I returned to my computer after the market was closed to see reasonably positive headlines on the business news sites accompanying GSK's 3rd quarter results. Expecting to see the share price little change I was amazed to see it had fallen almost 6%! For a mega cap stock which would fit into Ben Hobson's definition of low beta this is an extreme reaction and represents a bigger fall than Unilever and Reckitts warned on sales last week. GSK said that sales and profits were on track so what has gone wrong or has the market over-reacted as it definitely very skittish at the moment. Witness the punitive reaction to any earnings miss in small cap even when they are quite modest shortfalls.

As the trading, sales and profits are largely in line with expectations if not slightly better I think the market is worried about the cash flow and dividends. Like the major oil companies this is one of the most widely held income shares in the UK and any threat to the dividend payout will panic the market. The new CEO is obviously aware of the issue as she says that 'cash flow generation continues to improve' but she is also trying to rebase the business by focusing more on its drug portfolio and becoming less of a sprawling conglomerate.

Recently, Neil Woodford who had been a long term holder sold his holding citing the threat to the dividend as well as the refusal of the company to demerge its business so it could realise value to shareholders by becoming more than the sum of its parts. Given his recent track record his sale could be a good contrary indicator but it does underline the market's thinking on the stock. The management is caught between a rock and a hard place. To improve the quality and success of the drug portfolio, as the new CEO wants, it will have to invest heavily in R&D but by doing it will eat into valuable free cash flow and threaten the dividend. By not investing the company will fall behind its competition and rapidly become even more ex-growth.

The FCF in the first 9 months will require strong generation in the final quarter to cover the dividend but the payment appears safe for the time being based on the management comments and trading performance…

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