Seeking Alpha
Long/short equity, deep value, special situations
Profile| Send Message|
( followers)  

Summary

  • The company has taken a beating due to poor earnings and corruption issues overseas.
  • But is this merely a buying opportunity for a solid company? It trades as one of the cheapest pharma companies around and offers one of the best dividend yields.
  • If you are buying the company, it's not for the growth, but for the income.

GlaxoSmithKline (NYSE:GSK) has been a scandalous company to own over the last year or so. It was all capped off with a dismal 2Q. Shares have cratered over the last 30 days. It's gotten so bad that management might be considering a breakup of the company in an effort to preserve shareholder value. However, we see this as unlikely, with the company choosing to focus on its consumer health business as a way to generate value for shareholders.

2Q was weak, but there are bright spots

GlaxoSmithKline reported core earnings of $0.64 per ADS back in July for 2Q, which was down 12% y/y. The results were impacted by problems in China, weak performance of the respiratory treatment portfolio, and intensified generic competition for Lovaza. The earnings were lower than the consensus estimate of $0.71.

The company has two major operating segments: Pharmaceuticals and Vaccines, and Consumer Healthcare. Consumer healthcare sales declined by 4% y/y and Pharmaceutical sales were down 6%. But its vaccine sales increased by 5% y/y because of strong performance in the emerging markets.

Pharma sales were negatively impacted by intensifying competition for Advair and generic substitutes for Lovaza in the U.S. Advair is seeing pricing pressure in the U.S., forcing sales of the drug down 12% y/y for 2Q.

Consumer healthcare sales were hit by temporary disruptions in supplies in the U.S. and Europe. The supply position is improving, but sales for 2014 are expected to be flat. Cost reduction measures should continue and the company expects to generate incremental cost savings of around $600 million in 2014.

The U.S. remained the company's biggest market, making up 30% of 2Q sales, but U.S. sales fell 12% y/y. Europe made up just under 30% of sales, and Emerging Markets Asia Pacific accounted for 27%.

But in digging deeper into 2Q results there were some positives. It has a new product pipeline that should continue driving sales growth going forward. Sales of new products (those launched within the last five years) were up 100% y/y for 2Q - accounting for 7% of total sales.

A couple key newly launched products include Anoro Ellipta, a bronchodilator that was launched during the second quarter; Tanzeum/Eperzan for Type II diabetes, which was launched in July; and Mepoluzumab, for asthma, is in Phase III trials and will be submitted to regulators later this year.

The bribery problems in China and elsewhere

The ongoing bribery overhang in China won't go away anytime soon. The company's former head of operations in China will stand trail on corruption charges. The UK Serious Fraud Office is also launching a criminal investigation of the commercial practices of the company.

As if this were not bad enough, the company is also facing allegations of corruption in Lebanon, Iraq, Jordan and Poland. Actions in these countries will not damage the company as bad as China, but they are a negative for brand image and reputation.

Now for the bright spot of the company: The Novartis deal

One of the most valuable parts of the GlaxoSmithKline business is the consumer healthcare segment. But given the company's negative press, it's likely that this part of its business is being undervalued. Although it's been speculated that GlaxoSmithKline might be looking to spinoff its consumer healthcare segment, the company has denied that it's looking to make such a move. Rather, it's becoming a larger player in the consumer health business.

GlaxoSmithKline is positioned to become one of the largest consumer healthcare companies in the world following a deal (asset swap) agreement with Novartis (NYSE:NVS) that was inked earlier this year.

It's a 3-part deal:

(1) GlaxoSmithKline is selling its oncology business to Novartis for $16 billion - This gives GlaxoSmithKline a way out of its struggling oncology business, which accounts for just under 5% of sales.

(2) GlaxoSmithKline will then buy Novartis' vaccine business for $7 billion - GlaxoSmithKline management has noted that the global vaccine market is expected to grow by 10% annually over the next decade.

GlaxoSmithKline generates about 13% of its sales from vaccines and it is one of the company's strengths, given the weak competition globally for vaccines.

(3) Then, the two companies will combine their consumer healthcare businesses in a joint venture, of which, GlaxoSmithKline will have a 63.5% stake.

The new company is expected to have annual sales of $10 billion. GlaxoSmithKline will have the option to buyout Novartis after three years. In addition, GlaxoSmithKline will receive a payment of roughly $6.7 billion, which it has promised to distribute to shareholders.

The other keys to expanding deeper into the vaccine and consumer health market is that it will help the company hedge against further patent cliff pressure, which was a key reason 2Q earnings were weak.

The deal is expected to be completed in 2015 and have a meaningful impact on its top and bottom lines as early as next year. After the deal closes, vaccines will account for close to 14% of GlaxoSmithKline's revenues and costumer healthcare will account for 24%. Ultimately driving pharmaceutical revenues to just 62% of revenues.

As well, the GlaxoSmithKline-Novartis consumer healthcare business will be the second largest consumer healthcare company in the world -- behind only Johnson & Johnson.

Strong shareholder returns

GlaxoSmithKline's current 5.3% dividend yield towers over the likes of Johnson & Johnson (NYSE:JNJ), Pfizer (NYSE:PFE), Merck (NYSE:MRK), AbbVie (NYSE:ABBV), Bristol Myers Squibb (NYSE:BMY) and Eli Lilly (NYSE:LLY). Trading at less than 15x earnings, GlaxoSmithKline is also cheaper than any of the aforementioned companies.

Its payout ratio (based on 2014 EPS) is right at 80%, while its payout ratio (based on 2015 EPS) is 72%. But on as a percent of operating cash flow, its dividend is only a 67% payout. The free cash flow generation is still strong, with the company having a free cash flow yield of 6%.

The shareholder return aspect gets even better when you consider the $6.7 billion that's expected to be returned to stockholders as part of the Novartis deal. This distribution is expected to take the form of a B share scheme. Factoring in the B shares and dividend, the return to shareholders could be close to 8% in income alone for the next year.

Bottom line

GlaxoSmithKline is by no means a growth story. Earnings growth is expected to be flat this year, versus previous estimates of 4% to 8% growth. However, it's still an interesting stock from an income perspective. With the shares down 12.5% over the last 30 days, GlaxoSmithKline's dividend yield has spiked. Now yielding well above any of the other major pharma companies. Investors with a long-term focus would be well served by buying up this leading pharma company at current levels.

Source: GlaxoSmithKline: The Bad Isn't All That Bad