Recent short term disappointments in the form of lacklustre Q2 numbers and the ongoing Chinese corruption investigation have not, in our opinion, altered GlaxoSmithKline’s long-term characteristics or fundamentals, although they have driven the share price to a level at which it offers compelling value. The shares now offer a prospective return on capital almost twice that of the market average, yet are trading on valuation levels which are well below the market, while its management has explicitly committed to align corporate strategy with enhancement of shareholder value.
The basis of the Economic Advantage investment process is that the best share price returns come from companies with a (hidden) competitive advantage stemming from one of three distinct intangible asset strengths: intellectual property, strong distribution and high levels of recurring revenue.
Most usually this advantage shows up in the form of superior earnings growth and/or return on capital, but sometimes it is revealed instead when businesses (or parts of businesses) are sold off. Recent management comments that a break-up might be considered are, in our view, entirely appropriate and such a strategy would most likely reveal substantial ‘hidden’ value which near-term earnings forecasts do not.
We like GlaxoSmithKline (and the other drugs companies) because its business model is built on the importance of intellectual property; large amounts of money are spent on R&D to discover ‘blockbuster’ drugs which, when patented, allow the companies to earn excess returns throughout the life of the patent. For Glaxo key examples include Zantac (anti-ulcer) and, more recently, Advair (respiratory). It has been our experience that the market systematically underestimates the cash flows accruing from this source, even when the drugs in question go off-patent.
In the last decade, as blockbuster drug discoveries have become less frequent (which may due to tougher regulatory requirements, or may simply be a cyclical phenomenon), so the second intangible strength – global distribution – has come to the fore. Deals with other companies to distribute their unique products (such as that with Dr Reddy’s of India) allowed Glaxo to leverage the strength of its sales force, a sensible strategy when experiencing difficulties in creating its own.
By these means, and by diversifying into consumer products, the company has managed to consistently sustain high returns (on capital) which are substantially superior to those of the market. This remains the case today and is forecast to continue: despite recent disappointments the company is forecast to achieve a Cash Flow Return On Capital (CFRoC) return of 10% this year and 10.2% next, compared with 5.5% and 5.8% respectively for the UK market average (source: Canaccord Genuity Quest)
Recently the company has seen setbacks due to the Chinese corruption investigation and disappointing Q2 results. The latter were particularly badly received as some amongst the City’s analyst community felt that the company, which has been desperate to demonstrate conclusively a resumption of sales growth, has mishandled its communications. As a result, the shares have underperformed significantly and sentiment appears to be at a low, with fewer buy recommendations than at any point in the past five years (source: Redburn Partners). Following the recent price falls the shares now yield about 5.8% while the FTSE All-Share offers 3.6%, and its free cash flow yield is 6.2% against 4.2% for the market (source: Canaccord Genuity Quest).
Although the hiatus in earnings growth may now continue for longer than previously anticipated, the intrinsic value of the company and its pipeline and respiratory franchise (which remains highly regarded) nonetheless remains high. Indeed, it is ironic the recent approach to AstraZeneca (hitherto regarded as the weakest link in the sector due to its imminent ‘patent cliff’ issues) has not resulted in more sustained re-rating for GlaxoSmithKline, which is further through the patent expiry cycle.
Julian Fosh is co-manager of the Liontrust Special Situations fund