Kahn Brothers, headed by Irving Kahn (Trades, Portfolio) (108 years old), has established a new stake in GlaxoSmithKline (GSK, Financial).
Kahn Brothers was founded in 1978 by Irving Kahn (Trades, Portfolio), who got his start at value investing in the 1930s while serving as Benjamin Graham's teaching assistant at Columbia University. The firm invests in unpopular and undervalued securities that have a margin of safety and attractive prospects for the future returns.
The new stake reported November 11, 2014 in a 13f filing reflects a new position of 51,000 shares. This new position only represents 0.38% of the overall portfolio.
GlaskoSmithKline creates, discovers, develops, manufactures and markets pharma products such as vaccines, OTC medicines and health-related consumer products. The company’s shares are down more than 7% over the past 12 months and closed at $45.96 per share on Monday, near a 52-week low of $41.91.
Quarterly financial results
For its most recent fiscal third quarter, GlaxoSmithKline reported revenue of $9.077 billion, compared to 10,483 billion in the same quarter a year ago. Net Earnings were $645 million (or $0.26 per diluted share), compared to $1.5 billion (or $ 0.64 per diluted share) per diluted share in the same quarter a year ago.
CEO Sir Andrew Witty expects full year 2014 EPS to be similar to 2013. They are exploring an IPO of ViiV Healthcare to enhance flexibility and visibility within the group. They are also executing a new restructuring program to refocus the global pharma business with a relevant cost base. This is in response to the divestment of the oncology products and the change in the US market dynamics regarding the respiratory industry.
GlaxoSmithKline’s 10-year revenue and earnings history
Cash on GlaxoSmithKline’s balance sheet totaled $6.5 billion as of 3rd quarter 2014.
Current perception
In ascertaining the current perception of GlaxoSmithKline’s stock, we use a Reverse Discounted Cash Flow calculation to help us see how the market is currently evaluating and pricing a stock.
The purpose is to ascertain a growth rate the market is giving to the current stock price.
This calculation helps us determine whether we have an edge in our potential investment. It's a frame of reference that allows us to determine whether the expected growth rate from the market is realistic (or have an edge).
If we believe the market is pricing growth too low (or incorrectly) we may have an edge or an opportunity we can exploit against the market.
We use most recent annual owner earnings of $12.314 billion, 2% terminal growth and a discount rate of 9%.
As you can see, these calculations tell us that the market thinks GlaxoSmithKline will grow earnings at a rate of 1.5% a year.
A dose of reality
In reality, here is a table of various historical multi-year growth rates. By comparing these growth rates to the market’s “implied” growth rate, we can now compare what the market is pricing in today versus historical growth rates.
Comparing the market’s “implied” growth of 1.5% going forward, to the past growth rates above you can start to ask yourself if that “implied” growth rate is likely.
As you can see, there is no real difference between perception and reality. The market seems to be in sync with the implied growth, at least compared to historical growth rates.
But alas…
The investor of today doesn’t profit from yesterday’s growth (or lack thereof).
In GlaxoSmithKline’s case, there is reason to believe there could be future impediments to growth and a potential for, at the very least, a cyclical top in revenue and earnings.
GlaxoSmithKline has been successful with the recent development of next gen respiratory drugs which have recently come to market. However, the company continues to face margin compression from health care payors.
Will GlaxoSmithKline be able to exceed expectations from the market pricing in implied growth of 1.5% in earnings going forward?
Will management be able to execute going forward?
Will the environment get better for margins?
These are the tough questions that must be answered in considering whether there is potential opportunity for investment in GalxoSmithKline.
Just for arguments sake…let’s say the business is able to execute going forward and is able to grow earnings at a rate of 5%.
What kind of valuation are we looking at in this scenario?
Valuation
We use last year's owner earnings $12.314 billion in our calculation of Discounted Cash Flow
(We are aware this may be high).
Other inputs for discounted cash flow calculation: growth of 5% for 10 years (with decay rate in years 4-10), terminal growth rate of 2%, and discount rate of 10%.
Conclusion
By many traditional metrics GlaxoSmithKline is fairly valued at current levels.
What we have is a business that currently trades at a P/E ratio of 16.8, P/B of 13.70, P/FCF of 20, EV/EBIT of 15.69.
GlaxoSmithKline also sports a very nice dividend yield of 5.8%.
So we have a business that seems fair-to-overvalued with the market pricing in current trends.
Although, numerous catalysts could exist in the form of share repurchases and increased dividend payments, GlaxoSmithKline seems to be moderately valued at current levels.
There doesn’t seem to be a great deal of difference between perception and reality.
It appears there is no real edge here, and therefore no great opportunity.
