GlaxoSmithKline (GSK): A High Yield but a Lot of Risks to Consider

As the market continues to climb to new record highs, many investors are searching for safe dividend stocks paying high dividends (see 28 such companies here).

 

The healthcare sector, pharmaceuticals in particular, is generally considered a defensive sector thanks to the recession-resistant nature of its product sales.

 

However, while this is true as a whole, not all high-yield pharma stocks are created equal.

 

Let’s take a look at to see if GlaxoSmithKline (GSK), which currently boasts one of the highest yields in the industry, could be a reasonable investment for our Conservative Retirees dividend portfolio.

 

Business Description

With roots tracing back to 1715 in London, GlaxoSmithKline is one of the world’s largest pharmaceutical companies, with nearly 100,000 employees operating in more than 150 countries.

 

GlaxoSmithKline has three primary business segments:

 

Pharmaceuticals (58% of revenue; 68% operating profit): patented drugs treating bacterial, viral (including HIV), as well as respiratory, cardiovascular, urogenital,metabolic, dermatological, and immuno-inflammatory conditions.

 

Vaccines (16% of revenue; 18% of operating profit): produces and distributes 25 vaccines around the world (833 million doses in 2016) to prevent diseases such as Meningitis, Hepatitis A, Hepatitis B, Tetanus, HPV, Diphtheria, Influenza, Pertussis, Measles, Mumps, Rubella, Typhoid, Varicella (Chicken Pox), Rotavirus, and Pneumococcal Pneumonia.

 

Consumer Healthcare (26% of sales; 14% of operating profit: oral health, nutrition, and skin health products (in the form of tablets, creams, syrups, and skin patches) under the Otrivin, Panadol, parodontax, Poligrip, Sensodyne, Theraflu, and Voltaren brand names

 

As you can see, while GlaxoSmithKline is a highly diversified company, the vast majority of its sales and profits come from its patented pharmaceutical division.

 

That’s because patented drugs, while potentially more volatile and prone to losing market share to competitors and generic rivals over time, have inherently higher margins.

 

Business Analysis

Like most large pharma companies, Glaxo’s sales and earnings can be highly cyclical and volatile.

 

In fact, over the past five years the company’s revenue growth has clocked in at -3.6% annually, and its core earnings shrunk every year from 2007 through 2015.

 

 

This is precisely because so much of the company’s sales and free cash flow are derived from just a handful of patented drugs.

 

In fact, GlaxoSmithKline’s top five pharma products accounted for 27% of the company’s total revenue in 2016 (and presumably an even higher share of total profits).

 

Patented drugs constantly face competitive pressure from rival products and patent expirations that allow much cheaper generics to steal market share.

 

As a result, Glaxo must continuously invest heavily into R&D and its new drug pipeline to make up for the steadily deteriorating long-term sales of its major patented cash cows, such as asthma drug Advair.

 

Advair, the company’s top-selling respiratory medicine, accounted for approximately 20% of Glaxo’s total sales and an even greater share of profits at its peak in 2013.

 

However, the drug lost patent protection in the U.S. in 2010 and in Europe in 2013. Generic competition and price pressure from insurers caused Advair’s sales to decline by 34% since 2013.

 

Management believes 2017 could be a tough year for sales of Advair in the U.S. because Mylan (MYL) and Hikma Pharmaceuticals (HKMPF) are expected to launch competing generic products.

 

If those cheaper products win approval from U.S. regulators, management expects core earnings to be flat or down slightly. Otherwise, core earnings are expected to increase 5% to 7% in 2017.

 

Glaxo’s pharma struggles were a catalyst behind its $20 billion asset swap with Novartis in 2015 that sent Glaxo’s cancer drugs over in exchange for Novartis’ vaccines business and a majority stake in a joint venture that combined the two companies’ consumer health businesses.

 

Glaxo’s CEO who orchestrated the deal (and has since retired) wanted to diversify the company into these lower-margin, but higher-volume businesses to combat the patent expirations and insurance pricing challenges it faced within its pharmaceutical portfolio.

 

The global vaccines and consumer healthcare markets are large in size ($18 billion and $70 billion, respectively) and expected to grow at predictable low to mid-single-digit annual rates over the coming years, which should provide more dependable cash flow for Glaxo.

 

While these moves should in theory provide a more stable operating platform for the company over the long term, pharmaceuticals still accounted for nearly 70% of Glaxo’s total operating profit last year.

 

In other words, the company still faces risk managing the decline of its Advair drug (12.5% of sales last year) while continuing to develop its drug pipeline, which has failed to live up to expectations for years.

 

Up until now, the company has managed to keep its return on invested capital at highly impressive rates.

 

 

However, in 2016 Glaxo saw its margins and returns on capital fall, especially compared to other blue chip pharma names such as Johnson & Johnson (JNJ). This was mainly due to two factors.

 

Company	Operating Margin	FCF Margin	Return On Invested Capital
GlaxoSmithKline	9.3%	11.1%	6.8%
Johnson & Johnson	29.4%	21.6%	17.9%
Industry Average	19.5%	NA	NA

Source: Morningstar

 

First was a substantial increase in tax liabilities due to having to pay more in taxes than it had anticipated. This resulted in an effective tax rate for 2016 of 45.2%, compared to just 20.5% in 2015.

 

Management expects its updated tax liability policies to avoid this kind of mistake in the future and projects a 21% to 22% tax rate in 2017.

 

However, the largest factor to its 2016 earnings drop was a substantial increase in charges and write-offs related to previous acquisitions, joint ventures, and restructuring costs, which totaled almost 4 billion pounds.

 

 

In fairness to management, these charges are part of its restructuring plan that was announced in 2014, launched in 2015, and has thus far had six quarters in which to run.

 

In addition, last year’s charges included acquisition-related expenses from acquiring several key HIV drugs from Bristol -Myers Squibb (BMY).

 

In other words, while the massive charges in 2015 and 2016 may look bad, investors need to realize that once the turnaround plan is completed these charges should become greatly reduced.

 

The good news is that if you exclude the one-time tax hit, Glaxo’s constant currency sales and adjusted EPS were actually up 6% and 12%, respectively, thanks to strong growth across all its business segments driven by the launch of 11 new product lines.

 

 

In fact, Glaxo has done a remarkable job in accelerating the release of new drugs. You can see that new product sales have increased from 8% of total revenue in 2015 to 16% last year. Within the company’s pharma segment, sales from new products total close to 25% of revenue.

 

 

This should help the company diversify its cash flows away from blockbuster drugs, such as Advair.

 

Better yet, Glaxo expects to potentially bring 20 to 30 new drugs to market by the end of 2018, which should play a big role in turning around both its top and bottom line growth (if the drugs gain approval).

 

That’s because Glaxo has been able to cut over $3 billion in costs over the past two years, greatly improving its earnings and free cash flow per share. Such actions are vital to helping maintain the security of the dividend, which has been frozen for 2017.

 

Glaxo also hopes to benefit from pursuing a rather bold strategy in terms of new product launches.

 

For one thing, the company is pursuing innovative new drugs, rather than merely improving already successful drugs just enough to achieve a new patent.

 

As a result, there is a higher likelihood that its drugs can’t make it through stage one and two of the FDA’s trial process, where regulators check to see whether a drug has sufficient benefits over existing treatments to be worth approving.

 

In addition, the company is trying to corner the emerging market with a tiered pricing model, in which it caps a drug’s price at about 25% of what it charges in the developed world, as long as manufacturing costs are covered.

 

In addition, Glaxo is investing 20% of profits in emerging markets into training local health workers and improving public health. This not just helps to build goodwill but can also mean winning government contracts for selling bulk drugs to a nation’s health system.

 

At the end of the day, the fact is that the pharmaceutical industry is very challenging one to generate consistent profits, much less grow them (especially for companies that lack product diversity).

 

While Glaxo has a reasonable turnaround plan, whether or not the dividend can remain intact will depend on how well new CEO Emma Walmsley (formerly head of Consumer Healthcare) can deal with numerous challenges in the years ahead.

 

Key Risks

Like all drug companies, Glaxo faces a lot of challenges to securing (much less growing) its dividend in the future.

 

First, the cost of developing and bringing a new drug to market can be extremely expensive, requiring billions of dollars.

 

 

In addition, there’s no guarantee that a promising drug will actually be profitable, because even drugs in phase III trials can fail.

 

In fact, only one in 5,000 drugs that enter the FDA’s drug trial gauntlet ever makes it to market, and the entire process often takes more than 12 years.

 

 

That’s why the pharmaceutical industry is one of the most active when it comes to mergers and acquisitions, or M&A.

 

The limited duration of drug patents and the incredibly competitive nature of this industry (if a drug becomes a blockbuster, then all of its competitors will race to develop their own similar treatments) means that steady sales, earnings, and free cash flow growth require a drug maker to periodically acquire a rival – one that either has an existing successful drug already on the market or a promising development pipeline.

 

However, that exposes investors to a large amount of execution risk. Management has to make sure not to overpay for an acquisition, deliver on promised synergistic cost savings, and hope that the pipeline they just bought doesn’t see several major drugs fail in trials.

 

It remains to be seen how successful Glaxo’s current drug pipeline will be.

 

There is also the threat of major litigation and regulatory changes. Remember that all drug makers need to maintain large legal departments to both protect their patents, as well as defend against rivals suing them for billions.

 

In other words, lost legal cases can result in massive and unexpected costs. Damages can be as much as $2.5 billion, which a court recently awarded Merck (MRK) in a patent case against Gilead Sciences (GILD).

 

The bottom line is that the pharmaceutical industry is a potential minefield, littered with numerous difficult-to-predict challenges and burdened with very high R&D costs to go along with political and regulatory risks.

 

These factors make it more important than ever for dividend investors to make sure that any drug maker they own has a highly secure and dependable payout.

 

GlaxoSmithKline’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

GlaxoSmithKline has a Dividend Safety Score of 24, indicating that its dividend could be unsafe and ultimately cut or suspended at some point in the future.

 

Management has generally chosen to be generous with the company’s dividends, to the point of creating what could prove to be dangerous payout ratios.

 

In fact, in the past 12 months Glaxo’s EPS and FCF payout ratios were 419% and 99%, respectively.

 

 

Meanwhile, over the past 10 quarters, Glaxo’s FCF payout ratio has been 145%, indicating that even over several years it still hasn’t been able to cover its dividend organically, and thus has had to resort to taking on debt in order to maintain the payout.

 

Even if you exclude restructuring costs, Glaxo’s free cash flow has largely come far short of its dividend payments.

 

The good news is that starting in Q3 of 2016 this trend finally turned around, and in Q4 the company was able to achieve a very good FCF payout ratio of 42%.

 

 

However, remember that any single quarter’s results can be misleading in terms of dividend safety because of the unpredictable timing of R&D, capital expenditures, various restructuring charges, and the ultimate future success of Glaxo’s drug pipeline.

 

Then there’s the issue of Glaxo’s highly leveraged balance sheet, which has been a result of years of steadily rising debt (I generally prefer companies with a debt to capital ratio below 50%).

 

 

Of course given the highly capital intensive nature of this industry, one can’t simply look at any company’s credit metrics in a vacuum.

 

However, comparing Glaxo’s balance sheet to its peers, you can see that the company’s leverage runs high.

 

While the debt levels aren’t high enough to pose any immediate danger to its credit rating, at the same time you can see that GlaxoSmithKline’s leverage ratio is nearly four times that of most drug makers.

 

Company	Debt / EBITDA	EBITDA / Interest	Debt / Capital	Current Ratio	S&P Credit Rating
GlaxoSmithKline	4.26	6.30	61%	0.97	A+
Industry Average	1.12	NA	38%	1.73	NA

Source: Morningstar, Fast Graphs

 

In other words, management has very little margin for error, should its turnaround plan not go as expected or the drug pipeline fail to deliver enough winners to offset lost revenue from patent expirations and continue pricing pressure from insurers.

 

Or to put it another way, with a strong need to deleverage the balance sheet (in order to pay for future acquisitions), Glaxo’s dividend is riskier than it might first appear.

 

GlaxoSmithKline’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

GlaxoSmithKline has a Dividend Growth Score of 22, indicating weak future growth prospects.

 

That shouldn’t come as that much of a surprise given that Glaxo’s dividend has grown at a generally slow rate over the years.

 

After growing at a mid-single-digit annual rate over the last decade, GlaxoSmithKline’s quarterly dividend has actually been frozen since mid-2013.

 

In addition, even if management is successful in its turnaround efforts and is able to generate long-term sales and EPS growth, the dividend would have to grow far slower for several years in order to allow the payout ratios to fall to sustainable levels while still permitting management enough excess cash flow to pay down its high debt load.

 

Even in a best case scenario, in which Glaxo doesn’t have to cut its dividend, investors can likely only expect low to mid-single-digit dividend growth in the coming years.

 

U.S. investors should also note that fluctuating exchange rates can impact the amount of dividends you will actually receive from Glaxo as well, further complicating the growth story.

 

Valuation

Despite underperforming the S&P 500 over the past year, GlaxoSmithKline’s stock doesn’t appear all that cheap.

 

Even assuming that the turnaround goes well and Glaxo’s profits in 2017 are much stronger, its forward P/E ratio remains slightly above its historical norm.

 

Company	Forward P/E	Historical P/E	Dividend Yield	Historical Yield
GlaxoSmithKline	15.1	14.7	4.8%	5.1%
Industry Median	27.3	NA	1.5%	NA

Source: Gurufocus

 

While it’s true that GSK’s dividend yield is among the highest of global pharmaceutical companies, keep in mind that compared to its 13-year median value, today’s investors are still paying a premium for this potentially shaky recovery story.

 

In other words, GlaxoSmithKline doesn’t appear to be paying investors enough to compensate them for the risks it faces, in my opinion.

 

Closing Thoughts on GlaxoSmithKline

While Glaxo has made solid progress in its turnaround efforts, the company’s dividend still faces risk over the coming years due to the company’s leveraged balance sheet, elevated payout ratios, pricing pressure, and uncertain drug pipeline outcomes.

 

Despite a nice dividend yield of 4.9%, only highly risk tolerant investors should consider owning this drug maker, and even then, understand that this is a fairly speculative stock.

 

On the other hand, if you are someone who requires very dependable income, such as a retiree living off dividends, then GlaxoSmithKline is a high-yield dividend stock that should likely be avoided.