This Big Pharma Has Found Its Way
02/24/2011 9:41 am EST
The bulk of GlaxoSmithKline’s troubles may be behind it, while stronger growth and an increased dividend loom ahead, writes Peter Shearlock in The IRS Report.
When the market falls out of love with an old favorite, it can take a long time before enthusiasm returns. I am betting, however, that it will not be long before the big institutions take GlaxoSmithKline (NYSE: GSK) back to their collective bosom.
In the meantime, value investors can still buy one of the world's great pharmaceutical companies on the sort of rating accorded to a low-growth utility. That kind of discrepancy is what value investing is built on.
The drug sector as a whole has been out of favor for the best part of a decade. Companies that used to sell for 20 or 25 times earnings are now seeing their shares change hands for little more than half that number. Glaxo shares are trading at ten times consensus forecasts for 2011 earnings.
Cheap for a Reason
Of course, there are reasons for the market's disinterest. Several of the major companies have invested heavily in new blockbuster drugs only to see them fall at the final regulatory hurdle. As patents on big-selling drugs run out, allowing competitors to launch low-priced generic equivalents, there are not enough new ones coming through to take their place. There have also been big product-liability suits and equally big damages to pay.
GSK's bogeyman is its diabetes drug, Avandia, for which it recently announced a $3.5 billion legal provision. This was on top of a $2.4 billion provision made at the time of the second-quarter figures, relating in part to Avandia, but also to litigation costs connected with the antidepressant Paxil.
These are large amounts, but they have to be put in the context of a company capitalized at over $97 billion with net cash generation running at around $11 billion a year. The balance sheet is extremely strong, while margins and return on capital have been consistently high.
Vaccines, Emerging Markets Key
Changes now afoot at GSK could be the prompt for a major re-rating. The company has recognized that it has become over-reliant on "white-pill prescribing" in the main Western markets. Now it is pumping money into areas such as vaccines, consumer healthcare products and, above all, the emerging markets in an attempt to diversify the business and make it grow faster.
The effects are plain to see. While overall sales are static, sales in the emerging economies are now growing at double-digit rates. Vaccine sales have grown by about one-fifth in the past year. Dermatology and consumer healthcare products are also growing strongly.
Along with others in the sector, GSK needs to find new sources of growth at a time when governments around the world are reforming health care and cutting spending.
Cost Savings, Dividends on Rise
But GSK is itself getting leaner and meaner. Across the business, it is on track to deliver $3.5 billion of savings by 2012. A large chunk of those savings are in research and development, where GSK is exiting certain areas of discovery research.
It is also outsourcing more research to partners to reduce risk. Its long-running collaboration with US company Theravance (Nasdaq: THRX) is responsible for one of GSK's most promising new drugs, the asthma treatment Relovair, which is now in late-stage development. GSK recently upped its stake in Theravance to 19%, and this is likely to be the pattern for other collaboration deals.
There is an added attraction to locking money away in GSK right now—and that is the yield of around 5.5%. [And more like 6.5% on a forward-looking basis after the recent increase.—Editor] The company is committed to a progressive payout, which in practical terms means the dividend, paid quarterly, is likely to continue to rise at a faster rate than inflation.
[Timothy Lutts recently recommended another European drug giant with a healthy dividend and strong cash generation. Josh Peters prefers a domestic pharmaceutical play with solid growth and a hefty dividend of its own.—Editor]