Glaxo’s vanishing trick

Holding shares in GlaxoSmithKline (GSK) must be the investment equivalent of waiting for a distant relative to die. You know there is a legacy in the offing, but you seriously wonder whether it will be worth the wait. Any legacy Glaxo offers will be turned into cash after it finally splits itself into two, sometime next year. After that, it is just a matter of time before a once-great company dies as one or both of its component parts are gobbled up by rivals or by private equity.

When it comes, it will be a sad end to one of the greatest growth companies that British industry has seen in the past 50 years. For a short while in the 1980s Glaxo turned itself into the UK’s most valuable company and the world’s most valuable pharmaceuticals stock. Its success was almost exclusively based on Zantac, an ulcer treatment that was rejected by Glaxo’s rivals but became the world’s top-selling prescription drug.

After Zantac lost its patent, Glaxo lost its edge. Nothing that Glaxo’s laboratories or its bosses did could make good Zantac’s declining revenues. Not that they were short of effort. During the 1990s, its bosses focused on growth by acquisition. In the process, the group turned itself into Glaxo Wellcome, then – in 2001 – came the deal that created the current corporate body. Along with SmithKline (which, ironically, had rejected Zantac) came the chief executive of the enlarged group, Jean-Pierre Garnier. He spent the next seven years presiding over much corporate activity and a share price response that said pretty clearly what investors thought about it (see Table 1).

Where corporate tinkering failed, Garnier’s successor, Sir Andrew Witty, turned to financial engineering to give the impression of growth. During his tenure, Glaxo’s net debt more than doubled from £6bn to over £13bn. Every bit of that £7bn-plus and another £2bn besides was spent buying in shares. The result was that operating profits shrank; earnings per share also shrank (although they would have shrunk even more without the buy-ins) and dividends rose a bit.

Still, compared with the share price performance during Garnier’s tenure, Witty’s time in charge could be judged a success. The same might be said of his time versus that of his successor, Emma Walmsley. Where Witty employed financial engineering, the current boss is turning to another old faithful in the handbook of corporate legerdemain – splitting the business into two. This relies on the idiosyncratic logic of corporate finance that, when a company is valued, one often equals less than one, but two halves, when added together, must always equal more than one.

Thus Glaxo’s consumer healthcare side – 22 per cent of underlying group operating profits in 2020 – is being split from the conventional pharmaceuticals side. This will be the culmination of Walmsley’s efforts, which have focused on the consumer operation (star products, Sensodyne toothpaste, Eno liver salts, Voltaren pain killer). First, healthcare was augmented via a deal with Novartis (SWX:NOV). Then the minority stake in the division held by US rival Pfizer (US:PFE) was bought out. Now, as a wholly-owned and pumped-up division, it is ready for independence.

However, when Glaxo’s two sides eventually split and each gets its own London-market listing, the move will chiefly highlight what Table 2 makes clear anyway – that, in the global scheme of things, Glaxo is already an also-ran. The table ranks nine pharma groups by their stock market valuation. Glaxo comes in ninth.

As such, it is already easy for a pharma giant, in combination with its Wall Street piranhas, to rip it apart. By splitting the group, which will divide its market value roughly into three-quarters for pharmaceuticals, one-quarter for healthcare, Glaxo is turning itself into bite-sized morsels. For example, roughly speaking, to buy the healthcare side would cost Johnson & Johnson (US:JNJ) 5 per cent of its current market value.

This much is pretty obvious, but the question is whether Glaxo’s shareholders should stick around for any payday or, indeed, whether the stock should be bought as takeover fodder. This is especially pertinent for income investors because Glaxo’s bosses have finally come clean that the dividend – 80p a year for seven years now – will have to be cut and Glaxo’s shares without the dividend yield won’t be the same, to put it mildly.

Shareholders have every reason to be miffed. After all, one justification for splitting the group was that the dividend would be saved. Maintaining the payout was a factor behind the share price recovery that started in early 2018 and it was almost promised in the gushing PR blurb that accompanied the tie-up with Pfizer. Now, there is guff about “optimised capital structure” and “delivering sustainable long-term shareholder value” – that’s good coming from Glaxo – but the long and the short of it is that the dividend will be cut.

At least its bosses promise another 80p for 2021. The intuitive response might be to tell Glaxo to stick it, but that would be silly. After all, with the share price down to £12.70, the dividend yields 6.3 per cent. Which leaves holding Glaxo’s shares feeling a bit like having herpes – easier to acquire than to be rid of, even though Glaxo does have a vaccine – but I am itching to be rid of them.

●  There is a case for saying that share prices in mining groups have recovered too much from the miserable days last spring when they were crushed by thoughts that a dystopian future would have little need of copper wire, steel panels or coal for smelting (I exaggerate). By the start of this year, the FTSE All-Share Mining index had more than doubled from its low point 10 months earlier. Simultaneously, shares in diversified miner Anglo American (AAL) put on 180 per cent and, at £25.70, their price is still within 10 per cent of its 12-month high.

That also makes Anglo American’s shares the best performer in the Bearbull Income Portfolio since they were bought in August – up 32 per cent. This prompts the thought that I might want to tighten the stop-loss level or even take profits, although I also want 2020’s final dividend, which will be declared on 25 February but doesn’t go ex-dividend until 18 March.

It is easy to understand why Anglo’s bosses forecast a lively recovery in production levels this year from 2020’s depressed output (see Table 3). Only output of coal is expected to come in below 2019’s ‘normal’ amount. In particular, it helps that Anglo’s biggest market – China, which accounts for about 30 per cent of the group’s $30bn (£22bn) revenue – is now performing almost as though Covid-19 had never visited. Similarly, strong demand from China and better-than-expected sales of jewellery in the US over Christmas has meant that 2021’s first round of auctions for rough diamonds has generated revenues 18 per cent higher than 2020’s equivalent round.

As a result – and further helped by strong demand for platinum group metals – City analysts expect an energetic rebound in 2021’s results. The average forecast is for approaching $39bn of revenue (against an average expectation of $29bn in 2020) and $11.2bn pre-tax profit ($5.6bn is 2020’s average forecast). In sterling terms, that would feed through to about 335p of earnings, based on a $1.35 exchange rate. True, that bounce may run short of fuel in 2022, so analysts reckon on some drop in revenue and profit and maybe just 280p of earnings.

Hence the thought that Anglo’s current share price is about as good as it will get for a while. That view is re-enforced by the valuations produced by capitalising the group’s weighted average of both accounting profits and free cash flow for the past five years. Indeed, given the likely volatility of profits from 2020 to 2022, using the averages of 2015 to 2019 as the base figures seems appropriate. The resulting estimates of value are close to the current share price. Capitalising accounting profits generates £25.88 per share of theoretical value. Using free cash flow – and a different method – produces £28.56. Given the wide margin for error needed in such exercises, the current share price looks bang on the money. In which case, no one should be buying the shares currently other than as a punt over the results (or perhaps to cover short positions).

Yet there is more to it. Recall that it is Anglo’s policy to distribute 40 per cent of underlying earnings each year, although a slice of that is usually consumed by share buy-backs. Assume, however, that all of the 2021’s possible payout is distributed as cash. Even with the share price at £25.70, that would mean a 5 per cent-plus yield is in the offing. To put that into context, and based on 2021 forecasts, the Bearbull Income Portfolio is in line to yield almost a percentage point less than that. For income seekers, what Anglo American offers may be too much to pass up.

Email: bearbull@ft.com