Many companies invest in the future, but fail to be rewarded by a market that prefers instant gratification. Instead they're punished for the drop in short term profits that result from that investment.
GlaxoSmithKline is one such company. A leader in medical research, it is building the best pipeline in the pharmaceutical industry. But it is trading level with the FTSE at a forward P/E of 15.4, well below the 19.1 average among major pharmaceutical companies, and well below the 25% premium it usually trades at.
The last time the rating got this low was when Hillary Clinton was trying to reform the U.S. health sector in the early 1990s.
A re-rating is on the cards.
Like other liquid mega cap stocks, GSK's derating probably reflected selling by company pension funds trying to improve their asset-liability matching. But now mega caps are being sold hard to investors as an asset class on the basis of solid dividend yield and cheapness.
Many mega caps are mature businesses facing margin and growth pressures, but GSK stands out. It warrants a higher valuation because it is a defensive low beta stock in a slowing economy.
Valuations in the European pharmaceutical sector are generally low in terms of price-to-book value and dividend yield. While the sector has been left behind over the last month, increasing 1% as markets advanced 4%, its defensive qualities are coming back into focus.
With 2007 likely to be cooler for U.K. company earnings, some fund managers are warming to GSK again because it offers positive earnings momentum as well as a solid dividend yield of 3.18% - compared to 2.5%pct for its peers. Earnings growth in the sector is set to be twice the market average over the next two years, according to SocGen.
The bonus is that GSK is also a call on some potentially positive product news next year.
The threat to branded pharmaceuticals from lower-priced generics, and the saturation of mature product categories may have prejudiced some investors. But F&C fund manager Ted Scott does not think GSK is being given credit for the potential blockbusters in the pipeline.
The bad product news, the wait for a blockbuster drug, and worries about the threat to its base business - the asthma drug Advair and diabetes drug Avandia - has probably been fully discounted.
The potentially positive news next year probably has not.
According to Lehman Brothers, GSK's exposure to late-stage product-driven events is now one of the highest in the industry. Its chief executive, Jean-Pierre Garnier, is confident enough in its product lineup to have extended his contract to May 2008.
One positive price catalyst could be Promacta, a unique drug that reduces bleeding in patients with low platelet counts, and which has recently showed promising results in hepatitis C patients.
And cervical cancer vaccine Cervarix will be sold in Europe next year. Merck and Sanofi Aventis got there first, but analysts think this market will be split down the middle.
GSK also hopes to launch breast cancer drug Tykerb, a potential rival to Roche's Herceptin, next year.
If exciting news leads analysts to increase sales expectations, more investors could take an interest in GSK. Those may be big ifs, but they could have a substantial effect on GSK's share price.
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