This article was written by Peter Shearlock and published in The IRS Report in February 2011

Big yield and new strategy sweeten the pill at GSK

When the market falls out of love with an old favourite, it can take a long time before enthusiasm returns. I am betting, however, that it will not be long before the big institutions take GlaxoSmithKline back to their collective bosom. In the meantime, value investors can still buy one of the world's great pharmaceutical companies on the sort of rating accorded to a low-growth utility. That kind of discrepancy is what value investing is built on.

The drugs sector as a whole has been out of favour for the best part of a decade. Companies that used to sell for 20 or 25 times earnings are now seeing their shares change hands for little more than half that number. The average P/E for the UK pharmaceutical sector is under 13. GSK shares are trading at less than 10 times consensus forecasts for 2011 earnings.

There are, of course, reasons for the market's disinterest. Several of the major companies have invested heavily in new blockbuster drugs only to see them fall at the final regulatory hurdle. As patents on big-selling drugs run out, allowing competitors to launch low-priced generic equivalents, there are not enough new ones coming through to take their place.

There have also been big product liability suits and equally big damages to pay. GSK's bugbear is its diabetes drug, Avandia, for which it recently announced a £2.2 billion legal provision. This was on top of a £1.57 billion provision made at the time of the second-quarter figures, relating in part to Avandia, but also to litigation costs connected with the antidepressant Paxil.

These are large amounts, but they have to be put in the context of a company capitalised at over £60bn with net cash generation running at around £7bn a year. The balance sheet is extremely strong, while margins and return on capital have been consistently high. The provisions have, however, scotched hopes of an early share buy-back programme.

Changes now afoot at GSK could be the prompt for a major re-rating. The company has recognised that it has become over-reliant on 'white pill prescribing' in the main western markets. Now it is pumping money into areas such as vaccines, consumer healthcare products and, above all, the emerging markets in an attempt to diversify the business and make it grow faster. Last week GSK sold a US business, Quest Diagnostics, described as "non-core", for a net $1.1bn.

The effects are plain to see. While overall sales are static, sales in the emerging economies are now growing at double-digit rates. Vaccine sales have grown by about a fifth in the past year. Dermatology and consumer healthcare products are also growing strongly. GSK has been making acquisitions to support this change of strategy. In December it bought a Chinese pharmaceutical business, Nanjing MeiRue, which has brought in new urology and allergy products. Its key attraction, however, looks to be its distribution and marketing base in China.

GSK has realised, somewhat belatedly perhaps, that its powerful worldwide sales and marketing team is almost as valuable an asset as its research chemists. If it can put more products through the same distribution chain it can push profit growth up several gears.

As an example of the new thinking, it recently announced plans to buy Maxinutrition, Europe's leading producer of protein-enhanced sports nutrition products. The Office of Fair Trading is looking into the deal, because GSK already owns Lucozade. But the logic is hard to fault. Maxinutrition currently sells in the UK and Europe; GSK can take it global.

Along with others in the sector, GSK needs to find new sources of growth at a time when governments around the world are reforming healthcare and cutting spending. But GSK is itself getting leaner and meaner. Across the business, it is on track to deliver £2.2 billion of savings by 2012. A large chunk of those savings are in research and development, where GSK is exiting certain areas of discovery research.

It is also outsourcing more research to partners to reduce risk. Its long-running collaboration with the US company Theravance is responsible for one of GSK's most promising new drugs, the asthma treatment Relovair, which is now in late-stage development. GSK recently upped its stake in Theravance to 19% and this is likely to be the pattern for other collaboration deals.

GSK has been out of favour for a long time but there are signs the tide is turning. In December, brokers Killik & Co put out a 'buy' note on GSK. They pointed out that the company "is less exposed to patent expiries than the peer group, while it has more than 30 products in late-stage development, some of which are novel compounds with the potential to become blockbusters." A number of institutional value investors have also turned buyers in recent months.

There is an added attraction to locking money away in GSK right now - and that is the yield of around 5.5%. The company is committed to a progressive pay-out, which in practical terms means the dividend, paid quarterly, is likely to continue to rise at a faster rate than inflation. Not even index-linked gilts offer that.

You can see all of Peter Shearlock's articles at www.TheIRSReport.com

Peter Shearlock writes in The IRS Report regularly

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