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QUALIPORT
By
Down 12% to 1,127p, the shares of GlaxoSmithKline (LSE: GSK) have had a tough 2004. Last week's annual results from the pharmaceutical giant explained the weakness, with generic competition and adverse exchange rates producing a poor fourth quarter and creating the prospect of a short-term earnings decline. Despite their fall however, GSK shares are not attractive enough for the Qualiport. Following the company's latest figures, the portfolio's buy price has been lowered from 1,172p to 1,024p. Background information on GSK can be found here and here. Five-year record GSK's five-year record is summarised below:
Year to December 31
1999
2000
2001
2002
2003
Turnover (£m)
16,796
18,079
20,489
21,212
21,441
Operating profit (£m)
4,378
5,026
6,053
6,694
6,920
Pre-tax profit (£m)
4,236
6,029
4,517
5,506
6,329
Earnings per share (p)
50.3
60.2
72.3
78.3
82.1
Dividend per share (p)
37.0
38.0
39.0
40.0
41.0
During 2003, group revenues inched 1% higher to £21.4b while underlying operating profits increased 3% to £6.9b. Excluding various exceptional items, full-year earnings per share (EPS) improved 5% to 82.1p.
The fourth quarter proved difficult for GSK's pharmaceutical subsidiary. Its turnover during the last three months of 2003 fell 2% to £4.5b while divisional operating profits tumbled 9% to £1.2b.
Reasons behind the disappointing Q4 performance include the onset of generic competition to the group's Seroxat/Paxil anti-depressant (Q4 Seroxat/Paxil sales collapsed 43% to £325m), Relafen legal costs of £225m and the weak US dollar. Old favourites, such as antibiotic Augmentin and asthma treatment Serevent, also witnessed substantial revenue declines. However, 17 of GSK's 34 main products did make sales progress in the fourth quarter, most notably asthma treatment Seretide/Advair (now the company's biggest selling brand), which witnessed Q4 turnover jump 34% to £617m.
Even with the troubles, pharmaceutical operating margins were a mighty 35% in 2003. Last year, GSK's consumer healthcare division (drinks, toothpaste, nicotine patches and so on) recorded a £603m underlying trading profit (up 10%) on sales of £3.3b (up 1%), giving margins of 18%.
Cash flow
GSK's cash flow is exceptional:
| Year to December 31 | 1999 | 2000 | 2001 | 2002 | 2003 |
|---|---|---|---|---|---|
| Operating profit (£m) | 4,378 | 5,026 | 6,053 | 6,695 | 6,920 |
| Change to working capital (£m) | (522) | 53 | 776 | 385 | (395) |
| Depreciation (£m) | 650 | 735 | 761 | 764 | 936* |
| Capital expenditure (£m) | (1,023) | (961) | (1,050) | (985) | (823) |
(*Includes 'other non-cash items')
The table shows GSK having no problem with working capital. Though cash spent on tangible fixed assets has generally run higher than the depreciation charge, the difference between the two figures is a tiny fraction of operating profits. In fact, this study clearly shows how GSK makes its money from attractive, intangible assets.Other good cash flow signs include net debt being reduced from £2.3b to £1.6b and £980m (or 17p per share) spent on share buybacks. The 2003 dividend was raised a penny to 41p per share.
The merger to form GSK throws up many complications when trying to gauge the company's incremental return on equity. But going on the rough and ready approach used previously, things still look promising. 'Adjusted' earnings for the merged group increased from £2.9b to £4.8b between 1998 and 2003, while shareholders' funds went from £4.2b to £7.7b. If the £2.7b of exceptional costs charged in the past five years are capitalised, the resultant incremental return on equity comes to a very decent 30% (£4.8b - £2.9b)/(£7.7b - £4.2b + £2.7b).
Even with a heavy weighting towards equities and a stock market rebound, GSK's FRS 17 pension deficit surprisingly stayed around the £1.3b mark. Not a major issue when after-tax profits are running at nearly £5b, but something to monitor.
Summary and valuation
In its annual statement, GSK admitted: "2004 will be a year of transition". The first nine months of the current year will be 'challenging' as Seroxat/Paxil (which generated £1.9b of sales in 2003, or 10% of group pharmaceutical revenues) comes under further generic pressure.
In addition, Wellbutrin (an anti-depressant, which generated £1b of sales in 2003, or 5% of group pharmaceutical revenues) is already facing 'limited' generic competition in the US. The product is expected to witness a significant sales shortfall anytime soon.
Despite that, GSK expects to deliver 2004 EPS -- at constant exchange rates -- 'at least in line with business performance EPS in 2003'. However, should the world's major currencies continue to trade at current levels, earnings would fall 7% this year. Whatever, GSK expects to increase the 2004 dividend by another penny to 42p. For 2005, the group anticipates a return to EPS growth, exchange rates permitting.
Nothing in these results changes the fundamental attractions of GSK. Supported by the long-term rising demand for healthcare, the company produces some of the world's most popular treatments, remains second only to Pfizer (NYSE: PFZ) and has one of the best set of accounts around. Though the short-term pipeline seems to hold little promise, it's difficult to believe annual R&D expenditure of £2.8b won't come up with a handful of big selling products over time.
At 1,127p, GSK shares trade on a 2003 price to earnings ratio of 13.7 and offer a dividend yield of 3.6%. Assuming exchange rates do cause profits to fall 7% in 2004, earnings per share (essentially free cash flow per share) will come in at 76.2p. Demanding a 7.5% free cash flow yield on this projection therefore requires an entry price of 1,024p, which, with a 4% dividend yield too, appears an appropriate level for a big bold Qualiport bet. Note, however, these calculations exclude the effect of a possible £2.7b (or 45p per share) payment relating to additional US taxes.
Where next? Glaxo Joins The Watch List | Glaxo's Great Accounts
The author owns shares in GlaxoSmithKline.