It feels like only yesterday that Mr Market was offering you a 4.5% yield for GlaxoSmithKlines (LSE: GSK) (NYSE: GSK.US) quality pipeline, while begging you to take the languishing AstraZeneca (LSE: AZN) (NYSE: AZN.US) off his hands yielding over 6%. I remember wishing that GSK was trading that little bit cheaper and so I held fire, hoping that manic trader would eventually change his mind
Two years later, Glaxo has been through a bribery scandal in China and lost patent protection on its blockbuster drug Advair, while Astra has built up its failing pipeline and had its valuation propped up by Pfizers attempted takeover.
These events have flipped Mr Markets sentiment and now you can buy Glaxo for 6%, while Astra yields 4%.
So today Im going to revisit these two shares to see if Glaxo remains the stellar income play it was then, and if AstraZeneca has earned its rerating.
Merger Madness Rejected, For Now
Mergers often destroy shareholder value. It is a well-known fact, and yet nothing gets (bad) CEOs and Mr Market excited like the idea of a mega deal. Earlier this year, Pfizer made a perhaps ill-advised 69bn bid for AstraZeneca which was duly rebuffed.
Fund manager Neil Woodford played a significant part in the defence of the British company, saying:
An independent AstraZeneca would achieve far better returns for its shareholders than the offer from Pfizer could have delivered.
Woodford sited tangible progress at AstraZeneca to back up his investment thesis against the acquisition, and Im inclined to agree. Pascal Soriot, CEO, has worked wonders since he took over a cash-rich Astra in 2012. A number of tactical acquisitions have seen the pipeline bolstered and revenue has grown in each of the last three quarters.
Furthermore, with 14 new drugs in late-stage development, Astras future looks increasingly bright.
However, I believe AstraZenecas valuation still remains inflated because of the ever-diminishing chance of a Pfizer deal.
Astras progress doesnt quite justify a forward PE of 20 for me, but the dividend looks well covered by last years cash flow. Soriot recently set the ambitious goal of a 75% revenue jump by 2023, to $45bn. Im a fan of long-term planning, but long-term predictions hardly ever last and Im not counting on that figure being achieved.
Dividend Danger Or Bright Future?
Glaxos pipeline has a pedigree that I believe differentiates it from the likes of Astra. It boasts 40 drugs in late-stage testing to Astras 14, and in the unpredictable game of research, it pays to be diversified.
However, Glaxos earnings have stalled recently. Last years earnings were virtually flat when compared to 2010, and earnings are set to fall slightly this year as blockbuster drug Advair, which brought in 5bn in sales last year, saw competition from generics after it lost patent protection.
The company seems to have lost four years, with both the share price and earnings going nowhere fast.
Of course, shareholders have been receiving that chunky dividend, but now even the payment is looking a little stretched, with a pay-out ratio of 90% of earnings.
Strong cash flow reduces the risk of the dividend being cut in the short-term, and I believe there are a number of reasons to trust it will continue.
The company plans to float its stake in ViiV Healthcare, the HIV treatment company, and predictions have valued it at between 10bn and 15bn bigger than ITV!
If the company can maintain the dividend for another year, which I believe it can, the proceeds from this sale could give Glaxo breathing space to grow organically.
It would be remiss of me not to mention some of the risks involved with GSK. They were recently fined $490m for bribing doctors and hospitals in China. It is not yet known how much damage the scandal has caused to GSKs advancement in the country, an important driver for future growth.
Furthermore, the company has changed the incentive structure for its sales force in a bid to prevent this repeating itself. It no longer pays commission, and some analysts are worried that they will lose out to more aggressive competition.
Final Foolish Thoughts
Personally, Im not so worried by either of these issues. Glaxo is investing directly to support the governments health care reform agenda in China, slowly rebuilding bridges. As for the sales team, Im sure theyll find a balance eventually. Management will obviously intervene if sales suddenly drop off, so I trust the damage here if any will be limited. Conversely, it may even yield benefits. After all, no one likes a hard sell, and maybe building relationships rather than pushing sales will see GSK do more business.
Im not sure there is enough margin of safety in the valuations of any of these companies to buy them right now, but GSK is not all that far off looking an attractive purchase. You must have an appetite for risk investing here, though, because the dividend coverage is slightly close to the bone.
Personally, I would avoid Astra at least until the Pfizer rumours resolve one way or another because the shares are certainly trading at higher levels than before the bid.
There certainly seems to be potential upside in Glaxo if you are willing to take on more risk, an important step to take if you want to make serious money in the stock market and one of the key steps our analysts have outlined in an exclusive investment report.
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