Bleak thoughts

So consumers and companies take refuge in an illusion – the illusion of growth. If people can’t become richer by their own efforts, at least they can spend more than they can afford. This both makes them feel good and it may stimulate some demand-led growth all round. If companies can’t create value via their own trading, at least there are devices available that can produce the appearance of growth.

Take GlaxoSmithKline (GSK), the UK’s number-one pharmaceuticals company – and the world’s sixth largest – that is also the fifth biggest company by market value listed on London’s stock exchange. Glaxo, which is best known for its blockbuster asthma treatment Seretide (Advair in the US), is indeed a big and mature company. True, its current structure was formed as recently as 2000 but it traces its antecedents back to the late 19th century.

Ostensibly, Glaxo had a good year in 2013. It had 14 products approved by drugs’ regulators, the most since 2004. Six of these were, by its own definition, “major medicines”. In addition, its share price rose 20 per cent on the year. All this prompted its chief executive, Sir Andrew Witty, to enthuse in the latest annual report: “Our performance in 2013 was defined by remarkable R&D output and further delivery of sustained financial performance for our shareholders.”

If he were writing today, Sir Andrew may temper his hyperbole – Glaxo’s share price is down 11 per cent so far this year largely because the mess in China into which the company has got itself might even turn into an existential threat. But, more to the point, we need to examine precisely what comprises this “further delivery of sustained financial performance” that Sir Andrew imagines took place.

That’s the purpose of the table. Big multi-nationals are slow-moving, slow-changing beasts. There is no purpose therefore in judging them on the performance of a year or two. The longer perspective is needed. Where such juggernauts have come from points to where they are headed. So I have looked at various performance metrics over the past 10 years and compared Glaxo with three of its major peers – the UK’s other pharma giant, AstraZeneca (AZN), which is best known for its anti-ulcer drugs, Nexium and Losec; Pfizer (NYSE: PFE) of the US, best known for heart-disease drug Lipitor and for Viagra; and Switzerland’s Roche (SWX: ROG), whose headline products are Tamiflu and Valium.

By comparing the 10-year growth rates and the nine-year return on capital data with the latest year’s data we get an approximate indication of the direction in which the companies are moving. There is an overwhelming feeling of decline – certainly for Glaxo, AstraZeneca and Pfizer. None has been able to muster sales growth much above 3 per cent at a compound rate in the period 2004-14, so none has been able to bring any leverage to the pre-tax profit line.

Indeed, the growth in pre-tax profits shown in the table flatters those three because it is based on so-called ‘clean’ profits. These figures ignore exceptional items, which are usually re-structuring costs and legal settlements (an occupational hazard for pharma companies). Yet include them in the calculation – as, arguably, we should since the ‘exceptional’ is really quite normal – and Glaxo’s growth in pre-tax profits has compounded at just 1.6 per cent a year for the period. But at least that’s better than AstraZeneca’s, whose ‘dirty’ pre-tax profits – thanks largely to £5bn-worth of re-structuring – shrank at the rate of 4.3 per cent a year over the period.

One concern is that lack of growth is feeding through to a reluctance to invest in research and development (R&D). If so, that would be serious since R&D provides a pharma company’s seed-corn. Certainly the impression is that, as sales stagnate, then R&D spending stagnates too. At both Glaxo and Pfizer the latest ratio of R&D spending to sales is below its 10-year average.

At Glaxo, the detailed picture may be of greater concern. Split the 10 years into two phases and R&D spending grew by 6.6 per cent a year on average in the first phase (2004-09). But it grew by just 0.6 per cent a year in the second phase (2009-14) and fell in three of the past four years. True, there may be operational reasons for this. R&D spending tends to rise as drugs go into late-stage trials, which are bigger and so more expensive, then fall when trials end. Glaxo’s drugs in final-phase trials peaked at 36 in 2010 and has since dropped to 22, the lowest figure in the 10 years. R&D spending has moved in a very loose tandem to that, hitting close to £4bn in each of the three years 2009 to 2011 then falling to about £3.5bn. Even so, it would be good to see R&D spending rise once more if and when drugs in mid-stage phase II trials – 46 of them at the start of the year – move into late development.

One piece of good news is that Glaxo generates decent returns on capital – indeed, that’s true of all four, with the possible exception of Pfizer. Granted, return-on-capital ratios are notoriously difficult to gauge since so many accounting rules can affect the book value of a company’s equity employed. That may be why the most useful of the three sets of return-on-capital data in the table is ‘return on assets’, which takes the widest base possible – the book value of all the resources that a company employs. The impression is that pharmaceuticals remains an enviably profitable business despite the pressures on healthcare spending applied by governments.

Of course it is most likely because of these pressures that growth is so elusive and an escape route for companies that can’t grow via their market is to grow through financial engineering. Glaxo has taken this route with enthusiasm and, in effect, this is what Sir Andrew refers to when he talks of “delivery of sustained financial performance for our shareholders”.

But sustained for how much longer? Glaxo’s financial engineering means it has geared up its balance sheet with borrowings in the past 10 years, using the proceeds to buy in its own shares, thus boosting earnings growth. The bottom section of the table shows this process and, both to grasp the scale of the financial engineering and make it comparable between companies, expresses the amounts companies have spent in the 10 years 2004 to 2013 in relation to the current market value of their equity.

The relationship between the increase in Glaxo’s net debt and the re-purchasing of its shares is the closest of the four. Putting the table’s percentages into money, Glaxo’s net debt rose £10.5bn in the period, while it spent £14.3bn buying in shares (net of £2.9bn-worth of new shares issued). Over the same period it distributed £30bn-worth of dividends. This financial engineering meant earnings grew more than twice as fast as pre-tax profits yet still trailed behind dividends’ growth. However, Glaxo’s dividends can’t continue to rise faster than earnings and three times the rate of pre-tax profits growth for that much longer.

In defence of their strategy, Glaxo’s bosses might point out that the company’s finances were not stretched and that there was always enough profit and – more important – cash flow to cover the dividends. True, but cover is getting worryingly thin (see table). Free cash flow – the cash from trading left over for shareholders – is always a volatile figure, but in the past 10 years Glaxo’s has averaged £4.8bn a year, with the trend more down than up. Meanwhile, the cost of Glaxo’s dividend was £3.7bn in 2013 and rising.

When those two figures will cross over depends less on Glaxo’s trading performance – the long-term growth in profit and cash flow will be minimal – and more on its directors’ willingness to ratchet up borrowings. What’s certain, however, is that on current trends Glaxo faces a crunch within the next 10 years and, more likely, the next five.

So why do I pick on Glaxo? Simply because its shares are in the Bearbull Income Portfolio and I wonder if they should stay there. I lightened the holding in August and may ditch it completely. Yet there is a generic concern – that what’s true of Glaxo applies to many of London’s blue-chip companies; that financial engineering has become as important to them as trading and that their scope to raise dividends will be badly constrained by their lack of real growth and the limits to this type of engineering.

This may be a huge problem in the making, not just for the ageing companies but for their ageing shareholders, too – the ones who haven’t quite grasped that they are not so affluent as they once were, nor have grasped that the dividend growth in their investment portfolio that they thought they could rely on simply may not be there. A bleak thought.