Interactive Investor

Stockwatch: is this an existential crisis for GSK?

After slumping to a six-week low on litigation news, this UK drug maker’s share price has attracted attention. Here’s what analyst Edmond Jackson thinks of the situation and his successful ‘buy’ tip.

4th June 2024 12:30

by Edmond Jackson from interactive investor

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Blue and green medicine tables

Well, what should we make of yesterday’s near 10% fall in FTSE 100-listed drug major GSK (LSE:GSK) after a Delaware state court allowed jury trials on cancer claims relating to the company’s Zantac heartburn drug?

This came despite very positive drug development news about how Jemperli has shown 100% effectiveness to spare bowel cancer patients the need for surgery and chemotherapy.

The Zantac matter has rumbled along for nearly five years, with the US Food and Drug Administration (FDA) insisting on withdrawal of Zantac in 2020 – other companies involved include Sanofi SA (EURONEXT:SAN), Pfizer Inc (NYSE:PFE), Boehringer Ingelheim and the GSK spin-off Haleon (LSE:HLN).

The justification was ranitidine, the active ingredient within Zantac, “containing a probable carcinogen”, which gave sufficient hook to the US litigation system to pursue the matter on behalf of people developing cancer. However, the analytical dilemma was that middle-aged to older people are more susceptible to cancer anyway, hence in December 2022 a Florida judge dismissed thousands of such litigation cases on grounds of insufficient evidence.

This has also been GSK’s position, re-iterated in yesterday’s announcement, about how “the scientific consensus is there being no consistent or reliable evidence that ranitidine increases the risk of any cancer”.

Moreover, and only on 24 May, it was announced that a jury in Illinois had found GSK not liable for a plaintiff’s cancer claim. What is there to fear then about the matter going to wider jury trials? 

Among five cancers qualifying for Zantac lawsuits, there appears a strongest connection with bladder cancer.

I think the medium-term view of the stock effectively hinges on what we make of jury trials generally: how consistent and reliable are they? Will any be convinced by fresh evidence? 

The stock market hates uncertainty, and the fact that a US judge considers the evidence of expert scientific witnesses should be weighed by juries, introduces a scenario where another jury potentially finds in favour of patients. Then where does it lead?

If GSK genuinely has nothing to fear or hide here, why is it investing so much effort trying to prevent plaintiffs’ scientists testifying? It defies the very nature of science where a key endeavour is to submit existing hypotheses to maximum scrutiny.

Some 72,000 of these cancer claims are allegedly related to GSK. In response to yesterday’s news, analysts at stockbrokers banded potential liability figures of $2-3 billion (a median £2 billion) with one citing a 50% chance of $5 billion. A radio broadcast summarising the day’s news, however, quoted £40 billion, and in response one bulletin boarder questioned if GSK would be left viable. I cite this just to show how the story is unfolding.

Around 1,600p currently, GSK is capitalised at £66 billion, or just over twice annual sales.

Potential for recovery buyers of GSK

Keeping one’s nerve, it is interesting because the situation already shows scope for sentiment to get over-alarmist.

Yet there is a genuine dilemma of being able to quantify much of the possible outcomes reliably. The US justice system can generate remarkable extent of damages, and while you can already see a steady stream of announcements with GSK settling cancer claims privately, so remain the details.

Objectively again, any litigation hinges on the target’s ability to pay, so even if awards gain traction, GSK is not going to be terminally affected. But given R&D is a significant need for a drugs group (see capital expenditure taking around 30% of operational cash flow) a millstone of substantial settlements would hit dividends.

GSK - financial summary
Year-end 31 Dec

Turnover (£ million)27,88930,18630,82133,75434,09934,114
Operating margin (%)9.313.917.820.622.818.1
Operating profit (£m)2,5984,1815,486 6,961 7,7836,165
Net profit (£m)912.01,532.03,6234,6455,7494,385
EPS - reported (p)23.366.088.0116143108
EPS - normalised (p)40.9118107169122109
Operating cashflow/share (p)165175212200209196
Capital expenditure/share (p)59.955.745.253.955.672.3
Free cashflow/share (p)105119167146153124
Dividends per share (p)
Covered by earnings (x)
Return on total capital (%)6.514.015.412.513.411.1
Cash (£m)4,9863,9113,9584,7866,3704,335
Net debt (£m)13,80413,17822,10625,72220,78019,838
Net assets (£m)1,124-68.04,36011,40514,58715,055
Net assets per share (p)28.6-1.7111288363374

Source: historic company REFS and company accounts.

A weak technical profile emerging for the stock

Existing GSK shareholders might psychologically opt to ride this out – witness online postings reflecting denial that this problem amounts to any serious matter, calling it “a gross over-reaction”.

But if the likes of me were now to slap a “buy” stance on GSK – which then proceeded to go pear-shaped – you, or indeed any other new buyer of the shares, might later claim this was negligent. The same applies to any fund manager with fresh money – why potentially blot your career?

A “hold” stance is much more defensible given the history of litigation, for example, versus the tobacco industry whose shares did subsequently recover. But overall, it doesn’t then counter-balance net selling by those investors who are fearful.

It could only be of modest effect, but I think this helps explain GSK’s muted rebound from below 1,600p yesterday, and a slip to 1,590p Tuesday morning.

Five-year chart context still looks nothing special

The drop can be interpreted as mean-reversion to an upward trend-line from July 2023 that is also quite consistent with volatility through 2021-22.

GSK performance chart

Source: TradingView. Past performance is not a guide to future performance.

Its significance, however, is checking what was shaping up as a potential break-out from the circa 1,800p high achieved in 2020 and 2022. Confidence has recently been growing, helped by regular successful drug announcements, and how GSK is in a “delivery” phase on investment made over the last few years under a new CEO since 2017.

January 2024 ‘buy’ case still up 10% before dividends

This Zantac development is unfortunate after GSK had risen 25% to comfortably over 1,800p in May after I made a “buy” case at 1,450p in January.

GSK had risen 12% from a modest double bottom at around 1,300p in July 2023, benefits of investment were materialising, and the board was targeting paying out 40-60% of earnings averaged across investment cycles. The 12-month forward price/earnings (PE) multiple was 9.3x and the dividend yield 4.2% with 2.6x earnings cover (assuming forecasts).

The discount to AstraZeneca (LSE:AZN),which traded then on around 16x forward earnings and similar yield considerations, was partly explained by GSK needing to overcome a reputation for relatively less vigour, which, yes, it was doing.

There was also the historic legacy of Zantac uncertainties, management appeared to be coping with by way of settling specific cases without acceptance of liability. This Delaware initial ruling does, however, disrupt that perception, potentially opening the floodgates.

What current stance to take on the stock is thus largely a function of risk appetite. With consensus for net profit of £6.4 billion this year and £7.2 billion in 2025, earnings per share around 160p and 177p respectively imply a PE multiple of 10, reducing to single figures. The prospective yield is just shy of 4%.

If the likelihood of successful mass-scale Zantac litigation is minimal, then the stock once again has double-digit per cent, medium-term upside.

But it is not reasonable to predict where this litigation is heading. Indeed, it is hard to know if downside risks are priced in.

Various stances can thus be rationalised

You could therefore say that if capital protection is the first objective when investing, the proper stance – also in respect of my January “buy” idea” – is now to “sell”. That does at least cut it cleanly, but I think that’s harsh given a worse-case scenario remains a long shot.

As things stand, it is possible to conjure both “sell” and “buy” stances according to one’s risk appetite, so perhaps you will excuse my compromising with “hold” as the only way to balance differences. I recognise potential negligence with “buy”, yet could end up looking daft by downgrading to “sell”.

With fresh money, I would see how the jury story evolves and if a weak technical situation prevails.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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