Sigma Healthcare, monitoring particularly Sigma's planned recovery through its project pivot program. We remain comfortable with the investment for now, and our view is that there remains a strategic logic of a combination with Sigma.

I will now hand back to Richard to provide more detail on our operational performance.

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Richard C. Vincent, Australian Pharmaceutical Industries Limited - MD, CEO & Executive Director [3]

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Thanks, Peter. I'll start with an overview of our Priceline Pharmacy results. Total retail network sales, which includes the dispensary, were $2.2 billion, up 2.4% on the 2018 financial year, with roughly half of our sales coming from the beauty ranges in the front of our store. Total front-of-store register sales, which exclude dispensary, were $1.2 billion, up 1.5% on last year.

The most pleasing element for the year was the return to like-for-like growth that I mentioned earlier. This was a solid performance considering the expansion of competition from specialty retailers and the tightness of consumer spend. The like-for-like growth was achieved while keeping store register margins in line with last year.

There was a marginal change in the total reported gross profit compared to last year, which was the result of the closure of 7 company stores. And I'll speak to that some more in a moment.

The continued focus on performance delivered an improved EBIT performance for the Priceline Pharmacy network, which was from strong cost control and support office management. The Priceline Pharmacy network grew a net 13 stores during the year, from 475 stores to 488 stores. We saw strong growth in our Priceline Pharmacy franchise network, where we increased our store numbers by 20. It is this ability to continue to attract independent pharmacists to our network that is central to our continued growth.

It should be noted that we're persevering with our policy of closing company-owned stores, where, in our opinion, landlord rental expectations impact the viability of stores. Consequently, we actually reduced our number of company-owned stores by 7 during the financial year, hence the increase in total stores was a net 7 stores.

Our growth of 0.7% in like-for-like sales was built from our investment in an improved product portfolio and was instrumental in delivering a like-for-like sales increase of 180 basis points from the negative comps of the prior corresponding period.

Key category growth for us came through the skincare and health categories, where we continue to build our market position. The growth profile of skincare is one that we've capitalized on and caters to such a wide range of shoppers.

Our strength is having the right mix of trusted brands and new product development, which gives us an enviable range matched by in-store product knowledge and service that is proving a winner with customers. The cosmetics market is more crowded than ever, but we held market share largely due to the introduction of new brands and ranges in the past 12 months.

Innovation is critical in this category, and we launched exclusively one of the world's fastest-growing brands, Revolution, which is now ranked seventh in our cosmetic range. And as I said, we have that exclusively. The development of exclusive products and ranges continues at pace. This ongoing investment in new products is essential to ensure we remain relevant to our customers.

Our health category growth has been pleasing across the total range, with vitamins growth responding particularly well to promotional activity. Our health services have also gained traction during the year. For example, we're seeing a significant increase in the number of people looking for services such as flu vaccinations, where we completed approximately 251,000 shots for the 2019 season, representing an increase of more than 50% over the prior year.

All of this has seen our -- growth in our market share in skincare, over-the-counter health products, vitamins and supplements. Our loyal customers in our Sister Club are responsible for much of our sales growth, with much larger basket sizes and more store visits than nonmembers. We're enhancing the value for Sister Club members through exclusive rewards, with things such as bonus points.

We have continued to invest strongly in the brand, and that's a key reason why independent pharmacists continue to choose Priceline Pharmacy over other options. Constant growth in the franchise network numbers for the last 15 years is testament to the difference our offer makes to pharmacists as is the fact that many of our franchise partners have invested in more than one Priceline Pharmacy.

Our annual independent franchise survey conducted in the middle of 2019 once again showed the broad satisfaction our franchise partners have with our operations. We remain on track to implement "click and collect" this year. This will allow our customers to order online and collect from the Priceline Pharmacy store that is most convenient to them. We expect to build on the momentum that we've gained in 2019 through the -- through remaining focused on our product offer and maximizing the promotional effectiveness during 2020.

Turning now to Pharmacy Distribution. Reported revenue was 1.9% down on the prior year. However, adjusted Pharmacy revenue, which excludes the impact of declining revenue from hepatitis C medications and ongoing PBS Reforms, was up 4.2% to $2.9 billion. The cumulative effect of price deflation and rising input cost means that while this is a reliable cash-generating business, it remains a tough environment in which to maintain returns year-on-year.

In that regard, our offer to independent pharmacy is critical, and the new programs launched during the year have gained traction. New merchandise and marketing offers to our Soul Pattinson Chemist brand, our Pharmacist Advice brand, have improved effectiveness, while the relaunch of the Club Premium offer, to include more retail and professional services, has increased members by more than 10% over the year. Overall, we now have over 1,450 members in our retail/pharmacy programs.

In March 2019, the Department of Health confirmed the funding for those wholesalers who deliver on the government's Community Service Obligation, or the CSO, up to the end of June 2020, giving certainty over FY '20 cash flows. Whilst this is good news, it's becoming progressively more difficult for wholesalers to fulfill the government's promise of the quality of access to PBS medicines for all Australians with delivery within 24 hours to any pharmacy.

The industry is engaged in discussions about the future funding for the CSO and our wholesale margin and how that will operate as part of the Seventh Community Pharmacy Agreement. While we're at the early stages of that engagement, there's no doubt that the government recognizes the value in the CSO in delivering the National Medicines Policy. And we expect the CSO to remain in place, with the potential to enhance the services that wholesalers offer.

The value of the CSO wholesalers was reinforced just this month with the return of AstraZeneca to the CSO system. This will allow community pharmacists to once again order all of AstraZeneca's medicines from their preferred full-line CSO wholesaler. From my perspective, it is a very welcome decision.

Consumer Brands. Our Consumer Brands division continues to go from strength to strength, with gross profit up 24.7%. The business has had success from further development of its health care portfolio and, at the same time, from building its Personal Care brands. For example, our Only Good brand has established a strong presence in major retailers in Australia, including Woolworths, and we have a foothold in overseas markets such as Asia and the U.K.

We now have a comprehensive range of health care products, and that is reflected in the long-term contracts we've negotiated with our trading partners. There are opportunities for us to grow this business, especially by extending health care categories, which provides us with confidence that the organic growth that we've seen in the past 2 years should continue in 2020.

And lastly, the Clear Skincare. This is our first full year with Clear Skincare as part of API's portfolio. Revenue was in line with our expectations, up 20% on the prior year. It is a high-margin business, and the gross profit for the year was $37.9 million.

The first 12 months has involved the repositioning of the customer proposition, bedding down systems and refining processes to enable longer-term growth. These steps have been necessary to take what's been a very good business and make it into a high-growth brand in Australia and New Zealand. While this took a little longer than we originally planned, the outlook for shareholder returns remains very positive.

The clinic rollout program has now accelerated as we've made the required operational improvements. We opened 8 clinics during the year, taking the total number to 52 clinics. And by the end of this month, we'll have opened another 3. We expect to comfortably exceed our target of 10 new clinics for FY '20.

And the growth opportunities for this business remain strong, primarily through new clinics in underserviced geographies as well as growing the range of offerings in existing clinics and by broadening the distribution of the proprietary skincare product range through our Priceline Pharmacy network.

While it is already a solid business, I'm confident that our expertise in retail, property development, marketing, distribution will see us increase profitability for the Clear Skincare network.

So the outlook. As I turn to the outlook for API, I want to reinforce my confidence in our business strategy. In Priceline Pharmacy, Clear Skincare and Consumer Brands, we have assembled a diverse but complementary portfolio of health and beauty assets that leverage API's existing competencies, expertise and infrastructure for growth. I'm expecting further growth in cash generation in FY '20 despite the persistent challenges across the retail and pharmacy sectors.

The longer-term outlook is clearly subject to the 7th CPA negotiations between the government, the Guild and the wholesalers. And the Minister, Greg Hun, is on the record as saying he would like the 7th CPA negotiations resolved by the end of this calendar year. So hopefully, we'll have some clarity around that. As I remarked earlier, the CSO wholesalers expect the CSO structure to be maintained.

As you know, we don't normally give guidance at this time of the year. Obviously, Christmas trading is a very significant component of our retail business, and performance through Christmas sets the tone for our forecast and our outlook. So I look forward to providing an update on the FY '20 outlook at our AGM in January and an update on the 7th CPA negotiations.

So thank you for your attendance this morning, and I'll now open it up for questions.

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Questions and Answers

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John Deakin-Bell, Citigroup Inc, Research Division - Director & Head of Healthcare in Australia and New Zealand [1]

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It's John Deakin-Bell from Citi. There's just a few. And I understand that changing mechanics probably made things a little complex. But the tax rate, first of all, just so we're clear on the exact difference because it's -- I think it's 23% versus 30% or something, is that related to the restatement in the valuation of the Priceline? Or what exactly -- why is it so low?

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Peter Mendo, Australian Pharmaceutical Industries Limited - CFO [2]

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We've got the Sigma dividend in our accounts. Whilst it's fully franked, it doesn't affect any tax. And the reassessment of the contingent consideration for Clear Skin of the $18 million, that's also not subject to tax. So basically, those 2, if you take them out of the profit before inventory, you'll end up with your tax rate.

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John Deakin-Bell, Citigroup Inc, Research Division - Director & Head of Healthcare in Australia and New Zealand [3]

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The cash flow versus the EBITDA was very low. Again, why was that so low this year?

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Peter Mendo, Australian Pharmaceutical Industries Limited - CFO [4]

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I think the cash flow, we've shifted in what we do. We're injecting working capital through our growth businesses. And the other thing we've done is also throughout Consumer Brands and Priceline Pharmacy. There's also been an increase in the CapEx of $10 million with Clear Skincare, the rollout of the clinics, the refurbishments and the relocations. So that's also added to that.

There's still some working capital that we could always improve on in that regard. And I think one of the main things, if you look back in previous years, we've basically had a sole reduction of debt philosophy. So as a result of what we've done in those earlier years, we're now able to invest and do what we're doing, so that's probably why you're seeing a reduction in the cash flow.

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Richard C. Vincent, Australian Pharmaceutical Industries Limited - MD, CEO & Executive Director [5]

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And there's also the investment in Sigma. So in the presentation that Peter's just explained, the 3 major items that show you the movement in the cash flow are listed there. And obviously, the largest one of those is the Sigma investment.

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John Deakin-Bell, Citigroup Inc, Research Division - Director & Head of Healthcare in Australia and New Zealand [6]

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I'll just ask one more because we're just struggling to try and work out what the actual underlying -- what's actually happening in underlying because -- so on Page 5 of your annual report -- in Page 6, sorry, you've got that -- you've got 2 tables there. One's reported EBIT, and one's underlying NPAT. But the reported EBIT includes $3 million of the dividends, I think. So the underlying EBIT's...

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Richard C. Vincent, Australian Pharmaceutical Industries Limited - MD, CEO & Executive Director [7]

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No, no. That's -- so for -- as Peter called out, that you're right, it does include that, but it also includes the financing costs attached to that, and they essentially balance each other out. So you've got the dividend in and you've got the interest out.

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John Deakin-Bell, Citigroup Inc, Research Division - Director & Head of Healthcare in Australia and New Zealand [8]

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So the interest expense doesn't include the financing costs of the Sigma?

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Peter Mendo, Australian Pharmaceutical Industries Limited - CFO [9]

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The interest expense.

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John Deakin-Bell, Citigroup Inc, Research Division - Director & Head of Healthcare in Australia and New Zealand [10]

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Yes. It's in the interest -- this is EBIT. Below that is the interest expense. Because it looks to me like the EBIT is $3 million higher because you've got the dividend, but then your interest expense is obviously...

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Peter Mendo, Australian Pharmaceutical Industries Limited - CFO [11]

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Yes. But there's also a cost. There's also the external cost of our transaction cost with Sigma as well, which is in the EBIT line.

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John Deakin-Bell, Citigroup Inc, Research Division - Director & Head of Healthcare in Australia and New Zealand [12]

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Okay. We might need to try and clarify this off-line because it is confusing. And then this underlying NPAT, the underlying NPAT is different because you've got the different tax rate. So if we normalize for the tax rate, the underlying NPAT would be $5 million lower, I think. Is that correct?

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Peter Mendo, Australian Pharmaceutical Industries Limited - CFO [13]

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Yes, but I -- once again, I think what you need to do when you look at the set of accounts, you just can't pick one line and say, oh, that's the reason because, I mean, I've called out plenty of pluses and minuses above. And the benefit in the tax rate actually comes from those decisions above.

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Gretel Janu, Crédit Suisse AG, Research Division - Research Analyst [14]

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It's Gretel Janu, Crédit Suisse. So just further on the accounts, just that $18 million benefit to EBIT because of the change in fair value of the -- what was it, the financial liabilities. Can you explain just further on that in terms of why that was taken now. So what was the timing decision? Is the...

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Peter Mendo, Australian Pharmaceutical Industries Limited - CFO [15]

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The timing decision is done basically on what I have to do on any reporting period on any impairment, accounting standards, as I'm required by the accounting standards to assess the likelihood of what the provision should be and shouldn't be. And this will be an ongoing theme until we own 100% of Clear Skin. So it will move up and down as we go through.

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Gretel Janu, Crédit Suisse AG, Research Division - Research Analyst [16]

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So it does mean though that you were -- you think that you're not going to make out the earn-outs, which is why that you've recorded that?

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Richard C. Vincent, Australian Pharmaceutical Industries Limited - MD, CEO & Executive Director [17]

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Maybe I should answer that. So Gretel, you're right, it's being written back because the targets that we set with the owners look like they will not be met. Now, those performance targets are stretch targets. When we look at what we have built our business case around, it's not those targets. So from my perspective, from an operational perspective, the business is growing in line with our expectations. However, we agreed stretch performance targets upfront with the owners, and based on where we are, as Peter said, that looks like those payments won't be necessary.

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Gretel Janu, Crédit Suisse AG, Research Division - Research Analyst [18]

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Okay. It makes sense. And then just in terms of the outlook, are you able to give any update in terms of how you have performed operationally in the last couple of months, so since -- in FY '20?

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Richard C. Vincent, Australian Pharmaceutical Industries Limited - MD, CEO & Executive Director [19]

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Yes. Just very briefly and we don't normally provide much detail around that, things haven't changed. The current consumer environment hasn't changed. Consumer demand, transactions, it's been a little bit lumpy from week to week. And we've had some good weeks and we've had some average weeks. But all of that says the environment remains the same. And that's why I've talked about what we need to do inside of our brand in terms of working with our Sister Club members to get more visitation, more transactions, bigger basket sizes. That's important as well as our new and exclusive products that will bring customers into our stores because the environment is the environment. And as you'd see from many retailers who have reported recently, it's tough out there.

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Gretel Janu, Crédit Suisse AG, Research Division - Research Analyst [20]

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And then just on the wholesale distribution business, so have we cycled through it, most of those PBS Reforms, so should we expect a pickup going into FY '20?

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Richard C. Vincent, Australian Pharmaceutical Industries Limited - MD, CEO & Executive Director [21]

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No. The PBS Reforms continue. So there's more PBS Reforms. And this year, we had the trailing effect of last year's PBS Reforms that have come into the second half of the year as well. So there is more that we need to deal with, and that's why our negotiation with the Minister and the Department of Health is so important.

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John Deakin-Bell, Citigroup Inc, Research Division - Director & Head of Healthcare in Australia and New Zealand [22]

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It's John again. Just so I'm clear on that cash flow. So you're saying the reported EBIT was $94 million, but your cash inflow from operations was 58. So that's -- it's a pretty big difference. Is that -- are you saying that's a one-off step-up in working capital, and next year, the difference between the P&L and the cash flow will narrow?

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Peter Mendo, Australian Pharmaceutical Industries Limited - CFO [23]

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It will.

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Richard C. Vincent, Australian Pharmaceutical Industries Limited - MD, CEO & Executive Director [24]

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All right. It looks like we've exhausted questions in the room. So thank you all for attending, and we look forward to catching up with you and having more detailed discussions. Thank you.