From high dividend yields to low multiples, BioPharma offers some of the greatest risk/reward plays. However, other times, the market properly factors in reasonable growth prospects. In this article, I will run you my DCF model on GlaxoSmithKline (GSK) and then triangulate the result against a review of the fundamentals of Amgen (AMGN) and Merck & Co (MRK). I find that GSK is one of those healthcare companies that trade at fair value.
First, let's begin with an assumption about the top-line. GSK had 27.4B GBP worth of revenue in FY2011, which represented a 3.6% decline from the preceding year. I model 5.8% per annum growth over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold eating 26% of revenue versus 33% for SGA, 14% for R&D, and 5.3% for capex. Taxes are estimated at 30% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around -3% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of 28.05 GBP, virtually in-line with the current market assessment.
All of this falls within the context of strong performance:
"On this basis, sales grew 2% and EPS grew 7% in the quarter. In terms of the 2% sales growth, it really demonstrates a resilient performance, given the continued economic pressures and challenging political environment we face in many markets. As is always the case in any quarter, there were some one-off factors which affected reported performance, and this was particularly acute in the emerging market region where sales grew 2% and were impacted by ongoing instability in the Middle East and the phase-in of some vaccine tenders. There was also an unfavorable comparison to the first quarter of last year, which you'll remember was a very strong one where we grew at around 20%. Looking forward, however, we remain very bullish on our prospects in emerging markets and continue to invest behind our objective to grow ahead of the market in this region, which we think at the moment is running at about an 11% growth rate".
From a multiples perspective, however, the firm will struggle to reach peer levels. It trades at a respective 13.9x and 10.3x past and forward earnings versus 16x and 10.2x for Amgen and 16.7x and 10.2x for Merck. The last two firms merit higher multiples due to the perception of greater catalysts and growth potential.
Consensus estimates forecast Amgen's EPS growing by 15.4% to $6.15 in 2012 and then by 10.6% and 13.8% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $6.75, the stock will hit $87.75 for 26.9% upside. Thus, while GSK offers a dividend yield that is 312 basis points higher than that of Amgen, I would still recommend backing the latter. Of the last 25 revisions to EPS, 22 have gone up for a net change of 1.6%.
Consensus estimates forecast Merck's EPS hovering around $3.80. Assuming am multiple of 13x and a conservative 2013 EPS of $3.66, the stock will hit $47.58 for 25.8% upside. With a dividend yield of 4.4%, a beta of 0.8, and a "buy" rating on the Street (source: NASDAQ), risk/reward remains highly compelling. Accordingly, I recommend an investment in the firm.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.