Is GlaxoSmithKline plc The Next Tesco PLC?

Could underperforming GlaxoSmithKline plc (LON:GSK) really follow Tesco PLC (LON:TSCO) into the investment abyss?

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The thought that GlaxoSmithKline (LSE: GSK) could suffer a decline as severe as that of Tesco (LSE: TSCO) is likely to strike fear into the hearts of many income investors, including me. But is it possible, or even likely?

Until a few years ago, the majority of City and private investors thought Tesco was a solid, profitable income stock. Tesco’s dividend payment had risen for 18 consecutive years.

Only a few savvy investors, such as Fundsmith founder Terry Smith, noticed that the firm’s return on capital was dropping steadily as the group expanded.

Eventually, it became clear to everyone that Tesco’s sector-leading profits margins and high profits were not sustainable. Today, shares in the UK’s biggest supermarket trade at a 12 year low. The stock is one of only a few in the FTSE 100 that doesn’t pay a dividend.

Could this happen to GlaxoSmithKline?

A quick look at Glaxo’s stock chart makes it clear that the firm’s shares have been in a downtrend since May 2013. Glaxo stock is now worth 20% less than it was 2.5 years ago.

The firm has struggled to maintain its profits against a tide of patent expiries on key products and currency headwinds. This has triggered a slump in profits, which fell from £5.4bn in 2013 to just £2.7bn last year.

However, a recovery to £3.7bn is expected this year.

Let me explain why I’m pretty confident that Glaxo doesn’t face a sustained decline in profits.

Glaxo is different

Firstly, GlaxoSmithKline owns and sells a large number of brands and products that no one else can offer. Customers often cannot choose to buy their medicines from a different supplier.

Secondly, Glaxo’s product pipeline may have been through a lean patch over the last couple of years, but it’s not empty. At a recent presentation to investors, the firm profiled 40 potential new products, 80% of which Glaxo believes could be ‘first-in-class’ — completely new to the market. These include potential new treatments for cancer, arthritis, HIV and Hepatitis.

Finally, Glaxo’s financial performance remains impressive. From 2009-2014, the group’s free cash flow covered its dividend payments 1.3 times. Over the same period, Tesco’s free cash flow only covered 20% of its dividend payments.

Glaxo’s ability to generate cash is the result of its high profit margins. These often vary from year to year, but the group’s operating margin has averaged 23% over the last five years. This year’s result is expected to be similar, on an underlying basis.

I’m also bullish about the long-term benefits of Glaxo’s asset swap deal with Novartis, which completed earlier this year. This deal should strengthen Glaxo’s position in consumer healthcare and vaccines. It has also helped Glaxo to reduce its net debt, which has fallen from £14.4bn to £10.5bn so far this year.

A dividend buy?

Star fund manager Neil Woodford remains a big fan of Glaxo, which is the third-largest holding in his income portfolio. He believes the firm’s long-term value is not fully reflected in the share price and has added to his fund’s holding this year.

Excluding this year’s 10p special dividend, Glaxo shares currently offer a prospective yield of 6%.

I recently topped up my personal holding in Glaxo, and in my view the shares remain a long-term buy.

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 Head owns shares of GlaxoSmithKline and Tesco. The Motley Fool UK has recommended GlaxoSmithKline. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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