Interactive Investor

Stockwatch: new reason to buy this defensive FTSE 100 share

Stuck in a trading range for many years, analyst Edmond Jackson believes this company now fits the bill as a sound inexpensive purchase amid hints at ‘something new’ in its investment rationale.

2nd January 2024 13:06

by Edmond Jackson from interactive investor

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I make no apologies starting 2024 with a relatively defensive pharmaceuticals idea. Wider sentiment is bullish, with financial markets pricing for six interest rate cuts this year, down from a current 15-year high of 5.25% to 3.75% by Christmas. 

Yet markets have also priced for Middle East conflict being confined to Gaza, and it is now morphing into a US/Iran stand-off (at the very least) over Iranian agents attacking container ships in the Red Sea. Extra costs and delays of re-routing around the Horn of Africa mean supply chain disruption and higher costs of goods, including food. 

The Brent crude oil price also rose 1.8% yesterday and natural gas by 5.7% after a US warship sank three rebel boats attacking container ships. Upward pressure on energy prices could disrupt central bank thinking on interest rate policy, where the US Federal Reserve changed its guidance only last month towards rate-cutting, but could flip-flop again. 

The Bank of England will be alert to the Fed’s behaviour given the UK really needs to lag the US with rate cuts to sustain sterling. Otherwise, foreign exchange traders would sell sterling, which would rekindle UK inflation because we substantially import energy. 

So I think it wise to be aware of at least another scenario to the bullish outlook which markets price for. Ratings both for growth and cyclical stocks rose from early November as markets expected rate cuts then cheered the Fed’s pivoting. 

For committing fresh capital in January, I would therefore avoid chasing these gains. Instead, I’d look for modest ratings versus decent underlying progress, where sentiment may also be weak.  

Why GSK fits the bill for a sound inexpensive investment    

Older investors may significantly own GSK (LSE:GSK) – or have inherited the stock – given the historic “Glaxo” earned respect in the latter 20th century as a blue-chip core holding. 

Indeed, the financial summary table below shows respectable operating margins in the order of 20% (the first nine months results of 2023 affirming 20.8%). Despite inevitable capital expenditure needs for drug development, the free cash flow profile has trended strongly. Return on total capital has blipped around after 17% in 2022, but should have risen over 20% in 2023 with return on equity likely over 30%. These are good numbers which explain why plenty of investors regard GSK as a solid if unexciting (to date) equity. 

GSK - financial summary
Year-end 31 Dec

Turnover (£ million)27,88930,18630,82133,75424,35424,69629,324
Operating margin (%)9.313.917.820.624.617.521.9
Operating profit (£m)2,5984,1815,4866,9615,9794,3216,433
Net profit (£m)912.01,532.03,6234,6455,7494,38514,956
EPS - reported (p)23.366.088.011611169.2104
EPS - normalised (p)40.911810716978.968.1114
Operating cashflow/share (p)165175212200209196181
Capital expenditure/share (p)59.955.745.253.955.672.355.3
Free cashflow/share (p)105119167146154124126
Dividends per share (p)80.010010010010010061.3
Covered by earnings (x)
Return on total capital (%)6.514.015.412.510.37.817.2
Cash (£m)4,9863,9113,9584,7866,3704,3357,877
Net debt (£m)13,80413,17822,10625,72220,78019,83813,110
Net assets (£m)1,124-68.04,36011,40514,58715,05510,598
Net assets per share (p)28.6-1.7111288363374263

Source: historic company REFS and company accounts.

Yet while the stock has recently risen by almost 12% from a modest double bottom at around 1,300p last July, with the price at 1,450p it remains in the middle of a roughly 1,300p to 1,600p sideways range since 2011. 

Going further back, in 2004 it traded in a circa 1,000p to 1,500p range. So, according to your entry point and excluding dividends, a long-term investor could have been stuck in dead money and at substantial opportunity cost elsewhere. 

Meanwhile, AstraZeneca (LSE:AZN) (which I have favoured) achieved a strong bull run in the last decade, perhaps benefiting from an extent of switching from GSK. Yet I have recently mentioned its growth rating suffered in 2023 from higher interest rates despite nothing adverse in its news flow. 

I last wrote GSK as a “buy” a year ago at 1,440p on a rationale that, despite a rather erratic financial performance under the current CEO since April 2017, the benefits of more focused investment were starting to materialise. A November 2022 trading update anticipated up to 10% sales growth that year and around 15% earnings growth. 

Despite 2023 revenue growth sounding quite dependent on Shingrix, an anti-Shingles treatment, both the late and early stage development pipeline had improved and there were various regulatory approvals. Third-quarter 2022 continuing operations saw £700 million of free cash flow aid a 7% reduction in net debt. 

Also, the board targeted paying out 40% to 60% of earnings as dividends, averaged across investment cycles, equating to a near 4% yield.   

Broad delivery in 2023 sets GSK up well for 2024 

The stock did little last year – a modest 7% rise to 1,535p by last September before settling down and trading at around 1,450p currently. 

Yet despite a weak first-quarter underlying performance, revenue increased through 2023 such that the third quarter saw a 10% advance – or by 16% excluding Covid treatments.  

Reduced demand for Covid drugs – despite variants of the disease kicking off this winter – have been the essential check on progress, as group revenue growth for the nine months to 30 September remained marginal at 2% but ex-Covid was a very respectable 13%. GSK’s medicines achieved broadly good performance. 

Moreover, group operating profit advanced 39% in the first nine months and continuing earnings per share (EPS) by 59% - helped in part by higher royalty income, partly offset by higher R&D investment and new product launches. 

Upgrading guidance for the full year, management added that R&D would support GSK’s longer-term growth outlook, with various drugs gaining approval in different jurisdictions. 

It raises interest in the forthcoming annual results, released last year on 1 February. The stock has only risen about 4% since third-quarter results on 1 November, barely in line with the market. 

At 1,450p and based on consensus forecasts, the share trades on a relatively modest 12-month forward price/earnings (PE) ratio of 9.3x and yields 4.2% with 2.6x earnings cover. This compares with AstraZeneca on just over 16x earnings and a 2.4% yield covered 2.6x – with its chart trending modestly downwards overall since last May.  

If GSK can build on its narrative – backed by firm numbers – then it may come across as the preferred play for relative value.   

Substantive acquisitions due in respiratory and auto-immune treatments  

This was flagged in media only last weekend, as if GSK’s financial PR is giving us a flavour of the 2023 results narrative. 

A multi-billion-pound acquisition programme – sounding as if management already has targets in these specialist areas – is aimed to raise GSK’s growth appeal. The focus is said to be very much on single/dual products available. 

They will be part-funded by cash raised from selling down a residual 7% stake in Haleon (LSE:HLN) (the consumer healthcare group best-known for Sensodyne toothpaste) that was divested last year for about £800 million initially in May, then a further £900 million last October. 

While this is rather speculative, my take is that GSK would not be putting it about without firm likelihood of delivery. 

Coinciding with relatively attractive valuation benchmarks, it hints at “something new” in GSK’s investment rationale. 

Together with a rising chart and a sense that this kind of stock should be relatively defensive, I feel more comfortable advocating it – where capital protection is the first priority – than momentum stocks riding the froth of lower interest rate hopes. 

10 non-executive directors bought shares on 20 December 

The chairman added £29,000 worth at 1,445p and nine others more like £6,000 each – modest amounts albeit seemingly free will-based rather than linked to a required investment plan. While hardly qualifying as aggressive cluster buying it is a marker for collective belief in value. 

I would not raise hopes for GSK to soar 130% this year, like the unloved Marks & Spencer (LSE:MKS) rallied consistently through 2023, but it looks timely to note its underlying prospects and relative value. Buy.  

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

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