GLAXF - Clouds Are Gathering (Again) For GSK

• GSK was having a turnaround year, with drugs pipeline strong and H1 results impressive.
• Zantac lawsuits are presenting a significant risk to investing in GSK.
• Haleon's public offering was underwhelming.

A few weeks ago, GSK’s ( OTCPK:GLAXF , [[GSK]]) CEO, Emma Walmsley, must have been feeling that her fortunes are finally looking brighter. After years of being embattled by investors for the lackluster financial and share price performance of GSK, she must have been feeling that this year is the turning point for her vindication. The main key anchor of her strategy, of spinning off the consumer healthcare business, has finally been completed last month. And, shortly afterwards, Ms. Walmsley announced bullish H1 earnings results and raised the outlook for the year. Here comes the sun finally, right? Wrong.

H1 results were indeed positive..

GSK presented H1 results on the 27 ^th of July 2022, noting in its presentation that 2022 is a ‘landmark year’. Mr. Walmsley and her colleagues in top management had all the right to boost. Turnover was up by a convincing 12%, adjusted operating profit by a very impressive 27%. Growth was strong across the board; even boring vaccines grew by 17%. Full-year 2022 guidance was raised for turnover growth of 6-8%, up from 5-7% when Q1 results were reported, and adjusted operating profits are expected to grow by 13-15%, up from 12-14%. These results would make any investor delighted and would have assured investors that the already generous dividend yield of around 5% was only headed upwards. But, in effect, the dividend yield did head upwards fast over the past week, not because GSK pumped up its dividend payments, but because GSK’s share price has been in a downward spiral.

Business progress significant across the board

GSK keeps building its drugs pipeline – now that management is free from the ‘distraction’ of the consumer healthcare division. The company increased its pipeline of drugs under development from 64 at the end of Q1 to 68, 21 of which are in pivotal studies. This compares favorably to the pipeline a year ago when GSK had a pipeline of 59 vaccines and medicines, and provides assurance that business is set to continue growing.

But Zantac saga is a significant risk

The once blockbuster stress-relief drug of GSK is facing increasingly significant lawsuits in the United States. While the lawsuits have been rolling on for a while, analyst reports by Morgan Stanley and other banks were published over the past days, highlighting significant litigation risks. Morgan Stanley estimated that damages could reach up to USD 45 billion, out of which around 60% would be charged to GSK – about a third of GSK’s market cap, and five times its net income in 2021. According to Bloomberg , Zantac was taken off the market in 2019 after the US Food and Drugs Administration indicated that then medicine indeed can create chemicals that can lead to cancer. This is significant and would counteract the claims of GSK and its partner in Zantac, Sanofi (SNY), that scientific evidence refutes the claim. The Zantac case will likely create an overhang for the share price of both companies, and will, rightly, scare off investors until the case is concluded. Despite the recent sell-off, it will be very difficult for investors to assess if the knife will keep falling, and what would make GSK’s valuation attractive enough compared to peers, given the hanging risks.

Was the listing of Haleon the best option for investors?

The recent listing of GSK’s consumer healthcare business, Haleon, was underwhelming – to say the least. It is not the first time (and unlikely to be the last) when management of a business rejects generous acquisition bids, due to unrealistic expectations that their assets are worth unlimited value if they go public. It is the same story repeated over and over again in the business world. We see it with both small entrepreneurs as well as with large multinationals such as GSK. I am even tempted to find a scientific lingo to describe it, such as the ‘fallacy of overestimating self-value’. In short, entrepreneurs, as well as CEOs and board of large groups, reject bid offers outright out of several reasons; the first of which is an emotional attachment to their business, and thus rejecting that their business is in the hands of another owner, after all the sweat and tears the entrepreneurs spent over many years in building that business. Given that Ms. Walmsley was a life-long consumer healthcare executive and was heading GSK’s consumer healthcare business before becoming CEO of the whole group, it is tempting to guess that she did have a strong say in the rejection of Unilever’s (UL) (generous) consecutive bids over the past ten months.

Haleon, the consumer healthcare business, was listed on the 18 ^th of July 2022, its share price has dropped by a fifth. In barely three weeks. Enterprise Value, including debt, is GBP 35 billion – a third lower than Unilever’s raised USD 50 billion earlier this year. And Haleon was on-loaded with a hefty portion of GSK’s debt, GBP 10 billion to be exact, which leaves Haleon’s leverage at an enormous level of 7.7x financial debt to operating cash flow. While Haleon is fundamentally a good business, the pitch of GSK’s management that Haleon will reach for the stars in value might have been too unrealistic. Back in January, GSK announced that it had rejected three bids from Unilever because Haleon offered “Superior growth and highly attractive financial profile” while Unilever’s bids, which are a third higher than Haleon’s EV today, “fundamentally undervalued the Consumer Healthcare business and its future prospects.” It is an overstatement, to say the least, that 7.7x net debt to operating cash flow represents a “highly attractive financial profile”. Haleon would need to work hard in the years to come on reducing its leverage, so that this legacy leverage does not distract from the other good fundamentals of the business, and so that Haleon would have sufficient financial capacity to invest in growth and in shareholder returns.

What could have been indeed a “landmark” year for GSK is turning into a challenging year. GSK has overcome many other challenges in the past, and it is likely to exceed those ones as well. But for now, clouds will overshadow the otherwise great progress that has been happening on the operational side.

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