4 Reasons This Hated Pharma Stock is a Buy

Temporary setbacks at a company can often create profit opportunities for patient investors.

It's hard to believe BP (NYSE: BP) was caught in the middle of an environmental disaster just two years ago, responsible for an estimated 200 million gallons of oil dumped into the Gulf of Mexico. Burdened by cleanup costs and a public-relations nightmare, BP watched their stock downfall to the $20s range. Fast forward to 2012 and the company is now trading in the low $40s after reporting profits of $25.6 billion in 2011.

Investors lucky enough to capitalize on this opportunity experienced a 50% gain as the stock continues to grow. But let me tell you about another company experiencing a setback, but which I think could face a similar turnaround. 

 

U.K.-based GlaxoSmithKline (NYSE: GSK), the world's second largest pharmaceutical manufacturer, has been charged with marketing two popular drugs -- anti-depressants Paxil and Wellbutrin -- for unapproved uses and because it failed to report important safety data about a third drug (diabetes drug Avandia) to the U.S. Food and Drug Administration (FDA). Glaxo agreed to pay $3 billion in early July to settle criminal and civil charges brought by the U.S. Justice Department, the largest fine ever levied against a drug company.

Even for a company with a $113 billion market value like Glaxo, $3 billion is a huge hit to earnings and the taint on Glaxo's reputation could last years. In the days following the announcement, Glaxo's shares lost 4% and some analysts anticipate a further downward slide.

Despite this setback, Glaxo remains an attractive holding for income investors and any further share price slide just makes the stock even more appealing.

Here are four reasons why I think this stock is particularly attractive now…  

1. Glaxo has an industry-leading pipeline of new drugs.

Glaxo has 26 major drugs and vaccines in late-stage development, more than any other pharmaceutical company. Three years ago, Glaxo committed to improving its research and development (R&D) productivity and the progress since then has been impressive.

So far this year, Glaxo has secured FDA approval of a neuralgia drug and a combination vaccine for meningitis and Meningococcal disease. In addition, Glaxo has submitted six new drugs for FDA approval this year, including treatments for asthma and chronic obstructive pulmonary disease, sarcoma, hepatitis C, atherosclerosis and melanoma. Income contribution from new drugs has more than doubled in three years from 5% of sales in 2009 to 11% in 2011. Analysts expect new drugs to drive 28% growth in per-share earnings this year and 7% growth next year.

2. Glaxo is consistently more profitable than its peers.

Glaxo's five-year average operating margin is 27% and well above competitor average margins of 16%. Glaxo is also improving profitability through greater efficiency. In the past 12 months, the company's operating margin has risen to 31%, or roughly three times the 12% operating margin of industry peers.

Glaxo's 12-month return on assets (ROA) is 12.6% and nearly twice the 6% ROA posted by competitors Merck (NYSE: MRK) and Pfizer (NYSE: PFE) during the same period. In addition, even taking into account the $3 billion fine, ratings agency Moody's has given Glaxo's balance sheet "A1" (stable) grade. The company is also bargain-priced at the moment, with a price-to-earnings (P/E) ratio of  15 , which is below the industry average P/E of 16 and Glaxo's five-year average P/E of 26.  

3. Glaxo delivers consistent, safe dividend growth.

Glaxo generates enough cash flow to cover the dividend twice. The company has $9.1 billion in available cash and produced cash flow from operations exceeding $9.8 billion in the past 12 months. That is more than enough to cover $5.5 billion of annual dividend payments, with plenty left over for dividend increases, acquisitions and share repurchases. The company has grown its dividend on average 8% in each of the past five years and raised payments another 6% in April to a $2.20 annualized rate that yields about 4.7%.

Unlike other European companies, Glaxo pays quarterly dividends and there is no tax withholding. The only difference from U.S. dividend payers is that the amounts vary slightly, but in a predictable way. Glaxo pays a slightly larger dividend in the first and fourth quarters of the year.  

Glaxo is also using its strong cash flow to make more share repurchases this year. The company targets $3 billion worth of share repurchases in 2012. Buying back stock further increases the safety of the dividend and enhances future earnings-per-share growth.  

4. A major new acquisition could create synergies and broaden the pipeline.

In mid-July, Glaxo announced plans to acquire Human Genome Sciences (Nasdaq: HGSI) for $3.6 billion. Through this purchase, Glaxo gains full ownership of three potential blockbuster drugs, including Benlysta (an FDA-approved treatment for lupus), Darapladib (for cardiovascular disease) and Albiglutide (for diabetes). Glaxo had partnered with Human Genome Sciences on the development of these drugs. The acquisition price appears reasonable given analyst estimates that Benlysta by itself could generate peak sales exceeding $4 billion. Glaxo also expects to achieve at least $200 million in cost synergies by combining the businesses and adds that the deal will positively affect earnings per share next year.

Risks to consider: By making one large settlement, Glaxo resolves criminal charges that would have resulted in negative publicity for years to come. The company also eliminates what would have been an unknown cost burden holding back the share price. There are some fears that these charges are just the tip of the iceberg and indicative of broader mismanagement issues, but I don't think that is the case. All of the alleged misdeeds occurred during the tenure of the previous CEO (2000-08) and current CEO Andrew Witty has been recognized for his honesty and forthright approach to settling the charges.