Glaxo's health set to improve

The main point for income investors is that Glaxo’s dividend looks more sustainable now that it has agreed to buy the part of its consumer healthcare joint venture owned by Novartis (SIX:NOVN), a Swiss pharma giant. This comes with an upfront payment of $13bn (£9.2bn), but it will remove an £8.6bn liability, which makes the balance sheet look far more stable. It is also excellent news that Glaxo has given up on its pursuit of the consumer healthcare arm of Pfizer (US:PFE), another pharma giant – a transaction that may have cost $20bn and stretched the group’s net debt.

The dividend – which currently yields 5.3 per cent – has been held at 80p a share for the past few years due to the waning free cash flow. But, according to forecasts from investment bank JPMorgan, 2018 will be the last year the dividend is not covered by cash flow and by 2019 it will be covered 1.3 times. That’s within management’s target for a dividend hike.

Investors’ biggest concern is the recent loss of patent protection for high-margin respiratory drug Advair, which contributed 8 per cent of 2017's revenue. The arrival of generic competitors is expected to cut Advair revenues from £1.6bn to £250m between 2017 and 2020, which JP Morgan thinks will hurt profits and earnings in the next two years. But despite an apparent lack of investment in the new drugs pipeline – last year Glaxo spent 13 per cent of is revenue on R&D compared with 27 per cent at AstraZeneca (AZN) – the group has recently launched some impressive new drugs.

Nucala and Elipta are forecast to grow sales from £1.9bn to £3.7bn in the next three years and, as they pick up pace, profit margins should expand. Thus by 2020, revenues, pre-tax profits and earnings are all forecast to be moving in the right direction again. Meanwhile, the recent appointment of industry veterans Hal Baron and Luke Miels to head up the pharma team gives confidence that Glaxo's bosses are willing to invest more in drug development.  

In pharma, Glaxo holds a strong position in a relatively defensive segment of the market – its focus on lower price, higher population illnesses (including respiratory and auto-immune diseases) means it is well placed to sidestep the drive to clamp down on drugs' prices. Broker Liberum thinks average prices in speciality pharma (including oncology and rare disease) could fall by 30 per cent, while prices for primary care (such as respiratory) could rise in the next few years.

Glaxo's low-risk, cash-generating consumer healthcare business helps smooth out revenue declines during years when drugs come off patent. True, operating margins of 18 per cent in consumer healthcare lag those of the other two divisions (34 per cent in pharma and 32 per cent in vaccines), but margins are expected to expand. What’s more, the ratings commanded by similar UK consumer greats – such as Unilever (ULVR), which has lower operating margins than Glaxo's consumer arm, and Reckitt Benckiser (RB.) – indicate that there is inherent value in consumer health.

But Glaxo's hidden jewel is its vaccines business, which has a host of exciting new products that should allow for impressive growth. In the first quarter of 2018, Shingrix – the new shingles vaccines – recorded £110m of revenue, up from £22m in the final quarter of 2017. Barriers to entry for new vaccines are incredibly high and Glaxo boasts a market-leading position.