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Glaxosmithkline (GSK) Buy

FY2013 helped by low tax rates

GSK FY 2013 suggested sales growth challenges (GSK sales grew just 1% in FY13). This is apparent in pharmaceuticals (1% growth), vaccines (2% growth) and consumer (2%). Partly this reflects the higher proportion of GSK’s overall sales in the consumer business (29% sales) a development that has taken place in the last four years but also weaker performance in core areas such as anti-virals (-6%) oncology (-8%), central nervous system (-8%).

GSK new launch sales totalled £1.4bn or 7.8% of sales with Synflorix and Votrient accounting for half of the new sales. Recent Phase III product failures are negative for GSK 2014/15 launches. As the sensitivity table identifies, GSK is highly sensitive to sales growth. Assuming sales growth were 4% in 2013 (all other ratios remaining the same) net profit would have risen 9.3%.

Screen Shot 2014-09-26 at 09.34.30

Source: CSS Investments Ltd

Consensus forecasts for GSK do not appear very demanding. In order for GSK to hit consensus EPS forecasts for 2014 of 118.5p (using similar tax and non-core expense ratios as in FY13); sales would need to rise by c£450m.

Screen Shot 2014-09-26 at 09.35.07

Source: CSS Investments Ltd

GSK / Novartis asset swap very positive on many fronts

We consider the recent major transaction with Novartis as very positive for GSK for the following reasons:-

  1. Outstanding exit price for GSK’s oncology business $16bn of cash ($1.45bn depending on COMBI-d trial) for a portfolio of cancer drugs with annual sales of $1.63bn – hence an exit multiple of 8.9x sales (assuming COMBI-d fails) and 9.8x sales (if COMBI-d succeeds). This is a significant premium to group price/ sales ratios (see below) especially given recent Phase III failures.
  2. Extends GSK lead in global vaccine market and cuts the number of players to GSK, Sanofi, Merck and Pfizer, adding Novartis new meningitis vaccine Bexsero to the GSK portfolio. The transaction for an initial $5.25bn with further payments of $1.8bn represents excellent value and revives GSK’s vaccine opportunities.
  3. The deal alters GSK revenue split to Pharmaceuticals (62%)(down 5.5%), Consumer/ Wellness (24%) (up 4.4%) and Vaccines (14%) (up 1.1%). This broadly helps lower GSK EPS sensitivity to pharmaceuticals/ US markets whilst lifting the global consumer/ wellness exposure. This furthers strategy objectives considerably.
  4. £4bn shareholder capital return via B shares – worth around 82p per share payable in 2015 – this will increase the cash return on GSK shares over the next 12 months to c. 10%. The payment will be funded out of net cash of $7.8bn.
  5. The merger of consumer operations leaves GSK in the driving seat with over 63% of the merged entity.
  6. Overall revenues will rise by £1.3bn to £26.9bn with annual cost savings of £1bn by 2019 against a total upfront cost of £2bn. Using a sales estimate of £26.9bn and deducting cost savings we arrive at core FY16 operating profits in the £9.4bn range.

Valuation – pharmaceutical valuations surge due to deal frenzy

The recent jump in pharmaceutical valuations owing to takeover approaches for Allergan, and Astra Zeneca, a strong set of EPS guidance post Q1 2014 for the US sector – Pfizer guided to $2.25 and Merck $3.44 plus the GSK/Novartis deal has seen GSK trade near the best levels of 2013. GSK rating multiples both historic and forward are below its peers.

Company P/E historic (x) P/E forward (x) Price/ Sales (x) Price/Book (x) (net assets)
Astra Zeneca 15.6 18.6 3.87 4.3 ($23.2bn)
Bristol Myers 32.9 26.1 5.11 5.5 ($15.1bn)
GSK 16.1 15.1 3.05 10.3 ($13bn)
Merck 39.1 16.7 3.83 3.4 ($49.7bn)
Pfizer 19.2 14.1 3.94 2.7 ($76.3bn)
Average 24.6 18.1 3.96 5.2 (NM)

Source: CSS Investments Ltd

Conclusion

We are positive on building EPS momentum going into 2015/ 2016 with the prospect of progress on GSK’s rebalancing into consumer healthcare and a large capital return on a 12 month horizon. On the valuation side we see GSK as inexpensive relative to sector peers but offering better EPS transparency and cost / £2bn restructuring savings to FY16.

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