Stock to Watch: GlaxoSmithKline

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What to make currently of the FTSE 100 shares in international pharmaceuticals group GlaxoSmithKline (GSK) which, despite renown for a reliable yield, can still be quite volatile?

I initially drew attention in October 2008 at 1,000p a share, along a rationale of essential products, international currencies and a 5% yield. While you cannot expect a defensive share to perform as well as a cyclical, from a market low there has been good progress - the price flirting with 1,500p in the New Year.

However it fell from near 1,400p to 1,200p in last August's panic and shed a pound in January as some investors rotated into riskier assets.

While this is overall good progress with less volatility than financials or cyclicals, holding GSK has required awareness of wider risk/reward issues and sentiment affecting the shares, otherwise even a 5% yield can get clipped in a market value context.

At about 1,400p currently, the shares have firmed despite the 7 February prelims, which cited quite soft performance in the final quarter of 2011. While hardly surprising, this likely explains the shares' initial dip in reaction. The fourth-quarter revenue outcome was £7.0 billion relative to a consensus £7.3 billion expected, with operating profit at £7.0 billion against consensus of £7.3 billion; however normalised earnings per share of 28.4p was in line - helped by a lower tax charge.

This is just a snapshot of business performance versus sentiment, however. The benchmark is management's long-term delivery on its key priorities: a diversified global business with more value-generating products and improved efficiencies.

Underlying sales growth was 7% last year, led by vaccines, up 11%; consumer healthcare, up 5%; and pharmaceuticals, up 2%. This has been normalised however to factor out the loss of some products, otherwise reported sales were down 6% in the first half then rose 1% in the second half. This can make for frustration, interpreting genuine trends in a big complex group - as obviously managers like to present progress as best they can.

Variance is partly explained by the phasing of vaccine tenders and government pricing. "White pills in Western markets" have nearly halved to 22% of group sales, affected by 5% lower growth in Europe, albeit with 38% of group sales generated outside of Europe and the US. Japan has been strong, with sales up 35% in the last three years and in the next three years over 25 new products are planned to launch there.

Research and development (R&D) and pipeline progress is the key factor for expectations surrounding a pharmaceuticals group - with GSK's management implying this is positive.

Only time will tell how the numbers translate into sales. Meanwhile it is at least encouraging how the expected R&D rate of return has edged up from 11% to 12% since 2010 - the long-term goal being 14%. If steady progress can continue towards this then it should help keep the price-earnings multiple (P/E) in double digits.

As regards dividends you need to watch cash flow primarily. With GSK's cash conversion rates improving, normalised free cash flow was £5.6 billion last year and this will improve with reduced restructuring charges. Annual savings of £4.7 billion are expected to have been achieved this way, over 2011-12, with a further £2.8 billion by 2014.

While helping 2011 dividend growth of 8% to 70p a share, GSK will also imminently pay a 5p supplemental dividend following the sale of non-core US over-the-counter brands. The dividend looks set to continue being enhanced this way for the medium term amid "active discussions with other buyers for the remaining non-core assets."

Cash flow also supports GSK's share buyback programme, with £2.2 billion repurchases were made last year and £1-2 billion targeted for 2012. While buybacks can seem a cop-out for investment and dividends, they are happening in a context where GSK is already progressing on those scores - so it should help grind earnings per share higher.

So while it is very hard to interpret a £70 billion group like this precisely, as to what will be the impact of various products, the prospects look overall healthy when you consider key drivers for capital growth and dividends. Size precludes fast growth but GSK offers relative security with its mix of pipeline, restructuring and international diversity.

On raw valuation metrics some analysts question GSK relative to AstraZeneca (AZN) which at 3,000p a share sports a yield just over 6% covered twice by forecast earnings. This is despite the expectation for earnings per share to fall over 20% this year then flatten, compared with over 20% earnings growth projected for GSK and 8% in 2013.

Consequently GSK's price-earnings multiple is about 11 times the 12-month forward scenario compared with eight times for AZN - justifiably so, I contend. P/Es are going to vary and for a truly defensive share I would favour robust earnings.

Brokers are positive on GSK, with Company REFS showing the recent consensus at 'buy/add' - the only 'hold' appearing separately, Panmure Gordon which even so has raised its price target from 1,350p to 1,450p.

The end-December balance sheet had net debt of £9.2 billion relative to £8.8 billion net assets, supported by £3.8 million goodwill and £7.8 million other intangibles. While this may not be to some (conservative) investors' taste, it reflects a branded pharmaceuticals group. The 2011 net finance expense was covered nearly 12 times by operating profit.

For medium-term stock selection the key issue is probably macro: whether January's risk appetite continues, for example following the Greek deal over austerity measures. But if these fail to be implemented and there is the risk of runs on banks among weaker European states, or if the Iranian nuclear threat escalates to pre-emptive action by the US, then it is quite easy for investors to scramble for cover into defensive shares again.

As a core holding to help charter an equities portfolio through these difficult times, it is therefore worth keeping an eye on GSK.

For more information see gsk.com and for more Stocks to Watch, visit Edmond's archive.