About this piece
The rate of conversion from income to cash flow matters because the more cash a company generates, the more cash it can invest or return to shareholders without increasing debt. The cash conversion ratio has various definitions, but here I look into the ratio of Free cash flow to Profit after tax, before making adjustments that deviate from those metrics.
In this piece I try to stick to historic facts rather than predict future cash conversion, and I don't cover the effect of the deal with Novartis on future cash conversion.
Where core earnings have leaked before reaching free cash flow
I've made two tables for different periods, because the nine months reported for 2015 include the deal with Novartis (NYSE:NVS), where Novartis acquired the oncology business (but not the pipeline), GlaxoSmithKline plc (NYSE:GSK) acquired vaccines, and the consumer businesses were pooled, with GSK holding the controlling interest. Also the nine-months-2015 figures are not reported in as much detail as the annual figures.
The category "Major restructuring" has been -
- Relatively consistent
- Deducted from core results
- Not deducted from free cash flow
- Therefore it's dragged cash conversion down
- It's been the biggest factor in dragging cash conversion down.
I don't speculate in this article on how big Major restructuring will be in the future, but I think that to have an opinion about it you probably ought to know about those six points.
There's more to GSK's cash conversion than Major restructuring, but much of it is complicated. Because the item is significant and relatively simple, I've taken the opportunity to spell out the facts.
Looking back further
GSK started reporting core results in 2012, so I can't look back to earlier years and use the same reconciliations as a data source. It's still possible to look at some key items.
In my opinion the chart above shows that major restructuring and legal expenses have not been unusually high since 2012. (If they continue at their historic levels, their negative effect on cash conversion will continue.)
Intangibles are a fairly complicated area regarding cash conversion, with several related items in the reconciliations from core profit after tax to free cash flow. They are listed on the left in this image from a spreadsheet -
The three minus signs in the bottom row indicate a negative effect on cash conversion from intangible assets (by "negative effect" I mean tending to pull the conversion rate down below 100%).
The lack of reconciliations before 2012 meant I couldn't backtrack in a comparable way. Instead I made the chart below. It shows net cash charges lower than the net non-cash charges in most years, contrary to the results since 2012 based on all the reconciliations. The difference is mostly because I included the cash investment flow "Proceeds from sale of intangible assets" (in the red line for purchases minus proceeds). GSK's free cash flow includes the purchases but not the proceeds, and in that sense it's a conservative measure.
The chart above shows that in 2012 there was an exceptionally big positive contribution from intangibles to cash conversion, which was the result of big proceeds from sales. The cash proceeds and purchase are shown in the next chart, which also has the non-cash items (I made those less prominent). The quantities in the chart are highly variable, with Purchase of intangibles looking the most regular.
To sum up about the proceeds from sales of intangible assets - they aren't included in the reconciliations, and the figures in the reconciliations show a negative effect on cash conversion from intangibles. When the proceeds are included, there's a positive effect on cash conversion from intangibles. However, the proceeds have been irregular and they spiked in 2012, so when I later adjust for the proceeds, there could be some doubt over the justification for doing so.
The effect of non-controlling interests
The cash conversion in the table at the top is between core profit after tax and free cash flow. I've already mentioned that GSK's definition of free cash flow excludes the sale of intangibles. There's also an issue due to starting with core profit after tax - it excludes the core profit attributable to non-controlling interests (NCI). It's the core profit attributable to shareholders (after deducting core profit attributable to NCI) that is divided by the number of shares to get core earnings per share. So, if you estimate a rate of cash conversion and you want to apply it to core EPS to get FCF per share, the cash conversion needs to be between core profit attributable to shareholders, and FCF. Although not the most relevant quantities, I started with core profit after tax and FCF (by GSK's definitions) and the conversion between them, because all the data for the conversion is in reconciliations, which makes errors less likely and checking easier.
Adjusting conversion for NCI and the sale of intangible assets
The table above shows that if you already have an estimate for the rate of conversion between core profit after tax and free cash flow (by GSK's definitions), and you want the rate of conversion between core profit attributable to shareholders and FCF adjusted to include proceeds from the sale of intangibles, then you could add about 13.5% to the estimate (or reduce the leakage by 13.5%). However, there's no guarantee that the combined effect of non-controlling interests (NCIs) and the sale of intangibles will be the same in the future as over the periods in the table. If you are thinking about the future, you might prefer to use the 9-months-2015 figure of 10.63% for the profit attributable to NCIs, but there's a complication - while bigger NCIs make profit after tax bigger for any given profit attributable to shareholders, it also leads to more dividends paid out to the NCIs, and the cash payments reduce free cash flow. That's a complicated point - the takeaway is that you should be wary of assuming the recently higher profit attributable to NCIs will mean better cash conversion from core EPS to free cash flow per share.
Referring to the previous table, the leakage-reducing adjustments are in the rightmost column, in cells Q24 and Q26, with values 13.72% and 13.22% (of core PAT). Using those figures to adjust the leakages in the table at the top of the article, the total leakage (including "other") adjusted for non-controlling interests and the sale of intangibles is -
2012 to Q3 2015 ~ 42.12%
2012 to 2014 ~ 28.65%
Those leakages are between:
Core profit attributable to shareholders (which core EPS is based on)
Free cash flow as defined by GSK plus Proceeds from sale of intangible assets.
I believe the two metrics are more relevant than the core PAT and FCF that I started with, and I consider the figures for the two periods to be the main result here.
Relating core EPS, leakage and FCF per share
The table above is just simple math and is not meant as any kind of prediction. For example, the top left shows the obvious fact that if core EPS is 100p and the leakage before hitting free cash flow is 30%, then free cash flow per share will be 70p. The table is only useful if you have some idea of what core EPS and the leakage will be. If you think cash conversion will improve so that FCF per share will be 80% of core EPS, then you look at the row for 20% leakage. If you think core EPS will be less than 100p or more than 130p, then the table isn't much use to you. I walled off the cells in the top left where FCF per share was less than 80p because GSK have stated their intention to pay an annual ordinary dividend of 80p for each of the years 2015 to 2017 (which excludes a special dividend).
GSK's M-Score for earnings manipulation
According to GuruFocus, GSK's Beneish M-Score signals that the company is likely to be an accounting manipulator. If so, this analysis would be seriously undermined. I don't think management would take the risk after the company's trouble on the ethics front (see "Three Take-Home Messages from China's Glaxo Verdict" by Yanzhong Huang, Sep 25, 2014 (forbes.com), and from 2012, "GlaxoSmithKline to pay $3bn in US drug fraud scandal" (bbc.co.uk)). There have also been measures to be more ethical (see "GSK confident halting payments to doctors will pay off" by Andrew Ward, January 7, 2016 (ft.com)). It could also be argued that GSK have less incentive to manipulate earnings because they can emphasise core results where various costs are excluded. Even so, my view that GSK have probably not manipulated earnings is only an opinion, and while I believe the M-Score is flawed, it is at least objective.
The rest is just details
I've given the adjusted leakages which I regard as the main result regarding the record. Readers who don't like much detail should probably not read the rest of this piece, although I suggest following the comments.
Coming up, I give GSK's definitions of core results and free cash flow, and the reasons why I used those metrics. Then I say why the areas of leakage were not easy to spot, and describe my methods. After that most of the piece consists of various breakdowns of the info I summarized in the chart at the top.
GSK uses the term "core results" for everything from turnover to earnings per share, which they arrive at by excluding many items. It's the conversion of core "Profit after taxation" to free cash flow that I wrote about before applying adjustments.
"Core results exclude the following items from total results: amortisation and impairment of intangible assets (excluding computer software) and goodwill; major restructuring costs, including those costs following material acquisitions; legal charges (net of insurance recoveries) and expenses on the settlement of litigation and government investigations; other operating income other than royalty income; disposals of associates, products and businesses, and acquisition accounting adjustments for material acquisitions, together with the tax effects of all of these items." (Annual report for 2014)
"Free cash flow is the net cash inflow from operating activities less capital expenditure, interest and dividends paid to non-controlling interests plus proceeds from the sale of property, plant and equipment and dividends received from joint ventures and associated undertakings." (Annual report for 2014)
Reasons for starting with core profit after tax and free cash flow
The reason for using a measure of core profit rather than just profit is that GSK have made statements about the growth of core EPS they expect from 2014 to 2020. (I've already explained that by using core profit after tax I only needed to use the reconciliations, until adjusting for the profit attributable to NCIs).
The reason for using free cash flow rather than cash from operations is that free cash flow has deductions for investment, and the same dollar can't be used for capex and paid out in dividends. There's room for argument about that, for example if you believe capex could be reduced without too much effect on future earnings, or if it could be reasonably financed through debt. It could also be reasonable to use definitions of free cash flow other than GSK's own definition. I settled on using free cash flow as defined by GSK (before adjusting for the sale of intangibles) without too much agonizing, because no metric is guaranteed to be acceptable to everyone.
The reconciliations in GSK's reports don't make it immediately clear where cash conversion has been failing. I've lined up the various reconciliations between core earnings and GSK's FCF, and in the chart above the biggest and most consistent drops have been in the last stage, which is GSK's "Reconciliation of free cash flow". However, looking into that reconciliation does not usefully identify any leakage. For example, in 2014 there was £707 million interest paid, and the payment is included in the reconciliation of FCF. But, there's a £727 million "Finance expense" in the income statement (and a smaller amount of "Finance income"), which is also in the core earnings that the series of reconciliations starts with. What has happened is that the non-cash item "Finance income net of finance expense" (of £659 million) is added back in the cash flow statement, before the cash payment of £707 million interest is deducted in the free cash flow reconciliation. Given the procedure, it's not surprising that there's a drop-off in the FCF reconciliation.
It's the same for other deductions in the FCF reconciliation. For example, there's the cash item purchase of property, plant and equipment, which corresponds to the non-cash item "Depreciation" which is added back in the cash flow statement. The upshot is, you don't learn where the leakage is between core profit after tax and FCF just by looking at the FCF reconciliation, even though it looks like that's where the problem is from the "reconciliation roller coaster" chart.
To find where cash conversion was failing, I grouped the adjustments differently. Instead of grouping them according to which reconciliation they were in, I grouped together everything which related to "Interest", and everything which related to "Depreciation", etc. For each grouping I calculated a "conversion" quantity, simply by adding up the grouped quantities. The addition was possible throughout because the signs were already correct for the reconciliations, and the reconciliations formed an unbroken chain from core profit after tax to GSK's free cash flow. For "everything related to depreciation", the items are: Depreciation, Purchase of property, plant and equipment, and Disposal of property, plant and equipment. The first of the three is positive because it was added back in the cash flow statement, the second is negative because it represents a cash outflow, and the third is positive because it represents a cash inflow. After grouping related items, some "stand-alone" items remained, such as "Major restructuring".
The procedure is not from a book and my terminology is likely to be non-standard. I called the sums "conversions", but "net adjustments" (between core profit after tax and GSK's FCF) might have been better.
I could only take that particular analysis back to 2012 when core results were first reported. The figures for 9 months 2015 are lacking in detail, for the reconciliation between "Profit after tax" and "Cash generated from operations". I've 'kludged' them into the same categories as for the whole years, by setting non-disclosed quantities to zero. The non-disclosed quantities are not likely to have been ignored by the accountants, and they could be in "Depreciation and other adjusting items". The period "9 months 2015" includes seven months after the Novartis transactions.
Leakage broken down by year and type
I've charted the spreadsheet results in various formats, either absolute amounts or as percentages, with different splits of the 3 year and 9 months period. I'll start with a cumulative chart which shows how the adjustments or "conversions" eat away at the core earnings at the top to end up with the smaller amounts of free cash flow at the bottom. A negative adjustment pulls a line to the left, and a positive adjustment pushes it to the right.
The next chart is the same except the quantities are expressed as a percentage of the year's core earnings. It means the series all start at 100% at the top, making it easier to compare years.
The two charts above were cumulative, which meant they were good for showing how the various accounting items eroded core profit after tax on its way to being reconciled to free cash flow, but the impact of each item could only be represented by quite a small horizontal distance. The next two charts are not cumulative and it's easier to see how the effect of the items compare to each other.
In the next chart, quantities are scaled as a percentage of "total conversions" (for the period); for example, the red bar for "Major restructuring" reads over 25%, which means that over 2012 to 2014 the category accounted for more than a quarter of the erosion between core profit after tax and GSK's FCF. Note that "Share-based incentive plans" (at the top of the chart) is negative, at about -13%. The plans are good for cash conversion because they are a non-cash expense, making earnings lower (the higher the expense) without affecting FCF. Because the expense is good for cash conversion, it's a negative percentage of the erosion or leakage between core earnings and FCF.
The next chart shows absolute amounts rather than percentages. Visually, it's a mirror image of the previous chart, because the negative adjustments just stay negative (instead of being a positive percentage of the total negative adjustment).
The next chart breaks the absolute amounts down into four distinct periods, which means you can tell how consistent or variable the effect of each item is. None of the "conversions" are constant, but some are more consistent than others. For example "Major restructuring" has been consistently high, although in the two low periods the item was only about half the size as in the two high periods. In contrast, the "Acquisition and disposal" conversion has not been consistent, being highly positive in 2012, while being negative in the other periods, and very highly negative in the 9 months 2015 period.
I've written "GSK's cash conversion - systematic guesswork", where I try to assess the future rate of cash conversion. As the title implies, I'm not confident about being able to predict the future accurately.
For the tables where I calculated the "cash conversion factors", see "GSK cash conversion - excess charts and selected spreadsheet images".
Disclosure: I’m long GSK
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