Is GlaxoSmithKline plc An Annuity Alternative?

The annuity market is expected to shrink by up to £7.6bn per year – and GlaxoSmithKline plc (LON:GSK) could be one of the main targets for this cash.

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Annuity giant Legal & General expects the UK annuity market to halve in size following the changes announced to pension rules in last week’s Budget. Adrian Boulding, who is L&G’s pension strategy director, told the Financial Times that the firm expects the UK annuity market to shrink from around £12bn per year to between £4.4bn and £6bn a year.

That means that £6bn per year could be sloshing around the UK economy, looking for a more profitable home than the low-yielding government bonds that annuity providers are forced to buy.

gskIn my view, George Osborne’s decision to liberate pension funds could end up giving the stock market a boost — in particular, large cap dividend stocks like GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US).

A cash machine

GlaxoSmithKline is the fifth-largest company in the FTSE 100. In 2013, it paid out £3.7bn of cash dividends to shareholders, and repurchased £1.5bn of its own shares.

However, what makes it special is its ability to generate this cash. Unlike the FTSE 100’s biggest dividend payer, Royal Dutch Shell, Glaxo’s dividend was fully covered by free cash flow last year. In fact, it’s been covered by free cash flow, on average, for at least the last six years (I didn’t check any further back).

Glaxo’s free cash flow yield has averaged 6.0% over the last six years, equating to free cash flow per share of 581p. Of this, 405p, or 70%, has been paid to shareholders in the form of dividends, while much of the rest has been used for share buybacks.

Serious quality

In my view, two figures highlight the quality of Glaxo’s business from an income investors’ perspective.

Firstly, the firm’s ability to convert its accounting profits into free cash flow: over the last six years, Glaxo’s free cash flow has averaged 80% of its normalised earnings per share.

Secondly, Glaxo’s outright profitability: during the same six-year period, the pharma giant’s operating margin has averaged 26%. Such high margins point to Glaxo’s economic moat — it has few competitors, and the barriers to entry for new firms are very high.

A high yield for the long run?

Glaxo’s dividend yield has averaged 5.0% over the last five years: it’s currently 4.8%, and is expected to rise to 5.1% this year.

The question for would-be retirement investors is whether the firm’s dividend will remain stable, and growing, over the long term. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland owns shares in GlaxoSmithKline and Royal Dutch Shell, but does not own shares in Legal & General. The Motley Fool has recommended shares in GlaxoSmithKline.

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