Qualiport

The valuation continues

By Bruce Jackson (TMF Googly)

Melbourne, Australia -- As promised, today we'll have an extended look at Glaxo Wellcome's (GLXO) valuation.

I've spent quite a few hours trawling through the financials of Glaxo Wellcome's 1997 annual report, looking at the various ways to value the company. This can be a rather imprecise art, courtesy of those pesky accountants and their reporting standards. The most difficult concept to come to terms with is purchased goodwill. Back in March 1995, Glaxo acquired Wellcome, and this mega merger left Glaxo with over £8 billion of purchased goodwill to deal with. Up to the end of 1998 reporting periods, this goodwill was rather conveniently written off to shareholder reserves and hence distorted the traditional return on equity (ROE) calculation.

To make matters more complicated, Glaxo created a merger reserve, and £2.8 billion of that goodwill was charged to this reserve. In the years since the combination of Glaxo and Wellcome, over £2.6 billion has been spent against that provision. This sort of "big bath" accounting can distort the true costs and benefits of an acquisition. In calendar 1997, Glaxo spent £279 million on Wellcome related integration costs. As at 31st December 1997, "only" £177 million remained in that slush fund. And I guess you were thinking that mergers and acquisitions were supposed to save companies money!

Depending on which way you calculate the treatment of that merger reserve, you get a different raw ROE figure. Looking forward, this starting point can hugely vary the final valuation of the company. I can sometimes see why some investors will throw the valuation criteria out the window and just buy good companies. Valuations are very subjective things.

Glaxo Wellcome's net profit for 1997 was £1850m, and from that they paid £1249m out in dividends. This means that they were paying out a rather high 67.5% of their profits in the form of dividends and, therefore, only retaining 32.5% in the business. In comparison, SmithKline Beecham (SB.) paid out about 50% of their profits in the form of dividends in 1997, as did Zeneca Group (ZEN). For companies with a high ROE, it makes sense to retain profits in the business, but only if they have growth opportunities and can reinvest that money at an above average ROE.

PizzaExpress (PIZ) has an ROE of around 28% and plenty of growth opportunities. It only pays out only 16% of its profits in dividends, the rest of the earnings being retained in the business to fuel future growth. On the other hand, Carpetright (CPR) has relatively limited organic growth prospects, and even though it has a ROE of about 50% (and falling fast), it pays out a whopping 85% of its profits as dividends.

Glaxo Wellcome's low profit percentage retention perhaps indicates a lack of growth opportunities for the pharmaceutical giant, although this is hard to imagine. After all, the company has drugs that most of the world has never heard of, the challenge being to sell them to these new markets. Less than a quarter of the company's total sales are to regions outside North America and Europe.

A more likely reason for Glaxo Wellcome's low profit retention is that they have raised their dividend at a higher rate than they've grown their profits. They've even raised it when profits fell, in 1997, and are expected to do the same in 1998. The City hates dividend cuts and even static dividends, particularly from the second biggest company by market capitalisation on the London Stock Exchange -- even if profits are falling. Hence Glaxo have almost been forced to increase their dividendr because of pressure from the City, even though it may not make the best business sense.

For the record, I have calculated Glaxo Wellcome's average ROE up to December 1997 as being 28.8%. If it can be maintained at that level, and the profit retention rate of 32.5% remains constant, Glaxo will grow profits by 9.4% per annum (28.8% * 32.5% = 9.4%). Given that Glaxo's objective is to achieve double digit sales growth, in constant currency terms, from 1999, this may be a touch conservative. A long-term ROE of, say, 30% and a long-term retention rate of, say, 40% means profits will grow by 12% per annum (30% * 40% = 12%). From a starting point of £6431m, by 2008, shareholders' equity would have built up to £21841m, where profits would be £6552m (£21841 * 30% ROE = £6552).

In the last 4 years, Glaxo Wellcome has traded on a price to earnings ratio (P/E) of between 19 and 45. If you assign those multiples to the 2008 profits of £6552, then add on the dividend income over the 10 years, you get a total compounded annual growth rate (CAGR) of between 8.23% and 16.7%. I happen to think a P/E of about 28 would be about right in 2008, given the company's size and predictability of earnings, and this would give a CAGR of 11.8%.

As you can see, using this type of valuation work, the final results boil down to some rather large, and perhaps a little spurious, assumptions. For example, in another person's eyes, the starting point for ROE and the actual percentage return used in the calculations could be completely different, and that person could come up with a vastly different valuation.

That's why I like cash flow based valuations. You can't argue with the bank balance, and the accountants can't fiddle the numbers. In 1997, from ongoing operations, Glaxo Wellcome generated £1630m of free cash flow, or money that the company can use to create shareholder value. As we saw above, at the moment Glaxo is choosing to pay out a fair chunk of that cash in the form of dividends to shareholders. They obviously see that as the best way to enhance shareholders' total returns -- or perhaps the City makes the decision for them.

In the first half of 1998, Glaxo's free cash flow fell to just £439m, a full 44% less than the £783m in the corresponding period of 1997. An increase in stocks and debtors has done the damage. For analysts from the cash flow school of science, like me, this is a rather disturbing development. Just think of the carnage to the Glaxo share price if their earnings per share (EPS) fell by 44%!

Over the full 1998 year, Glaxo's free cash flow could fall by as much as 20%, down to £1304m. From that starting point, if you assume a 10 year free cash flow growth rate of 12%, a discount factor of 9%, a residual growth rate of 5%, and a capitalisation rate of 4%, you get a discounted cash flow intrinsic valuation of £53.655b. When you compare that to a current market capitalisation of about £68.856b, you can see that they are potentially trading at a 22% premium to their intrinsic value. The share price would have to drop to about 1480p for them to trade at intrinsic value.

Wrapping up today's rather heavy session, let's put down a couple of share price points.

ROE valuation, to achieve share price appreciation of 15% per annum: 1440p
Discounted cash flow valuation to trade at intrinsic value: 1480p

We have previously covered a 10 year earnings growth rate projection valuation. To be consistent, using the assumptions we've established today....

10 year earnings growth rate projection valuation, to achieve share price appreciation of 15% per annum: 1260p.

With the current share price hovering around the 1900p mark, we may have to be patient.

Sorry I've not been able to spend too much time on the Qualiport message board -- my telecommunications problems down under persist. But it's boomingly busy without me!

Have a great weekend, Fools. I'm off to the MCG to either watch some cricket or get rained on, or both.

                    11/02/99 Close

                   Company   Change    Bid
                    DELL     -$0.75  $96.75
                    EMA       +0.46   12.41
                    IIG       -0.03    2.28
                    MKS       +0.01    3.63
                    PIZ       -0.05    7.00
                    RTO       +0.04    4.34
                    ULVR      +0.09    5.89

Qualiport Stocks

Last Rec'd  Total #  Company   In At   Current   Change
 19/12/97    783       RTO      2.55     4.34     70.2%
 27/01/99     37       DELL   $89.25   $96.75      8.4%
 17/04/98    169       EMA     11.85    12.41      4.7%
 04/11/98    245       PIZ      7.93     7.00    (11.7%)
 27/10/98    755       IIG      2.58     2.28    (11.6%)
 17/07/98    298       ULVR     6.72     5.89    (12.4%)
 11/05/98    368       MKS      5.54     3.63    (34.4%)

Last Rec'd  Total #  Company   In At     Value    Change
 19/12/97    783       RTO    2046.53   3398.22  1351.69
 27/01/99     37       DELL   2007.42   2169.55   162.13
 17/04/98    169       EMA    2052.57   2097.29    44.72
 04/11/98    245       PIZ    1966.34   1715.00  (251.34)
 27/10/98    755       IIG    1972.64   1721.40  (251.24)
 17/07/98    298       ULVR   2052.54   1755.22  (297.32)
 11/05/98    368       MKS    2054.11   1335.84  (718.27)


Cash:                                 £2,000.18
Current Total :                      £16,192.70

Total Invested:                      £16,184.62
Profit/(Loss) :                         £  8.08 


Value Per Share

                    Day      Month      Year      
Qualiport          0.55%    -1.84%     -3.67%
FTSE 100           2.05%    -0.13%      0.10%
FTSE All Share     1.75%     0.58%      1.41%

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