Despite its issues, healthcare giant GlaxoSmithKline (GSK) remains one of the highest quality businesses on the London Stock Exchange. The Glaxo empire, which spans various patented drugs, vaccines and a consumer health segment that owns brands like Sensodyne toothpaste, has generated in excess of £16b worth of free cash flow over the past three years. That came on the back of circa £100b in cumulative sales over the same period. Yes, its share price performance looks very poor, with that true even over relatively long timeframes, but that doesn’t mean its business isn’t an absolute money spinner. It is.
That’s the good news. The bad news is that Glaxo has not been able to materially increase profits in recent years. Ten years ago the firm generated annual sales of £28.4b and, after stripping out various legal costs associated with diabetes drug Avandia and US antitrust issues, posted after-tax profit in the £6.2b area. Fast forward to 2020, which was another relatively staid one for the firm. Total revenue decreased 2% to £34.1b after accounting for currency fluctuations and the impact of a full year of results from the Pfizer consumer healthcare joint venture (“JV”). Revenue declined by low single-digits across its three major business lines: Pharmaceuticals, Consumer Healthcare and Vaccines. Adjusted operating profit fell 3% to £8.9b, while adjusted net income attributable to shareholders came in at circa £5.8b. Adjusted earnings per share (“EPS”) dropped by around 4% to 115.9p.
Consider the above performance alongside the old adage of how a premium business should command a premium valuation. This is true, but only on an “all else being equal” basis. The quantitative support for this expression rapidly diminishes when profit growth falls below the market average. And that is why Glaxo stock now only trades at roughly 11x EPS despite still being a cash cow.
Back in 2019, Glaxo and US giant Pfizer agreed to merge their respective consumer health businesses. Glaxo owns 68% of the resulting JV, which posted circa £10b in sales last year. Now, that business is to be hived off next year, with the pharmaceutical and vaccines segments then becoming “New GSK”.
The best argument for not doing this, or rather for keeping the business whole, is that consumer health takes the edge of the cyclical business of drug making. I mean, folks buy their Sensodyne toothpaste when the old tube runs out. Rinse and repeat, that’s it. Pharmaceuticals, on the other hand, need a boat load of R&D cash and when patents run out, such as for respiratory drug Advair, cashflows can head south. That then needs investment into fresh drugs and so on. One of the counter arguments is that two separate businesses will attain higher individual valuations than the whole does now. In any case, none of this matters much now because the separation is nailed on for next year.
Glaxo stock finished the day at just under the 1,280p per share mark. That means the 80p per share annual dividend represents a current yield of circa 6.25%. That looks attractive enough, but bear in mind that the dividend faces the chop after the separation next year. We will find out more in a couple of months, but management has guided that the resulting two dividends will be lower than the current one. Suffice to say that news of this de facto cut did not go down too well in the City: the shares remain down over 6% on their pre-announcement level, which was delivered alongside 2020 results back in early February.
The above notwithstanding, my view is simple: you won’t go too far wrong by paying 11x profit for Glaxo stock. Granted, the firm faces its potential headwinds – drug pricing is one, especially in the US where the group generates over 40% of its sales. The dividend cut is also annoying for income investors, though it doesn’t really alter the bigger picture here. Compared to 10-year UK government debt (0.8%) and corporate bond yields (1.85%), the 9% earnings yield on offer here looks like a very good deal. First and foremost, that extra retained profit arising from the dividend cut obviously has its uses: net financial debt stands at a rather chunky looking £20.7b, especially versus retained profit in the £1.7b area, so reducing leverage is one. Glaxo can also reinvest the surplus back into its business in order to fund growth.
On a broader level, expectations for the soon-to-be two businesses look really quite low. The company has dozens of new medicines and vaccines in the pipeline. It reckons that ten of those that are currently in late-stage development have the potential to become blockbusters. That won’t translate into EPS growth this year – namely due to a higher expected tax rate, higher R&D and some further pressure from COVID on the high margin vaccine business – but from 2022 onwards the firm will hopefully return to growth. The consumer health business is expected to grow by low single-digits this year, possibly a shade higher. Ultimately, that kind of top line growth is really all an 11x profit multiple needs. EPS and dividend growth running a few points ahead of that should then be enough to produce decent returns overall.
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