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The Hidden Nasty In GlaxoSmithKline plc’s Latest Results

GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US) is a firm that I rate highly and own shares in myself, but when I took a closer look at the company’s results recently, I uncovered a worrying trend that could threaten the safety of the pharmaceutical giant’s dividend payments.

Glaxo spent £2.5bn in share buybacks, and £3.8bn on dividend payments last year — massive amounts that have helped maintain its reputation as one of the top dividend stocks in the UK.

However, I believe this dividend could be threatened in the not-too-distant future, thanks to Glaxo’s addiction to borrowed money. Glaxo currently has net debt of £15bn, giving it uncomfortably high net gearing of 252%. To put that in perspective, anything over 100% is usually seen as fairly high, except for utilities.

Low interest rates, a strong credit rating and reliable profits have enabled Glaxo to sustain these high debt levels for some time without problems. The average interest rate on Glaxo’s debt is just 4.8%, which is almost identical to the prospective yield of 4.9% offered by its shares.

Debt vs. dividends

Glaxo’s board has a choice: it can buy back Glaxo’s own shares, saving the cost of future dividends, boosting earnings per share, and keeping shareholders happy, or it can use extra cash to repay debt, cutting the cost of future interest payments.

At the moment, it’s slightly cheaper, and much more attractive, for Glaxo’s board to use the firm’s spare cash to keep shareholders happy, with buyback programmes and bumper dividends. Unsurprisingly, that’s what’s been happening: Glaxo is targeting £1bn-£2bn of buybacks this year, and the full-year dividend is expected to rise by 5.3%.

The problem is that this situation can’t last forever. If market interest rates rise, then it will become cheaper for Glaxo to stop buying its own shares and start repaying more of its debt.

When this happens, Glaxo’s dividends will suddenly become harder to afford, as the number of shares in circulation will stop falling and may start rising again. Above-inflation dividend growth could become very expensive indeed.

In my view, Glaxo’s management needs to take the initiative and start reducing its £15bn net debt, before it’s forced to by changing market conditions, or an unexpected dip in profitability. High debt levels always carry an extra risk, and while I’m not planning to sell my Glaxo shares, I am keeping a close eye on the situation.

A share to retire on?

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> Roland owns shares in GlaxoSmithKline. The Motley Fool has recommended GlaxoSmithKline.