Join our community of smart investors

GSK demerger: can 1+1-½ = 3?

As activists add to the pressure on the GlaxoSmithKline board ahead of a proposed demerger, Robin Hardy asks if it will create value for shareholders
GSK demerger: can 1+1-½ = 3?

How can 1+1-½ = 3? This is what shareholders in pharma giant GlaxoSmithKline (GSK) are being asked to accept as the business is radically reshaped. GSK is to split itself in two by demerging its consumer products division. A demerger can create value for shareholders (the 1+1 = 3 part) but GSK is asking investors to trust that this plays out while also having to accept a much lower dividend (the ‘-½’ part). Is this too much to ask or do shareholders stand to gain enough to compensate?

What is a demerger? 

Importantly it is not a sell off or dissolution because after the demerger investors still own the same assets and income streams but hold some through company A (‘parent’) and the rest through newly created shares in company B (‘spin-off’). 

In a demerger it is hoped that by focusing on a narrower range of operations, they can be better run. Also some investors believe that when non-identical businesses are combined they suffer from a ‘conglomerate discount’ where the whole is deemed to be worth less than the sum of the parts; others question this. Separate the businesses, allow each to become more focused, eliminate the discount and the overall value can rise to, or above, the sum of the parts: 1+1 = 3. 

In a demerger, not only revenues and assets can be re-packaged but also debt, and that is the case here. Debt has dragged on GSK, limiting research and development (R&D) spending and slowing growth. In the split, the spin-off business will assume a disproportionate share of the old group debt. 

Do demergers work?

On paper, splitting businesses to give more autonomy and focus looks positive, but in practice gains are much harder to realise and the split can make life more difficult. Trading can become more cyclical, competition may react aggressively, the narrower focus may make the parent less defensive, new management may be weaker than old PLC leadership or the market may simply not apply the imagined revaluation. In many cases, the demerged business is taken over, which while potentially boosting short-term value makes it harder to assess the merits of the split. Some recent examples of demergers:

eSure and GoCompare: GoCompare was twice bid for after demerger, doubling the initial share price when finally bought by Future (FUTR) in 2020. Esure began to flourish after the split but was hit in 2017 by changes in how insurance compensation payments are calculated. Retaining GoCompare may have stopped eSure’s share price dropping by one-third on these changes by making it more defensive. 

WH Smith (SMWH) and Connect/Smiths News (SNWS): Concentration and focus was not enough to counter the strong decline in printed newspapers and magazines: Smiths News is a national distributor. Here the demerger helped the parent by avoiding this decline but it has since faced its own high-street retail problems.

BHP (BHP) and South 32 (S32): a good move for the spin-off and a lost opportunity for the parent. South 32 swung from losses and debt to (pre-covid) doubled revenues, profitability and net cash. BHP’s sales have risen only 4 per cent compound since, despite a very heavy bias to China. 

Almost but not quite: Whitbread (WTB) and Costa Coffee: a hedge fund activism-led decision saw the coffee chain headed for demerger before being sold to Coca-cola. The sale bumped the WTB share price on the day but the shares plateaued even as £2.5bn was returned to shareholders. The core business (Premier Inns and restaurants) was not re-energised with revenues flat between 2017 and 2020 (before Covid). 

Overall, it feels like a bit of a coin toss as to whether shareholders and/or the parent do end up better off following a demerger. It feels somewhat similar here with GSK.  

The post-demerger GSK

Investors will retain their investment in the parent pharmaceuticals business ‘New GSK’ and will be given new shares in the spin-off, ‘New consumer healthcare’, in addition. In effect, this reverses the 2006 merger and effectively re-establishes Glaxo Wellcome and Smithkline Beecham as separate companies. 

New GSK – a focused pharmaceuticals business with three core disciplines: general medicines (in slow decline), vaccines (decent growth), and speciality drugs (high growth). This will structurally align New GSK more closely with its largest global competitors (AstraZeneca (AZN), Merck (US:MRK), Pfizer (US:PFE), Sanofi (FR:SAN)). Revenues are c24bn and Ebit (earnings before interest and taxes) is c£9bn or c£6bn after R&D expenses but growth is lacklustre.  

New consumer healthcare – a mixture of personal health products (toothpaste, nicotine replacements, vitamins etc) and over-the-counter (OTC) medicines (such as Panadol, Advil, Zovirax) with revenues of c£10bn and EBIT of £2.3bn: sales growth is a moderate 4 per cent. GSK owns 68 per cent of this business, in a joint venture with Pfizer and this is an attractive business with low R&D requirements and high cash conversion. After the demerger, however, there is a risk of stock overhang, with GSK looking to sell the 13.6 per cent stake it will retain and Pfizer’s commitment is unclear. Also the split will load this business with debt and these combined factors risk dragging on the valuation. 

The dividend cut

Alongside the demerger, GSK is cutting its dividend. GSK has been a staple equity income stock consistently yielding around 5 per cent, but there has been little increase in the dividend level in recent years owing to the lack of earnings growth and, arguably, overdistribution. Against an historic 80p a share, the aggregate dividend from the two new companies from 2022 is targeting 55p (44p New GSK and 11p Consumer) – all things remaining equal, this drops the yield to 3.8 per cent, assuming investors retain shares in both entities, in line with the market average. This does, however, risk causing some income-oriented investors to sell out. 

Motivation for this move

GSK has struggled for growth with sales rising by an average 1.8 per cent and Ebitda by 4.7 per cent over 10 years. Since 2017, a concerted effort to improve saw sales growth pick up to above 5 per cent but profits rose by less than 1 per cent. Dr Adam Barker at Shore Capital believes GSK’s drug pipeline has been anaemic and notes long-term issues with drugs coming off patent (notably HIV treatment Dovato in 2028 which accounts for 30 per cent of group EBIT). There is a pressing need to focus on the faster-growing markets in vaccines and specialist/rare or 'orphan' disease drugs which require accelerated investment in R&D. However, high debt and the dividend commitment have prevented this.

GSK is also under pressure from an activist investor, US hedge fund Elliott Management. Elliott acquired a substantial stake in GSK and has corralled other disenchanted investors to push for radical change. GSK has promised improvements via the demerger but are they enough to reassure disgruntled investors and prevent a wider shareholder revolt? That is far from clear. 

Revving the growth engine

Post-demerger, New GSK must improve and higher R&D is the key. There is considerable extra resource available with around £1.75bn saved annually on dividends and c£0.5bn on debt interest, all available to plough into R&D. In addition, the balance sheet can be re-geared and there is scope to sell down the retained investment in Consumer Products. All told, over five years New GSK could invest an additional £8bn-£10bn in organic R&D and acquisitions. The promise is for a steady 5 per cent revenue and 10 per cent profit growth annually for 10 years.

The problem is that while there are resources to invest, achieving good returns is not assured. GSK has underwhelmed with its spending and outcomes so why should investors believe in a brighter future? New GSK has to invest in more complex, riskier areas such as cancer treatments, areas on which its competitors are also focused. The money may also not go as far as management hopes. Many biotechs are well-funded by private equity with no pressure to sell and their owners can hold out for high valuations. 

If all goes well, returns could be good. Old GSK averaged ROCE of 13 per cent over the past five years but that was dominated by the declining general medicines arm – vaccines and specialist drugs should make higher returns. The £8bn-£10bn of investment could generate £1.5bn-£2bn of incremental annual profits in time – 2021 consensus forecast Ebit for the pharma side is under £6bn, so such a boost would be transformative.

If New GSK gets it right, the market’s view of the stock could materially shift and the rating improve from current, implied low-double-digit price/earnings (PE) ratio – about right for a business struggling to make headway, take Bristol-Myers Squibb (US:BMY) as comparison – to somewhere in the low to mid teens, right for a pharma stock hitting its stride: reference Novartis (CH:NOVN) or Merck (US:MRK). Below we make a quick sketch of how the above changes could impact the valuation. 

How value might be created
 

Pharma

Consumer

Combined

 

£m

£m

£m

EBIT - 2021E

5,700

2,400

 

Pre-tax [1]

5,200

2,000

 

After tax

4,420

1,700

 

Attributable profit [2]

4,420

1,156

 

P/E [3]

10.9 *

20.5

 

Value [4]

48,302 *

23,698

72,000

* implied by deducting Consumer from Combined / Group value

After tax boost from investment

1,400

  

New attributable profit

5,820

  

Improved P/E - 20% uplift

13.1

  
    

New value

76,322

23,698

100,020

    

Value of 10 years' lost dividends

  

-13,000

Net new value of combined

  

87,020

    

Potential gain in value

  

15,020

Per share

  

297p

Gain %age

  

20.9%

[1] assumes £500m/£400m interest split  [2] deducts minority for Pfizer share of Consumer  [3] values GSK Consumer same as Reckitt Benckiser [4] Pharma value deduced by subtraction 
Source: Investors Chronicle   

This rough analysis shows that well-executed investment could add around 300p to the equity value. But there are a lot of 'ifs' here. Will GSK pick the right drugs to promote/advance, can enough new good drugs be added to the pipeline, will GSK be able to buy up capable biotech businesses at fair valuations, will new drugs grow fast enough to counter patent expiries and does just throwing more money at the pipeline make it better? 

The achievable outcome is unclear and the rewards a long way off, which is why the share price barely moved on news of the demerger – investors seem to need more convincing, but at least opportunity is being created where there was none before.