I’m working my way through the latest annual reports of your favourite FTSE 100 companies, looking for insights into their businesses. Today, it’s the turn of the UK pharmaceuticals giant GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US).
China
There was bad news for GSK during June, when the Chinese authorities announced an investigation into allegations that the company had paid bribes to doctors through a local travel agency. GSK subsequently reported that third-quarter sales in China fell 61%.
I looked to get a handle on GSK’s exposure to China, and what the news meant for the group as a whole. I learned from GSK’s annual report that China contributed £759m to the 2012 top line, or 2.9% of total group turnover. China turnover was 17% ahead of the previous year; and, furthermore, GSK had just upped its investment in the country:
“Given the importance of the Chinese market we have opened an R&D Innovation Centre in the country that will be concentrating on developing new products for this fast-growing market. Researchers will focus on innovations specifically developed to meet the needs of consumers in China”.
So, while the contribution of China to group turnover is relatively small at the moment, and the investigation by the Chinese authorities isn’t devastating, the news is a short-term knock to GSK’s expansion plans in what is a huge, high-growth market. Furthermore, we don’t yet know if there will be any longer-term implications.
Consumer healthcare
GSK is certainly ‘Big Pharma’, but in addition to pharmaceuticals and vaccines the company has a consumer, or over-the-counter (OTC), healthcare business. OTC generates around one fifth of total group turnover thanks to brands such as Sensodyne (oral health), Horlicks (nutritional drinks and foods) and Panadol (analgesics).
I like GSK’s OTC diversification, although this business does have lower margins. Nevertheless, as the table below shows, the OTC margins are still very decent.
| 2010 | 2011 | 2012 | |
|---|---|---|---|
| Pharmaceuticals and vaccines turnover (£bn) | 23.30 | 22.11 | 21.32 |
| Operating profit (£bn) | 8.75 | 8.34 | 7.79 |
| Operating margin | 37.6% | 37.7% | 36.5% |
| Consumer Healthcare turnover (£bn) | 5.09 | 5.27 | 5.11 |
| Operating profit (£bn) | 1.04 | 1.08 | 0.94 |
| Operating margin | 20.4% | 20.5% | 18.4% |
Free cash flow
I learned that GSK paid £3.81bn in dividends during the year, and had ‘adjusted’ free cash flow of £4.66bn. However, actual free cash flow was £2.05bn due to legal settlements of £2.61bn.
It’s a concern that actual free cash flow didn’t cover the dividend payments, and I checked back a few years to see if the legal settlement was exceptional or whether such settlements are really just as much an annual cost as R&D, marketing and so forth.
| 2009 | 2010 | 2011 | 2012 | Annual average |
|
|---|---|---|---|---|---|
| Legal settlements (£bn) | 0.25 | 2.05 | 1.47 | 2.61 | 1.60 |
As you can see, the 2012 cost was above average, but these legal settlements do seem to be a regular annual drain. With GSK’s description of current legal proceedings extending to eight pages of the annual report, free cash flow is something to keep an eye on, seeing as the dividend must come from this or from increased debt.
Overall, I felt GSK’s annual report was a mixed bag; and I see the company — at a recent share price of 1,620p — as probably fairly valued on 14.3 times forecast earnings with a 4.8% dividend yield.