GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US) shares are down 9.6% in 2014. In the last twelve months of trading, they have lost 14.7% of value. If Glaxo is serious about slimming down in the right places, however, upside for shareholders could be 40% or more.
Consumer Health Business
Glaxo’s joint venture with Novartis will create a consumer health company with £6.5bn of revenues, it was announced earlier this year. The deal is expected to close in the first half of 2015. The British company will retain a 63.5% stake in the venture.
While it appears that structural changes are on the cards, Andrew Witty, Glaxo’s chief executive offer, runs the risk of losing the backing of key shareholders.
In an interview with the Financial Times on 27 July, he hinted at the possibility of spinning off Glaxo’s consumer health-care division from core activities.
“GlaxoSmithKline has no plans to spin off its consumer health-care division, a spokesman said,” Bloomberg reported the following day.
If anything, Glaxo should do a better job in managing expectations. That said, a spin-out of the consumer health business — whose capital requirements for research and development (R&D) are relatively small — may not be the best solution for shareholders. And it may not be the strategy that Mr Witty has in mind right now.
“Well, I never understood why they were in consumer health to start with,” a senior pharma analyst in the City told me. “That’s the obvious thing they could spin out, though they’ve been building it up for a while so it would seem a rather odd move,” he added.
What’s There To Break Up?
Glaxo may break up its operations geographically, although such a strategy would pose serious problems with regard to capital allocation. There’s a better alternative, in my view. Core R&D expenditures stood at £3.4bn in 2013 – some 90% of which were invested in core pharmaceutical activities. The consumer health operations are non-core, and account for roughly 10% of Glaxo’s total R&D investment.
Take Convergence Pharmaceuticals, which was spun out of Glaxo in 2010. It is planning an IPO of up to £100m either in London or in New York. Glaxo retained a minority stake in Convergence, and will benefit if the float is successful. More such deals would make a lot of sense in the next 12 months.
Decisive action is needed. From revenues to earnings, every single P&L item was a big disappointment in the second quarter. The bribery scandal in China is also a big problem, but that’s fully priced into Glaxo shares, in my view.
Operationally, Glaxo isn’t in great shape, as quarterly results showed. Its product pipeline is better than that of AstraZeneca (LSE: AZN) (NYSE: AZN.US), but its existing drugs are faced with fierce competition as cheaper alternatives pose a threat to its market share globally.
Glaxo Vs Astra
Forward trading multiples based on earnings before interest, taxes, depreciation and amortisation in 2014 and 2015 indicate that Glaxo’s shares trade at a discount of between 9% and 16% versus Astra’s.
Glaxo is more profitable than Astra at operating level, though — and is also expected to remain more profitable into 2015. Its net leverage is higher than Astra’s, but is manageable, which signals a more efficient balance sheet. As a result of a better capital structure, Glaxo offers higher returns to shareholders than Astra.
Astra shares still price in an M&A premium in the region of 25%, in my view.
That premium may well be assigned to Glaxo by Pfizer, particularly if Glaxo shows a commitment to shrink direct R&D investments ahead of disposals. Alternatively, a more efficient Glaxo may decide to go for Pfizer, which has lost more than $40bn of market value in less than one year. Then, say in the second half of 2015, Glaxo may even be able to impose its own terms at the negotiating table.
