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GlaxoSmithKline (LON:GSK): Why dividend growth stalls and falters

The idea that a dividend aristocrat like GlaxoSmithKline (LON:GSK) would ever cut its dividend may be unthinkable to many investors. The pharmaceutical giant has consistently paid dividends since the 1980s and dividend ETFs like S&P UK Dividend Aristocrats have invested huge chunks of money in Glaxo. Nevertheless, recent years have seen a number of blue chip companies, including Tesco, Rolls Royce and Rio Tinto reduce their dividend.

Although Glaxo has not cut its dividend, the rate of dividend growth has already slowed considerably. Cash payouts have remained static at 80p per share since 2014. Dividend hunters may find this frustrating, but there are a number of metrics that investors can use to understand why dividend growth slowed in the past, and assess whether dividends could rise or fall in the future. I will use this article to discuss these metrics, paying particular attention to GlaxoSmithKline.

Why hasn’t Glaxo increased its dividend?

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In order to assess dividend safety, it is important to check company cashflows. Whenever a company pays a dividend, investors receive a cash payment, so dividend growth may stall if a company doesn’t have much cash. This is exactly what has been happening with GlaxoSmithKline.

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The latest interim results explained that the firm 'intends to build free cash flow cover of the annual dividend to a target range of 1.25-1.50x, before returning the dividend to growth.' The cashflow cover is calculated by dividing free cashflows (FCF PS) by the dividend (DPS). A firm with a higher cashflow cover is deemed to have a safer dividend.

We can see from the above graph that GlaxoSmithKline’s cashflow cover has been lower than 1.5 every year since 2011. Furthermore, the cover has been below 1.25 each year since 2013. Glaxo had a FCF PS figure of 84.4p for the year ending December 2016. A 1.25 cover ratio would mean that Glaxo will need to have 100p in FCF PS by the end of the year (ie. 100p = 1.25 times 80p). As such, the FCF PS figure would need to grow by 18% this year in order to reach the 1.25 target.

In essence then, recent cashflows haven’t been strong enough to support a higher dividend. So let’s explore why free cashflows have been low.

Glaxo’s cashflow problem

It would be helpful to pause for a moment and understand exactly what cashflows are. Free cashflow is basically calculated as operating cashflows, minus capital expenditures (ie. investing cashflows) and minus cash paid out as interest or dividends (ie. financing cashflows). A company would end up with less free cashflow if capital expenditures grew, interest/dividend payments increased, or operating cashflows fell, (or a combination of the three).

The image below has been put together to help visualise cashflows. I’ve simplified for operating cashflow, but this should at least help us analyse GlaxoSmithKline.

59d3c04eb968bCashflow2.png
59d3c04eb968bCashflow2.png


Higher investing cashflows (including capital expenditures) have arguably been the biggest factor placing downwards pressure on free cashflows.

  • Cash inflows from operating activities were low in 2014 and 2015, but they were higher in 2016 (£6.5bn) than in 2011 (£6.25bn).

  • Cash outflows for financing activities totalled £6.2bn back in 2011, compared to £6.4bn in 2016. That’s only 3% growth.

  • On the other hand, cash outflows for investing activities were £0.1bn in 2011 and have grown enormously to £1.3bn in 2016.

  • Capital expenditures are essentially cash investments in fixed assets (eg. property and equipment) or intangible assets (eg. patents). The first chart below shows that Glaxo’s CapEx budget has increased each year since 2011. Capital expenditures totalled £1,328bn in 2011, compared to £2,352bn in 2016 (see here for the full cashflow statement).

    59d3c6c7651a4gsk4.png
    59d3c6c7651a4gsk4.png

    It seems that GlaxoSmithKline has spent more money on fixed assets, but the company has become less effective in using those assets to generate sales. The chart on the bottom-right plots Glaxo’s fixed asset turnover ratio, which is calculated by dividing sales by fixed assets. A higher (lower) ratio means a company is more (less) effective at using assets to generate sales.

    Glaxo’s fixed asset turnover ratio has declined between 2011 and 2016 as fixed assets, the denominator in the turnover ratio have grown faster than revenues (ie. the numerator). Fixed assets grew by 17%, from £18.8bn to £22.1bn, while revenues have only grown by around 2%, from £27.4 to £27.9.

    Several factors are placing downward pressure on revenues. Glaxo products including Seretide and Advair are starting to face generic competition. Furthermore, pricing pressure is particularly problematic in Europe and the US, where a number of consolidations amongst healthcare insurers enable drug buyers to command lower prices, simply because pharmaceutical companies have fewer customers they can sell their product to (see here).

    So the upshot is that revenues have hardly grown and Glaxo increased its CapEx budget. The bad news for investors is that higher investing cashflows translate into lower free cashflows and limited dividend growth. We have explored why GlaxoSmithKline has not increased its dividend, but the key question is whether dividends will actually fall as we go forward.

    The profile of a dividend cutter

    GlaxoSmithKline’s forward dividend yield is 5.4%. Many readers will want to know whether Glaxo is simply compensating shareholders for putting money up for a risky investment. It is impossible to forecast the future, but we can assess whether GlaxoSmithKline has the characteristics of a stock which did make a dividend cut in the past.

    59d3c722601f0gsk_5.png
    59d3c722601f0gsk_5.png

    Last week I mentioned an excellent paper titled To Cut or Not to Cut by Laarni T. Bulan. Bulan analysed 901 dividend cuts over a 39 year period (1965-2004). He identified the common characteristics of companies that were about make a dividend cut. Does Glaxo have these characteristics? It has some, but not all of them.

    Bulan noticed that ‘firms with poor financial flexibility (low cash holdings and high leverage) are more likely to cut their dividend.’ Cash holdings are defined as cash as a proportion of total assets. The chart on the top-right has been taken from Bulan’s paper. Dividend cutters (red) are firms that reduced their dividend by 10% or more in a fiscal year. Control firms (blue) are firms that did not reduce their dividend.

    We can see that Glaxo’s cash holdings do have the profile of a typical dividend cutter. Over the last three years, the value of cash on the balance sheet declined from £5.6bn (2013) to £4.9bn (2016). In the meantime, the asset base grew by around 40%, from £42bn to £59bn. The expansion of Glaxo’s capital expenditure budget helps to explain why the value of intangible assets (eg. patents and copyrights) has basically doubled, from £9.3bn to £18.8bn. The value of property, plant and equipment has also grown by around 20%, from £18.8bn to £22.1bn.

    In a nutshell then, the declining value of cash holdings as a portion of sales is one red flag for Glaxo’s dividend, at least according to Bulan’s study.

    Hidden nasties on the balance sheet

    An analysis of dividend safety would not be complete without an analysis of the balance sheet. A company may have to make cash payments in order to pay off liabilities and debts, meaning less money would be available to pay dividends to shareholders. Glaxo is quite honest about the skeletons it has in the closet. If you turn to page 71 of the 2016 annual report, the firm explains that ‘we may from time to time have additional demands for finance, such as for acquisitions, including potentially acquiring increased ownership portions of the ViiV Healthcare and the Consumer Healthcare businesses where minority shareholders hold put options’ (see here).

    The minority shareholders Glaxo is referring to are Pfizer, Shionogi and Novartis. In recent years, Glaxo has made joint venture investments with these pharmaceutical companies.

  • ViiV Healthcare specialises in HIV treatment and was created as a joint venture by Pfizer and GlaxoSmithKline in November 2009. Shionogi joined the venture in 2012.

  • GlaxoSmithKline also made a Consumer Healthcare Joint Venture with Novartis.

  • The issue is that Novartis and Pfizer both have put options on their investments. If these options are exercised, Glaxo must buy out Pfizer’s shareholding in ViiV, or Novartis’ shareholding in Consumer Healthcare. The put options are recognised on Glaxo’s balance sheet as a liability which may require a future outflow of cash. Glaxo would potentially have less money for dividends.

  • The recent interim statement put the value of Pfizer’s put option at £1,259m.
  • The Consumer Healthcare put option liability was valued at £8,271m (see pg. 53).
  • To put this in a wider perspective, Glaxo paid out £4,850m in dividend in 2016. In other words, the liability to Pfizer alone is equal to 25% of Glaxo’s 2016 dividends.
  • 59d3c763a41d6GSK_6.png
    59d3c763a41d6GSK_6.png

    On top of this, investors should note that Glaxo’s overall leverage - measured as the ratio of liabilities to assets - has risen in recent years, as we can see from the first chart on the right. Assets have grown by around 40%, from £42bn to £59bn between 2013 and 2016. Liabilities grew faster (ie. by 65%) from £35bn to £57.9bn.

    The put options are bundled in with minority interests and ‘other liabilities’ (here). We can see that the combined values of these line items has risen by around £17bn since 2013, while total liabilities have risen by £22bn. The value of the put option liabilities has increased in recent years. For example, Glaxo initially had the right to block Pfizer from exercising the put option, but revoked this right in 2016 and therefore recognised the liability for the first time.

    We can also see from the second chart above that Glaxo’s leverage chart looks like the leverage chart of a dividend cutter. Indeed, it is perhaps unsurprising that Bulan’s study identified that dividend cutters became increasingly leveraged in the years preceding a dividend cut (see above image).

    Is Glaxo making enough profit?

    59d3c34cd6228prof.png
    59d3c34cd6228prof.png

    Bulan’s paper also explains that profitability, measured in terms of the Return on Assets (RoA) declines in the run-up to a dividend cut. The first chart on the right plots this downwards trend. The second chart below shows how Glaxo’s RoA has declined recently. This is potentially another red flag for the dividend.

    Returns generated over the last twelve months (ie. TTM) and in 2016 were lower than in any year since 2012. Net profits, the numerator in the RoA equation have fallen from £5.4bn (2013) to £0.9bn (2016) while assets (the denominator) have grown, causing the overall the RoA figure to shrink.

    The decline in profits can be explained by generic drug competition and pricing pressures. These factors have restricted revenue growth (see above).

    Profits have also been harmed by a series of restructuring charges worth £970m in 2016, £1,891m in 2015 and £750m in 2014. Total selling, general and administrative expenses (SGA) increased by 11%, from £8,180m (2013) to £8,859m (2016). These costs were incurred partly as a result of joint deals with Novartis. In 2014, Glaxo agreed to buy Novartis’s vaccines division, while Novartis would buy Glaxo’s cancer drugs business. In addition, Glaxo’s Major Change restructuring Programme is focused on opportunities to simplify supply chain processes (see pg. 197 for full details).

    The fall in Glaxo’s earnings is potentially a bad sign for dividend hunters, because dividends are considered less safe when the ratio of earnings (EPS) to dividends (DPS) is lower. The earnings dividend cover is essentially the ratio of EPS to DPS. We can see from the company’s StockReport below that Glaxo’s earnings cover is a quite low. Many investors like earnings to be at least 1.5 times (ideally 2 times) the size of the dividend. The recent cover ratios of 0.23 (2016) and 0.49 (TTM) could be a sign of dividend risk.

    59d3c39fcc303DiviCov.png
    59d3c39fcc303DiviCov.png

    So recent trends in Glaxo’s cashflows, leverage and profits have not been too great.

    Will Glaxo cut its dividend?

    Bulan’s research found that companies which were about to cut their dividend had common quantitative characteristics. The full list can be found here, but in summary, Bulan found that “on average, dividend cutters are poorly performing firms with profitability and sales growth levels well below their industry peers...capital expenditure declines in the year of and after the dividend cut...leverage increases significantly...cash holdings declines sharply.”

    Glaxo has adopted some of these characteristics in recent years. Leverage has risen. Cash holdings have fallen. Profitability has declined. Glaxo’s sales and capital expenditures could also come under threat as we go forward. If this happens, the company will even more like the company that Bulan described above.

    In the US, the Trump Administration has promised to bring down drug prices by forcing big pharmaceutical companies to bid for government contracts. This would place even more pressure on Glaxo’s sales and profits, meaning less money could be available to pay dividends and/or invest in capital expenditure.

    In addition, Pfizer and/or Novartis could decide to exercise their put options. Glaxo would be obliged to buy out ViiV or Novartis’ investment in the Consumer Healthcare venture. Glaxo may also decide to make the buyouts voluntarily. This would potentially means less money available for capital expenditures and, moreover, for dividend payments. Also note that the put option liability could increase if ViiV’s prospects improve -for example as a result of successful drug tests- because value that Glaxo would need to pay for the ViiV shares could rise.

    It’s important to stress that it’s difficult to make forecasts about future dividend levels in a business as large and complex as Glaxo. However, it’s useful to explore some of the tools and metrics that can be used to assess dividend safety and see how the payout at a stock like this could become vulnerable. To sum up, investors can check a company’s cashflows, profitability and leverage levels. Particularly useful metrics include the dividend cover and the RoA. A lot of the data used to make this analysis can be found on Glaxo’s StockReport, balance sheet, income statement and cashflow statement. Feel free to take a look and provide your feedback below. If you have not already had the chance to use our data, you can sign-up for a free trial here.

    The author of this article owns shares and is long in GlaxoSmithKline.



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