After decades of superior performance, Neil Woodford has rightly earned his reputation as one of the UK’s top investors, yet he’s not immune to getting it wrong from time to time. And I believe Woodford is wrong when he calls for the break up of pharmaceutical giant GlaxoSmithKline (LSE: GSK).
To be clear, Woodford is bullish on GSK and owns a position worth some £700m in his Equity Income Fund alone. However, his insistence that management split the business into two or three separate companies would rob current and future investors of the huge benefits from the company’s diversified approach to business.
To see where Woodford is coming from, it’s important to examine the company as it currently stands and what he images for its future.
Results by division 2016
|
|
% of Revenue |
Year-on-year growth (%) |
|
Pharmaceuticals |
57.7 |
3 |
|
Consumer Healthcare |
25.8 |
9 |
|
Vaccines |
16.4 |
14 |
Woodford believes that pharmaceutical unit would fetch a higher valuation were it spun off from the consumer healthcare and vaccine divisions. The argument goes that investors wanting Unilever-like reliability but low growth could buy the consumer healthcare and vaccines businesses while those looking for a high-growth AstraZeneca option could buy the pharma bit.
He may well be right about this in the short term, but over the long term I reckon investors benefit hugely from the combination of the higher-risk pharma business and the lower-risk consumer healthcare and vaccines divisions.
For one, selling vaccines, toothpaste and cold treatments is a relatively non-cyclical business that provides reliable revenue and profits in bull and bear markets alike. This is a major benefit for shareholders as it evens out the very lumpy revenue that comes from selling pharmaceuticals that can take decades and billions of pounds to develop and then lose their patent after a few years.
While these drugs can make huge profits in the years when they’re under patent, their going off patent can be seriously detrimental to a company’s sales. This is the very reason year-on-year growth from the pharma division was a meagre 3% in 2016. Amongst others GSK’s blockbuster respiratory treatment Advair is going off patent, which lead to sales plummeting 13% year-on-year even without the introduction of a generic challenger in the US.
And the firm isn’t about to say goodbye to cutting-edge blockbuster drug treatments anytime soon simply because another bit of the business is selling aspirin. This is clear in the stunning 125% year-on-year rise from sales of the company’s new drugs platforms. This includes what could be the game-changing series of HIV treatments whose sales rose 82% to £2.7bn in the year.
Another benefit of combining cyclical but high-growth pharmaceutical sales with reliable consumer healthcare sales is that it keeps earnings, and thus dividend potential, relatively level over the long term. This is why the company can afford to pay out its current 4.8% yielding dividend even though earnings didn’t cover payouts last year.
The management team, and City analysts incidentally, are confident that the temporary fall in earnings due to the loss of pharma patents doesn’t require a dividend cut because reliable consumer staples and vaccines sales provide revenue visibility.
All in all, Neil Woodford and I agree that GSK is a wonderful business. While breaking it up may bring short-term gains I believe long term investors will find the current combined business a much smoother and more rewarding investment.
