Stockwatch: A 'buy' for security and income

Should you prioritise international earners by way of GlaxoSmithKline following the EU referendum?

Adjusting to a Brexit environment means a re-consideration of stalwarts stocks that offer capital protection and yield, versus medium-term economic risks. Chief macro issues are lower economic growth in the European area as a whole, compounded by Brexit and weaker sterling as Britain runs the largest current account deficit - 4.2% of GDP - among advanced economies.

Not surprisingly, sterling has started this week much lower. It will take time for markets to adjust and the exact terms of trade Britain agrees on the single market will be crucial to our economic well-being and currency traders' view of sterling.

Some commentators are complacent to say, "It's an adjustment: markets will settle and then we can move on."

We have no sense what terms will result, nor how Britain's finances will stand in a year's time; there being other risks such as China's credit bubble. It's wise to plan for a lower sterling regime, if speculative to assume which exporters will benefit. More reliable is the effect on overseas earners where analysts are already quantifying benefits.

Pharmas offer quality exposure

Last Friday, a variety of stocks rose, e.g. consumer staples' providers Reckitt Benckiser and Unilever, the UK being relatively minor in their international revenue profiles. Yet there is a significant aspect of "buying the story" to such stock moves, the market having (generally) priced in the expectation of a 'Remain' victory.

Pharmaceuticals companies are to some extent tarnished

On basic criteria, both stocks trade on forward price/earnings (PE) multiples over 20 versus earnings growth in the low teens and dividend yields of 2-3%. Tobacco stocks such as British American Tobacco and Imperial Brands also rose, despite ethical issues for some investors.

Pharmaceuticals' companies are to some extent also tarnished, exploiting public health services for high margins, implying volatility if regulators bare teeth.

But major firms such as GlaxoSmithKline and AstraZeneca are high-profile beneficiaries from lower sterling: an overall 10% drop versus all currencies is estimated to enhance Glaxo's earnings by at least 6% with Deutsche Bank top-of-the-range targeting a 12-14% boost to earnings per share (EPS). Astra is so far targeted to benefit a smaller 2%, so Glaxo is likely perceived as the better play for the medium-term.

Forecasts raised following Brexit vote

It may take time for numbers to settle, but since the weekend I notice the consensus expectation for Glaxo shows £4.4 billion pre-tax profit for 2016 raised to £5.3 billion, with 2017 up from £5.2 billion to £5.4 billion.

As yet there's some disconnect with EPS, the 2016 consensus up from 87.8p to 87.9p and 2017 from 91.3p to 92.6p. With the stock currently testing 1,500p this implies a forward PE of 17.1 reducing to 16.2, if supported by a yield near 5.5%. The new consensus has dividends slightly higher than the 80.0p maintained dividend the board guided towards in the first-quarter results, last April, although better assume 80p.

Underlying story improving

A chief reason the market came to price Glaxo for a circa 5% yield was the sense of a mature business: having a strong cash flow profile to 2013 (see table) albeit with some major drugs coming to the end of their patents, hence cash flow reducing and a sense of "ex-growth" to overcome.

Sterling devaluation also makes Glaxo attractive to acquirers

So it was encouraging how first-quarter 2016 results showed new product sales soaring like-for-like, from £269 million to £821 million. Core operating profit was up 19% in sterling terms (before devaluation) to £1,559 million on group revenue up 11% to £6,229 million, and with core earnings per share up 14% to 19.8p.

Furthermore, the pipeline is being strengthened with R&D progress in key therapy areas of respiratory, HIV, oncology, immune-inflammation and rare diseases. It's a powerful new theme to the Glaxo story as investors are properly attracted to growth, not just for capital upside, but to reinforce the dividend hence downside protection.

New drugs are typically seen as one of few industries able to buck a recession, compared say with IT that depends also on capital spending cycles, and it helps that Glaxo is a £72 billion-plus group with a sizeable portfolio - compared with smaller, higher-risk pharmaceutical firms.

Sterling devaluation also in principle makes Glaxo attractive to acquirers, especially if global interest rates persist ultra-low. In practice, the logistics of combining big groups makes this highly speculative, yet in commercial and currency terms the time to bid is ripe.

Continental Europe significant

Europe - including the UK - represents 29% of group revenues. Glaxo's CEO asserted in January, Brexit would have less of an immediate impact on sales as it would on drug discovery, but still meant an overall negative outcome. The concern is mainly regulatory: drugs being approved by a centralised European Medicines Agency (EMA)

Glaxo has lost its influence over the EMA as enjoyed by EU member states

"Europe has gone from 27 fragmented, independent, not-talking-to-each-other regulatory authorities in the healthcare space, to one. That's a big deal," the CEO said.

There could have been an aspect of scaremongering, though, when you consider rules as apply to the European Economic Area, Britain might join along with Norway and Iceland. Such countries are covered by the European Medicines Agency and retain access to single marketing authorisation, meaning firms only have to go through one approval process before launching drugs across Europe.

What is lost is influence over the EMA as enjoyed by EU member states. It's natural for Glaxo's boss not to want a change in the status quo, but with economic risks for continental European economies arguably greater than Britain's, it's in no-one's interests to throw sand into the machine.

Admittedly, the EMA's location in London is now exposed: Denmark and Sweden lobbied in the run-up to the referendum to become the agency's new home. So be aware of this regulatory angle which partly offsets the foreign exchange benefits.

Balance sheet isn't compromising

In the three months to end-March, net debt rose from £10.7 billion to £12.5 billion, comprising gross debt of £17.0 billion and cash/liquid investments of £4.5 billion. Mind, this arose from paying £919 million dividends during the period and taking a £496 million exchange rate hit as a result of US dollar denominated debt - a factor now set to recur with sterling's fall.

With £12.2 billion "other long-term liabilities", net assets whittle down to £6.5 billion, including £23.0 billion goodwill/intangibles - hence the trend in negative net tangible assets. Underlying cash flow is improving: without restructuring costs and an additional tax payment on a business sale, the adjusted free cash inflow would have risen 31% to £456 million. Obviously, it's a bit cute to subtract cash realities, but in terms of dividend capability it looks fair for the board to assert 80.0p a share as continuing.

Strength hints at prospects

Glaxo's rising from about 1,450p to 1,500p last Friday and Monday, shows it is perceived as advantageous for the new environment, with exchange rate and product issues likely to outweigh regulatory concerns. A major company like this isn't going to shine for capital growth, yet it rates an overall "buy" for security and income.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.