GlaxoSmithKline: Turning a Corner in Q1

The evidence of the optimistic recovery plan at GSK is borne out in the first-quarter results and management have gone as far as they can go in giving confidence to an 80p dividend payout this year and next. The shares represent a well paid rational speculation on longer term earnings recovery, in my opinion.  

GlaxoSmithKline (LON:GSK) has been a useful share to be in. It has maintained its dividend payout in Q1 and has said that it plans to pay an annual dividend of 80p this year and next. Over the last twelve months the share price was up a modest 2 per cent (last seen) whilst the market, measured by the FTS100 Index, has fallen 12 per cent.

Clearly, in relation to the market’s preoccupations over the last twelve months – China, global slowdown and Brexit – GlaxoSmithKline has been above them all as a defensive stock in a weak market. A long-term private investor with surplus investable funds needs to be invested in the market to a significant extent, partly because selling all your shares and staying in cash is one of the risks of having an insufficiently diversified portfolio. To be in cash when the market puts in one of its growth spurts – seemingly against the odds – can prove costly. So Glaxo over the last twelve months has done its duty by investors.

Shortening the perspective, to cover the last six months, the share price (last seen) was up more than 8 per cent and the market down nearly 2.5 per cent. Pulling to a longer term view, the shares price of GSK over five years is up 10 per cent whilst the market only managed to put on 3.4 per cent.

However, that performance is not simply the reciprocal of the poor performance and concerns about other sectors and the market at large; it is also the outcome of its own efforts and prospects. GSK has continued to enthuse with its pipeline of research and development and by the fact that it has continued to reward shareholders with steady dividend payments, at a juncture when the firm has previously major prescription products going off patent. The latter has put a considerable dent in profitability and has required the company to demonstrate that it has enough products in its research and development pipeline capable of mitigating this.

Turning a Corner in Q1 2016

The results were complicated by the changes made to the company’s operating base last year when GSK did its asset swap with Swiss pharmaceutical company Novartis. First we are given the reported statutory results with comparisons; then the so called ‘pro forma’ figures used on occasions of corporate change to show what the situation would have been had those changes been in effect throughout – to iron away their distorting effect on past comparisons of performance – and finally (largely for assessing future prospects) the ‘core’ figures effectively reflecting the progress of the changed operating base.

The results for the first quarter of the current year to December 31^st seem at first sight encouraging to this stock’s followers. Top line sales revenue was reported as rising 11 per cent to £6,229 million. The company evidently benefited from the fortuitous effect of currency movements. When you take those out of the equation (known as the ‘constant exchange rate’ or ‘CER’ figures) the increase was still a handsome 8 per cent. In other words, something other than helpful currency translation costs was at work to produce a genuinely significant operational improvement.

Core operating profit did even better, increasing 19 per cent to £1,559 million, and boosting operating margins and cash flow. Most significantly, new product sales were reported as worth £821 million, an increase of over three times the figure of new sales reported in Q1 a year earlier and a 20 per cent increase from the last quarter of 2015. Core earnings per share increased 14 per cent in money value and 8 per cent in CER value.

The products which drove sales were new products which accounted for a substantial 20 per cent of total Q1 pharmaceutical sales. The improvement in margins seems to be down to these increasing sales figures plus successful cost control, the benefits of restructuring and integration measures and what is described as improved operating leverage – which I interpret to mean as having more sales and a more efficient operating cost base.

Cost savings in the last quarter were £400 million. That is the quarterly instalment of cost cuts which are planned to amount to total savings of £3,000 million by the end of next year. That suggests management are keeping up with that target over the next seven quarters. If the company keeps up that rate of cost reduction over the next seven quarters it will meet and surpass the target.

Operating margins were helpfully broken down on a segmental basis. In the first three months they were 32 per cent in pharmaceuticals, 29 per cent in vaccines and 17 per cent in consumer health care.

Although ‘total’ earnings per share (which I take to mean statutory earnings) were down at 5.8p and down on a year-on-year basis, we have to put htis into the context of the comparative Q1 in 2015 that benefited from booking profits on the sale of oncology and other assets which were not available in Q1 2016. Furthermore, progress was put into context by stating core profits to be worth 19.8p and having risen by 8 per cent on the aforementioned CER basis.

It was not a quarter of huge R&D newsflow. In Japan there was approval of ‘Nucala’, an asthma medicine; and a HIV therapy was promoted from Phase II to Phase III development of its preventative and ‘maintenance’ attributes. Much earlier progress included Phase II trials of what was described as an anti-inflammatory antibody; and there was some good news back from the FDA in the US regarding a carcinoma product in phase I/II.

Future Prospects

Recent market consensus estimates include the expectation of further growth in sales revenue – an estimated 7.5 per cent increase for this year and then a further 3 per cent or so in 2017. If the next set of quarterly sales figures are anything like as good as the first quarter’s, then that will tend to put these sales forecasts into the conservative category of estimates. Clearly, there is a particularly strong reason why GSK has to demonstrate turnover growth in its pharmaceutical prescription segment where earlier important prescription drug champions are going off prescription.

Earnings per share are estimated to rise 15 per cent in underlying terms this year to a forecast 87.4p a share and then, at this stage, by a further 4 per cent in 2017 to 91.2p.

In valuation terms, those estimates put GlaxoSmithKline on a prospective multiple of 16.5 times for this year and 15.8 times for next year. Given that the estimated earnings growth for this year is 15 per cent, this makes the shares, in relation to this year’s consensus estimates, near fair value. The accompanying annual dividend of 5.5 per cent (‘underwritten’, so to speak, by last quarter’s management guidance of an 80p annual dividend for this year and next) makes the shares good and useful value at this stage. The last quarter’s figures confirm that progress of the right kind was being achieved and that the annual dividend over this year and next looks reliable.

The share price chart pattern also looks good, indicating that the shares, having recently reached and bounced off the trend support line, look to be trending in a northerly direction.