A promising pairs trade in the drug sector

By Associate Editor David Stevenson Jul 23, 2010

David Stevenson

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Drug giant GlaxoSmithKline (LSE: GSK) is to shell out almost £1.6bn in settlement of legal issues, and it has just reported a £304m second-quarter loss.

Hardly the most obvious reason to buy the stock, you might think. But for 'pairs' traders (to read what pairs-trading is all about here) – it could present an interesting opportunity.

Why? The two top UK-listed drug makers are Glaxo and AstraZeneca (LSE: AZN). Both stocks – along with the other 'big pharma' firms worldwide – have been overshadowed for several years about how the looming 'patent cliff' will hit earnings. Now we happen to think this is all priced in, but in the meantime, investors have largely shunned the sector. Compared with the rest of the stock market, it has become just about as cheap as it's been for years.

And Glaxo has been particularly hard hit. In fact, Glaxo shareholders have seen their investment undershoot Astra by almost 60% over the last 17 years, as the chart below shows. While Astra has recently rallied to a four-year high, Glaxo has stayed in the doldrums.


Source: Bloomberg

Yet Glaxo could be on the verge of a turnaround in investors' eyes.

It's "become unrecognisable from the company that CEO Andrew Witty inherited two years ago", says James Moore in the Independent. "Gone is the emphasis on expensive research into the next blockbuster. Instead, the company is much more concerned with soaps and toothpastes, with a particular bent towards emerging markets".

But what about that second-quarter loss? Well, it's not as bad as it looks. As well as the £1.6bn settlement figure, it was driven by major US restructuring costs of £590m. Without those, the firm actually did better than last year. First-half sales rose by 7% while net cash inflow from operating activities climbed by 21%.

As Moore continues, "we'd be among the first in the queue to pick up the shares on a undervalued multiple of just 9.7 times forecast full-year earnings and dividend yield of almost 6%".

To recap, we like both these stocks. But given the sheer scale of Glaxo's underperformance, there's now a good pairs trade opportunity to sell Astra and buy Glaxo. Read more on how to do it here.

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Published in Spread betting explained | More articles by David Stevenson

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