Shares in income favourite GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US) have fallen by nearly 15% over the last three months, and by 7% so far in June.
This has pushed the prospective dividend yield on Glaxo shares up to a very tempting 5.9%. Add in this year’s special dividend of 20p per share and the prospective yield rises to 7.4%.
Many private investors hold Glaxo stock for income, and it appears that a good number have been topping up following the recent falls. Glaxo was the most bought stock by customers of retail broker TD Direct last week, just ahead of a second income favourite, Royal Dutch Shell.
Glaxo is one of my own income holdings, so I’m keen to understand whether the stock is cheap, or whether the weak share price is justified by falling profits.
To help me compare Glaxo to the wider pharmaceutical sector, I’ve chosen two smaller pharma stocks, Hikma Pharmaceuticals (LSE: HIK) and the recent Reckitt Benckiser spin-off, Indivior (LSE: INDV), for comparison.
Earnings slide
The grim reality is that Glaxo’s falling share price has probably been triggered by big cuts to earnings forecasts for the next two years.
Glaxo’s forecast earnings per share for 2015 have been cut from 91.9p to 81.5p over the last three months, a fall of 10%. Over the same period, Hikma’s 2015 earnings per share forecast has been cut by 3.4%, while Indivior’s has been increased by 9.2%.
Here’s how this is reflected in each firm’s current 2015 forecast P/E:
|
Company |
2015 forecast P/E |
|
GlaxoSmithKline |
16.6 |
|
Hikma Pharmaceuticals |
20.9 |
|
Indivior |
13.0 |
Given its yield, Glaxo doesn’t look bad value in this company. Hikma’s demanding valuation could come under threat if earnings don’t rebound in 2016.
Indivior looks cheaper but is expected to report a 54% fall in earnings per share in 2015, and a 21% decline in 2016. This is because the firm’s main product, Suboxene, a drug used to treat opioid addiction, is expected to face increased competition from cheaper generic products.
What about dividends?
Glaxo currently has the highest dividend yield in the pharmaceutical sector. Hikma and Indivior can’t really compete:
|
Company |
2015 prospective yield |
|
GlaxoSmithKline |
5.9% |
|
Hikma Pharmaceuticals |
0.9% |
|
Indivior |
2.8% |
Glaxo remains an attractive income buy, but the firm’s payout is beginning to look at little stretched, as dividend cover is expected to fall to only 1.0 this year. In contrast, Hikma has forecast dividend cover of 5.4, while Indivior’s payout should be covered about 2.7 times.
Cash is king
Historically, Glaxo has generated a lot of free cash flow, enabling the firm to fund its generous dividend and maintain R&D investment.
However, free cash flow has fallen over the last two years, and is no longer enough to cover the dividend payout. In fact, using the price to free cash flow ratio instead of P/E, Glaxo looks more expensive than both Hikma and Indivior:
|
Company |
2014 price/free cash flow ratio |
|
GlaxoSmithKline |
22.9 |
|
Hikma Pharmaceuticals |
19.0 |
|
Indivior |
6.1 |
Today’s best buy?
While Indivior looks cheap, investors need to trust that the firm will find a way of replacing the falling profits from its Suboxene brand.
Hikma’s growth valuation is too demanding for me, and I’m happy to stick with Glaxo, which I believe will deliver medium-term profit growth as newer products gain market share.
