The pharmaceutical sector is typically an income investors' dream come true since Big Pharma provides bountiful margins from innovator drugs, substantial cash flow, and often above-average dividend yields. U.K.-based GlaxoSmithKline (NYSE:GSK) is no exception.
Over the trailing 12-month period shareholders of GlaxoSmithKline stock have been privy to a nearly 6% yield – that's roughly three times better than the broad market average dividend yield. GlaxoSmithKline's superior payout has been powered by more than $7 billion in cumulative operating cash flow over the past four quarters and a gross margin in 2014 of a whopping 68%.
But, you know the old saying, "if it seems too good to be true, it probably is?" I believe that could be the case with GlaxoSmithKline and its delectable dividend. Overall, there are three reasons why existing shareholders should have little confidence in GlaxoSmithKline's dividend moving forward.
1. Weak next-generation respiratory drug launch
The biggest challenge currently facing GlaxoSmithKline is the upcoming introduction of generic competition to inhaled COPD and asthma maintenance therapy Advair within the next year or two.
Advair actually lost patent exclusivity years prior, which for most drugs wound entail the immediate entry of generic competitors. However, the Food and Drug Administration hadn't detailed what it'd need to see from a generic formulation of Advair in order to give its thumbs up of approval. The FDA only laid this information out in 2013. However, following a couple years of development, generic competitors are widely expected to chip away at the roughly $6 billion in sales Advair generated last year. Mind you, this is down from peak sales of more than $8 billion already.
GlaxoSmithKline and development partner Theravance do have four next-generation COPD and potential asthma maintenance therapies designed to replace Advair – Breo Ellipta, Anoro Ellipta, Incruse Ellipta, and Arnuity Ellipta – but the early reality is that sales of these purported blockbuster drugs haven't been progressing at a satisfactory pace. Drug launch challenges including insurer coverage, drug price, and impending generic (and thus cheaper) competition to Advair, have held back sales of Breo Ellipta, the first of four next-generation respiratory therapies to hit the market.
In GlaxoSmithKline's most recent quarter it recorded just $64 million in Breo Ellipta sales, despite the COPD therapy being on pharmacy shelves for nearly two years. That's an annual run rate of just a hair over $250 million for a drug widely expected to crest $1 billion in annual sales at its peak. The more recently launch Anoro Ellipta and Incruse Ellipta brought in $18.9 million and $1.6 million, respectively, however this is a far cry from the billions GlaxoSmithKline is set to lose in Advair revenue.
Long story short, it could be years before Glaxo generates solid revenue and profit growth, which I suspect is bad news for its dividend and payout ratio.
2. Reduced shareholder bounty from its transformative deals
Within the past year GlaxoSmithKline has also completed a major transformation that's completely reshaped its future and its focus.
In a roughly $20 billion-plus asset swap with Novartis, GlaxoSmithKline jettisoned its oncology portfolio and pipeline for as much as $16 billion, it purchased Novartis' vaccine portfolio for $7 billion, and it created a consumer health joint-venture between both companies. The deal itself created a windfall profit for GlaxoSmithKline of $14.6 billion that it recorded in the first quarter.
This one-time gain was highly welcomed by investors considering that GlaxoSmithKline had been open about returning approximately $6.3 billion to investors. However, in early May GlaxoSmithKline's management team pulled a mulligan on its promise and slashed its expected capital return to just $1.6 billion.
On the surface, keeping extra capital handy for flexibilities sake isn't a bad idea if GlaxoSmithKline has its eyes on possible acquisitions. But, cutting an expected shareholder distribution by 75% after such a large one-time profit has to be a bit disconcerting to investors and may have them questioning whether GlaxoSmithKline's own management team is concerned about its near-term and intermediate growth prospects.
3. Greater reliance on vaccines
A final concern would be one of GlaxoSmithKline's areas of focus following its asset swap deals: vaccines.
Vaccines are a two-headed monster that can be bring both pleasure and pain to investors at the flip of a switch. Greatly beefing up GlaxoSmithKline's vaccine portfolio could help with the company's pricing power, and it certainly won't hurt when infectious disease scares pop up, such as H1N1 or Ebola.
But, there's a notable catch with putting a greater reliance on vaccines for GlaxoSmithKline. Infectious diseases are typically mutable, which means that vaccine manufacturers can't just make endless supplies of vaccine, because it might render a vaccine useless and result in substantial writedowns. By a similar token, vaccine orders are often wholly dependent on the needs of government's around the globe. It's very difficult to estimate demand, meaning vaccine makers will sometimes ramp up production to fight an infectious disease and wind up being left with a huge stock of unsold vaccine.
In short, this aspect of Glaxo's operations could be more volatile than existing shareholders realize, and that could threaten GlaxoSmithKline's superior dividend.
I'll believe it when I see it
In the interim GlaxoSmithKline's management team has stuck by its promise to pay 80 pence worth of dividends per year between 2015 and 2017 despite the expectation of generic competition chipping away at Advair.
But the grim expectations of Wall Street suggest that major dividend cuts are in the offing. By 2018 GlaxoSmithKline could easily see its EPS erode from the $3.02 it reported in 2014 to less than $2 per share. In order for GlaxoSmithKline to pay out a prudent and sustainable dividend (let's arbitrarily say at a payout ratio of 75%) investors could be looking at a payout cut of between 40% and 50%, in my opinion. This would move Glaxo's dividend yield to a more reasonable and sustainable 3%, but it could sack a very important reason why investors have supported GlaxoSmithKline's stock price in the wake of its impending Advair sales loss.
GlaxoSmithKline certainly has some rough waters to navigate, and I'd be personally shocked if it made it through 2017 without enacting a substantial cut to its dividend. It remains to be seen how much of an effect a hypothetical dividend cut could have on its stock price, but let's just say that I would consider putting your money to work in other stocks within the Big Pharma sector over the coming years.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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