When I last wrote about pharmaceutical giant GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US) back in August, the shares were at 1382p. Today’s 1400p sees the price trading in the same area, but I can’t help thinking the trend still appears to point down.
The recent three-quarter results won’t help sentiment. On a constant-exchange-rate basis, revenue for the year so far is down 7%, operating profit is down 24% and earnings per share are down 28%. Predictions for a poor year’s trading are looking correct.
Is the valuation too rich?
GlaxoSmithKline’s forward P/E rating hovers just under 15 for 2015. Doesn’t sound too bad, does it? Yet, it looks rich compared to predictions of just 3% growth in earnings that year, and that after an estimated 17% earnings’ decline this year. In fact, earnings have been volatile over the last few years.
So let’s look at the dividend to justify the valuation. A 5.8% forward yield is enticing, but with adjusted earnings set to cover the payout just over once, to me it looks vulnerable. Maybe the firm’s record on cash generation underpins optimism:
|
Year to December |
2009 |
2010 |
2011 |
2012 |
2013 |
|
Net cash from operations (£m) |
7,841 |
6,797 |
6,250 |
4,375 |
7,222 |
Here we find encouragement. Naturally, both maintenance and growth capex compete with the dividend for the firm’s cash flow, but cash flow is the great strength that makes ‘defensives’ such as GlaxoSmithKline so worthy of investor confidence.
Dividend payments cost GlaxoSmithKline around £3,918 million last year. So, assuming that this year’s cash flow isn’t down there should be ample funds to service the dividend, which is why the directors run dividend cover so close to the wire.
Cash is king
It seems that dividend yield, backed by cash flow, is the dominant factor that justifies GlaxoSmithKline’s valuation at present. Investors place their faith in the firm’s ability to develop and market a new generation of blockbusting drugs that could reignite earnings growth down the line.
Let’s hope that confidence in the firm’s pipeline pays off. It wouldn’t surprise me if speculation drove GlaxoSmithKline’s share price artificially high in the wake of Pfizer‘s pitch at AstraZeneca. If so, there could be downside risk if the next numbers on cash flow disappoint.
What also of the valuation-cycle effect that tends to push defensive-style companies around? The valuations of defensives can move counter to the wider economic cycle. Companies seen as defensive, with reliable income streams, are most appealing to investors in volatile economic times, and valuations can rise. In more benign economic times investors often head for exciting investments and the defensives can see their valuations contract.
What next?
We’ll find out more with the full-year results due around 5 February — I’ll be heading straight for the cash flow report.