Monday, 25 August 2014

GlaxoSmithKline - is there value?

To continue the innovations on Financial Orbit I would like to introduce a second guest author. Harsha Boralessa is a CFA charterholder and a chartered accountant. He has several years of professional experience working with investments involving equity, fixed income, derivatives and private equity in a number of organisations including a European bank, a global asset management company and global accounting firms. He is interested in fundamental bottom-up value investing and how investors' behaviour may create opportunities where an equity's market price will differ significantly from its intrinsic value.  Having previously invested mainly in Funds, he is starting to invest in individual equities and as part of the process of developing his investment style, he has contributed the following piece.

'GlaxoSmithKline - is there value?' by Harsha Boralessa

After the bump in the share price of GlaxoSmithKline (GSK) following the announcement of its transaction with Novartis last April, GSK's share price has declined by approximately 14%, as of 22nd August 2014 and the last time that the price reached this level was in January 2013.

GSK has also underperformed the FTSE 100 by approximately 19% in the last year.

The question is whether this is a temporary blip and GSK is a potential value opportunity or is this the start of a long term decline? 

GSK has suffered damaging headlines relating to China involving the trial of two private investigators connected to a scandal involving a top executive of the company.  Unfortunately for the company investigations continue in country.  According to the GSK's Q2 2014 press release, Pharmaceuticals and Vaccines sales in China including Established Products fell by 22% to £267 million in H1 2014, which is approximately 3% of total Pharmaceuticals and Vaccines sales of £9,025 billion.

Despite recent bad headlines China is still potentially a huge market for GSK but a far more pressing issue appears to be falling sales in its Pharmaceuticals division as shown below. The table below and others in this report have been sourced from GSK's Q2 2014 press release, except where stated.

The falling pharmaceutical sector sales are being driven by the decline of Respiratory sales (see below) due to increased competition, in particular Advair/ Seretide sales. In H1 2014, Advair/ Seretide accounted for almost 69% of Respiratory and almost 39% of Innovative Pharmacuticals.  The key issue is how much the new Respiratory products such as Relvar/ Breo and Anoro will make up the decline, currently their sales are relatively small.

GSK's Established Products sales have also been hit hard.  In particular Lovaza's sales, which is being impacted by generics, have declined by 81% in Q2 2014 to £27 million.

Many of these issues are contributing to falling sales in the United States where general generic pricing pressures are also impacting more materially:

Unsurprisingly this sales decline has also been reflected by declines in core operating profit and margins again mainly driven by significant falls in the Pharmaceuticals division specifically and the US geographically.

Clearly, GSK is facing some fundamental issues, which GSK's CEO, Sir Andrew Witty summarised in this comment during the Q2 2014 earnings call: "As you know our strategy over the last six years has been to fundamentally reshape the Group and our R&D operations in particular, so that we can replace the significant sales we lost to generics and ensure that the Company can succeed in an environment where our biggest product Advair faces increasing competition".

So what is being done to address this? The Novartis deal, if approved, should bring significant growth in Vaccines through the acquisition of Novartis's global Vaccines business (excluding flu) and Consumer Healthcare, by creating the second largest Consumer Healthcare company (by revenue) in the world, which GSK would control and have a 63.5% stake, see slide below from the GSK presentation in April 2014.

This would reduce the reliance on Pharmaceutical sales and help in having broader sources of revenue growth, see slide below from the GSK presentation in April 2014.

It is also anticipated that £4 billion of capital would be returned in the form of a B share transaction, following the completion of the Novartis transaction, which is approximately 6% of the market capitalisation of GSK as of 22nd August 2014.

Furthermore, the Vaccines division (4%) and HIV sales (9%) continue to grow in H1 2014.  The sales of new pharmaceuticals and vaccine launches in the last 5 years (2010 to 2014 inclusive) was £565 million in H1 2014, a growth of 73%. According to GSK, there is a substantial development pipeline with over 40 new molecular entities (NMEs) in late stage development.

In terms of valuation, GSK is trading at around 13x EV/ EBIT (TTM), which is at the lower end of its pharma peer group.  GSK is also trading at a Free Cash Flow yield of around 6% (TTM), which is at the higher end of its pharma peer group.  Although GSK's net debt has risen to £14.4 billion since the end of 2013 giving it a net debt/ EBITDA ratio of around 1.6x, which is at the higher end of its pharma peers, this does not appear to be excessive as GSK has a history of generating good free cash flow.

GSK's management have a good track record of returning capital to shareholders through dividends and significant share buy-backs.  The dividend has increased by over 6% on an annualised basis over the last 5 years, although revenue and earnings have grown more slowly. The dividend yield is around 5.5% (TTM) and the dividend should be sustainable given GSK's strong cash flow generation and not excessive debt.  Overall, there has been an approximately 8% return of capital to shareholders per annum between 2011 and 2013 based on the average market capitalisation of GSK.

In the Q2 2014 earnings call, the GSK CEO, Sir Andrew Witty observed "the dividend remains our priority in terms of shareholder distributions. There is no change to the policy. Over the last couple of years, we have been paying out relatively high amounts as we go through this transition period and clearly decisions for the future for the Board of the time. But I think we have laid out our store on that front and there is no change in the policy"

Although there is uncertainty about GSK's future prospects with Respiratory and US sales, there do seem to be some positive signs, including the refocusing of the business with the Novartis deal.  I would consider buying GSK in the low to mid 1300s and would review at 1500p, whilst enjoying the dividends and other shareholder remuneration in the interim.

(Please note that all views are Harsha's and do not represent any form of investment advice. He does not have any direct equity holdings in GlaxoSmithKline, however the Funds in which he invests may have holdings).  

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