Why I’ve sold Glaxo despite its attractive 5% dividend yield

When I added GlaxoSmithKline to my portfolio in early 2015, the company was heading for trouble.

Some of its key blockbuster drugs (such as Advair, which generated almost a quarter of the company’s revenues) were going off-patent, which meant the easy profits Glaxo had relied on for years were about to vanish.

In order to offset those lost profits, Glaxo was going to have to invest massively into additional research and development (R&D), with the aim of producing new drugs and medicines which, once patented, would provide new revenue streams and fat profit margins.

In total, Glaxo was going to have to replace something like half its revenues over the next decade. There was, and still is, much uncertainty around whether or not this is actually possible.

None of this sounds particularly enticing, but this is exactly the sort of situation which can produce heavily discounted valuations. In this case, the discount resulted in a dividend yield of almost 6% from a company with a long record of dividend growth.

Today, Glaxo’s future seems as uncertain as ever, with management now pinning their hopes on a separation of the company’s pharmaceutical and consumer healthcare businesses.

In addition to this uncertainty, the recent market decline means there are more attractive fish in the sea, so I have decided to sell.

Here’s a quick snapshot of this investment’s results:

Buying GlaxoSmithKline as a potential turnaround stock

In the years leading up to 2015, Glaxo had generated a long series of growing dividend payments, backed by steadily rising revenues and earnings per share.

Its ten-year growth rate across revenues, earnings and dividends was a reasonable 3.5% per year, while its average return on capital employed was an impressive 19%.

This was clearly a very successful company, although thanks to excessive investor optimism in earlier years, its share price had remained largely unchanged since 1998.

And while the patents of Advair and other blockbuster drugs were in the process of expiring (a process known as the patent cliff) the impact had yet to show up in the company’s results, as the chart below shows:

In January 2015 I added Glaxo to the model portfolio and my personal portfolio. My assumption (or hope) was that the company would invest more heavily in R&D in order to increase the size of its drug pipeline and therefore, eventually, replace products like Advair which had expiring patents.

I thought this process would take several years at the very least, which was fine by me as I prefer to hold companies for years rather than months.

I also thought the dividend would probably be maintained during this period because the company didn’t have a huge amount of debt. With hindsight though, it did have enough debt, so taking on even more debt to fund additional R&D wasn’t a sensible option.

In terms of risk, Glaxo’s need for ‘big wins’ (i.e., coming up with new patentable drugs which can be sold on a massive scale) meant there was more uncertainty than I’d ideally like. Yes, Glaxo has come up with many blockbuster drugs in the past, but that doesn’t mean it will do so in the future.

In contrast, Domino’s Pizza (which I also own) can expand by opening dozens of essentially identical restaurants producing thousands of essentially identical pizzas. Which do you think is easier; curing cancer or making yet another pineapple pizza?

Besides this need for ‘big wins’ that solve massively complex problems, there was another issue. Glaxo was and is something of a conglomerate. It’s a collection of loosely related businesses from largely unrelated markets such as Vaccines and Consumer Healthcare. This structure:

• Makes it harder for investors to see which parts of the business are performing well and which are underperforming.
• Makes it easier for management to use excess cash generated by one business to prop up another less successful business unit.
• Allows management to buy and sell business units, which makes it harder to track the company’s underlying performance over a number of years.

Holding Glaxo as the company continued its long period of restructuring

Glaxo has been working through a long process of restructuring since 2008 with three end goals in mind:

1. To increase the geographic diversity of the company’s revenues
2. To improve R&D productivity
3. To reduce costs by simplifying the company’s structure

Each year since then has involved some degree of “radical transformation” in order to reduce risk and improve returns, and 2014 (the current financial year at the time of purchase) was no different.

For 2014, the transformation was centred around a three-part deal with Novartis, one of Glaxo’s main competitors. The three parts of the deal were:

1. To combine their consumer healthcare businesses (including brands such as Panadol, Aquafresh and Nicorette) to create the world’s leading over-the-counter ‘wellness’ franchise
2. For Glaxo to acquire Novartis’s vaccine business for around $7 billion
3. To sell Glaxo’s oncology business to Novartis for around £16 billion.

The idea was to increase the scale of and weighting towards Glaxo’s consumer healthcare and vaccine businesses, as part of the larger strategy of increasing diversity and moving away from western markets and pharmaceuticals. In that respect, the deal seems to have worked.

In 2015, Glaxo focused on integrating the new consumer healthcare and vaccine businesses, as well as simplifying and restructuring the pharmaceuticals business as part of a drive to reduce costs by £3 billion before the end of 2017. It was clear that trimming any operational fat was going to be a key component in its attempt to offset declining revenues from its previous biggest seller, the now off-patent Advair.

2015 was also notable because, for the first time in a very long time, the company failed to increase its dividend. The 2015 annual report highlighted the importance of cash flows to the dividend’s sustainability:

The current level of annual dividend of 80 pence exceeds the cash flows from our businesses. However, the Board has said it expects to maintain that level of payment for 2016 and 2017, which are important years of change. During this period, the long-term impact on cash flow of the decline in Seretide/Advair should become clearer but so should the benefit to cash generation of the growth of recently launched products, the expansion of our Vaccines and Consumer businesses and reduced restructuring expenditure.

In other words, the period of change and transformation would continue for another few years, which meant that uncertainty would remain high. Management was effectively crossing their fingers, hoping that the 80p dividend would prove to be sustainable once the dust had finally settled (assuming it was ever going to settle).

In the end, 2016 and 2017 turned out to be relatively good for Glaxo, with revenues finally breaking the £30 billion barrier. More importantly, free cash flows began to recover as the cost of restructuring and integrating the Novartis deal faded away. The Advair patent cliff was far from over, but with sales from new respiratory products more than offsetting Advair’s decline, there was at least a glimmer of light at the end of the tunnel.

As in 2015, the 2017 annual report highlighted the importance of healthy free cash flow cover before Glaxo could begin to grow its dividend again (emphasis added):

Our 2017 results reflect a continued focus on execution including driving growth from existing products and recent launches; controlling costs tightly to help build better operating leverage across the Group, while also investing behind our future growth drivers; and improving cash generation to increase our capacity to support both investment and the dividends we pay to our shareholders.

The Board intends to maintain the dividend for 2018 at the current level of 80p per share, subject to any material change in the external environment or performance expectations. Over time, as free cash flow strengthens, we intend to build free cash flow cover of the annual dividend to a target range of 1.25-1.50x, before returning the dividend to growth.

Selling Glaxo because of its robust share price and impending demerger

Overall, I think Glaxo has performed well in the face of significant headwinds; not least of which was and is the loss of revenues from Advair.

The chart below shows how the company has managed to more or less maintain its revenues, free cash flows and dividends despite (or perhaps because of) the ongoing transformation of the business:

So if things are going so well, with perhaps a glimmer of light at the end of the tunnel, why have I decided to sell? There are several reasons.

First, while there may be light at the end of the tunnel, the hard truth is that Glaxo hasn’t significantly grown in more than a decade. There are lots of reasons why, but none of them is a one-off freak event. Pricing pressure from buyers, competitive pressure from peers and the loss of patents on key drugs are all factors that are likely to be repeated in the 2020s.

Holding onto a company where there is a significant chance of zero or low single-digit growth for another decade is not something I’m keen on.

Second, Glaxo’s share price has stood up well in 2018 while much of the UK market has collapsed, or at least declined significantly. This broad decline in share prices makes many other companies look more attractive than they did six months ago. If Glaxo’s price had also declined I might have held on, but it hasn’t.

Finally, Glaxo’s transformation is still far from complete, with management recently announcing a proposed demerger of the company’s consumer healthcare and pharmaceutical businesses. This is what many investors (notably Neil Woodford) have been asking for in recent years, and I think it’s probably a good idea.

However, it does mean yet another major change to the composition of the company and the loss of what I think is the best part of the company, i.e. its consumer healthcare business.

This combination of low growth, robust price and significant ongoing change and uncertainty is why I decided to remove Glaxo from the model portfolio and my personal portfolio.

The investment’s annualised total return of 7% per year is acceptable, but not very satisfying.

My intention is to reinvest the proceeds into a company which is simpler, more focused, less likely to be endlessly ‘transformed’ and where the combination of dividend yield and dividend growth are more likely (hopefully) to produce double-digit annual returns.