I have a soft spot for GSK; it was the first serious investment I made after I set up my ISA. It seemed to offer everything I was looking for: relatively cheap starting valuation, steady, predictable growth, a juicy dividend (paid quarterly, which is even better), global operations, and long track record of shareholder friendliness. We are still on good terms today, but I am getting worried about the dividend situation.
Digital Look’s estimate for this year’s earnings is 94.75p with the full year’s dividend payment given as 81.30p, which would make for an eye-wateringly tight coverage ratio of 1.17. Despite the fact that Glaxo’s earnings have gone worse than nowhere in the last five years (they earned 112.92 normalized in 2009) the dividend has risen by a third over the same period. How can the current dividend be sustainable, let alone continue to grow, while earnings flat line?
Glaxo has had a truly horrible year with falling sales, exchange rate pain, and embarrassing difficulties in China that culminated in a profit warning in July. It announced plans to offload highly profitable, old drugs whose sales are declining, in order to focus on future developments but doing this will dilute earnings per share and perhaps raise that payout ratio to the point when a warning bell turns into something nastier – the Bell of Dividend Doom!
Fond as I am of Glaxo’s payout, I think it is time to brace myself for an end to its growth and that may not a bad thing. After all, the dividend should never be allowed to dictate how a company is run–it is not a bond payment. If cash is tight, then surely the dividend should be held while investments for the company’s future are made (what about finishing an Ebola vaccine or further advances into consumer healthcare?). Neither would I want debt to creep up and investment in research and development to fall for the sole purpose of a the current bosses not wanting a dividend cut on their CVs. I would rather increasing revenues and earnings were their priority.
Perhaps there is a lesson here in how AstraZeneca dealt with a similar situation; Pascal Soriot, shortly after becoming Astra’s CEO suspended share buybacks and froze the dividend. His positive outlook–striving to replenish the medicine cabinet–worked and Astra is on the mend. Hopefully Glaxo will remember what it is–a pharmaceutical company first and a dividend machine second. Of course I would miss the growing dividend, but if the focus is placed solely on beginning to grow revenues and then earnings again, in time the dividend should take care of itself.
Disclosure: Long GSK.
Disclaimer: This post is not a recommendation to either buy or sell. Please consult your investment advisor.