Shares of GlaxoSmithKline (LSE: GSK) rose by 4% in early trade on Tuesday after the company said it would pay $13bn to buy the consumer healthcare business of Swiss pharma group Novartis.
This business is part of a joint venture between the two firms which was created in 2014. Glaxo currently owns a 63.5% share, while Novartis owns the remaining 36.5%. The original terms of the deal gave Novartis the right to sell its stake to Glaxo in stages between 2018 and 2035. Through buying the business outright at the first opportunity, the British firm can avoid financial uncertainty.
It all makes sense now
Today's news explains why Glaxo suddenly withdrew from the auction to buy US pharmaceutical giant Pfizer's consumer healthcare business last week. Although it was expected to win the auction, the Brentford-based firm withdrew unexpectedly on Thursday.
Chief executive Emma Walmsley must have decided that a bid for the more familiar assets on offer at Novartis made more sense.
Is the price fair?
Today's share price rise suggests that Glaxo investors are impressed by this deal. But $13bn is a lot of money, especially for a company that already has net debt of £13.2bn ($18.5bn). Is Ms Walmsley wise to splash the cash in this way?
Let's take a look at the figures. In 2017, the Novartis share of the profits from the consumer healthcare joint venture was £494m. This means that Glaxo is effectively paying around 18.5 times earnings for this acquisition.
That seems about right to me. Brands such as Panadol, Sensodyne and Nicorette helped Glaxo's consumer healthcare business generate an adjusted operating margin of 17.7% last year. The company says it expects this figure to increase to "mid-20s percentages" by 2022. So shareholders should see higher profits from this part of the group, despite average sales growth of just 4% per year since 2015.
Although the extra debt required for this deal is a potential concern, the company says it has launched a strategic review of its nutrition business, which includes Horlicks. These products generated total sales of £550m in 2017, mostly in India. Today's comments suggest to me that this business might be sold to help fund the Novartis acquisition.
Good news for shareholders
Some investors have suggested that GlaxoSmithKline should spin out its consumer healthcare business into a new company. But Ms Walmsley -- who ran the Consumer Healthcare division before becoming CEO -- has said that her preference is to keep the diverse group together.
Today's deal should help to address concerns about the performance of the consumer business, which is less profitable than the Pharmaceuticals and Vaccines divisions. By increasing the size and profit margins of Consumer Healthcare, Ms Walmsley may be able to justify a higher valuation for the whole group.
Why I'd buy today
Valuation is a key concern for shareholders, because GlaxoSmithKline's share price has fallen by about 20% over the last year.
Personally, I think this could be a buying opportunity. The recent 2017 results showed an improvement in free cash flow and a slight reduction in debt levels. The dividend was held at 80p per share, but earnings cover for this payout improved.
Looking ahead, the shares trade on 12 times forecast earnings for 2018 with a prospective yield of 6.2%. At these levels, I'd rate Glaxo stock as a long-term buy for income and growth.
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Roland Head has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.