Haleon (HLN LN) – A Haleon Cure

Introduction

On Monday 18 July trading in shares in Haleon (HLN) will commence on the London Stock Exchange (ADRs will also be listed on the NYSE). This marks the culmination of a long-running effort to separate GSK’s Consumer Healthcare business from the rest of GSK. The IPO was nearly derailed by third party bid interest in the business, which sets a useful reference point in terms of valuation. In this piece I’ll discuss what Haleon offers to investors, its background, prospects and conclude with some thoughts on valuation.

Background to the IPO

On 23 June 2021 GSK confirmed its intention to separate its consumer healthcare business into an independent listed company. The separation will be effected by way of a spin-out of at least 80% of GSK’s 68% holding in the business to GSK shareholders, who will receive the same number of shares in Haleon as they currently hold in GSK. The other 32% is currently held by Pfizer. GSK shareholders approved the demerger at an EGM on 6 July. Prior to the IPO a dividend of £11bn is to be paid by Haleon to GSK and Pfizer.

Following the demerger, the share register will look like this: 54.5% held by GSK shareholders; 6% held by GSK directly; 32% by Pfizer and 7.5% will be held by Scottish limited partnerships (SLPs) linked to GSK’s UK pension schemes. GSK says that it “intends to monetise its holding in Haleon in a disciplined manner” and, in relation to the SLPs, GSK will also have the ability to monetise these, although there is an implicit hurdle to a sale in that proceeds up to £1.08bn are ring-fenced to fund pension deficits. For its part, “Pfizer intends to exit its 32% ownership interest in Haleon in a disciplined manner”. So at least 38% of the share register will be ‘loose’, with the prospect of a further 7.5% to come from the SLPs should GSK decide to sell, plus whichever of the 54.5% of current GSK shareholders are disinclined to hold Haleon within their portfolios.

What is Haleon?

To quote GSK: “Haleon is a new world-leader in consumer healthcare with a clear strategy to outperform and run a responsible business. For prospective investors, it will offer an exceptional and focused portfolio of category-leading brands with an attractive footprint and competitive capabilities; a highly attractive financial profile of above market, medium-term annual organic revenue growth of 4 to 6%, combined with sustainable moderate, adjusted margin expansion on a constant currency basis, with strong cash generation and conversion”.

Haleon has five product categories – Oral Health (28.5% of 2021 revenues); Pain Relief (23.4%); Digestive Health & Other (20.4%); Vitamins, Minerals & Supplements, or VMS (15.7%); and Respiratory Health (11.9%).

It has nine ‘power brands’ – (i) Sensodyne (the world’s leading sensitivity toothpaste and #2 overall toothpaste); Polident (the world’s leading denture care brand); parodontax (one of the world’s fastest growing toothpaste brands); Voltaren (the world’s leading topical pain relief brand); Advil (the world’s #2 systemic pain relief brand); Panadol (the leading systemic pain relief brand in the world ex-US); Theraflu (#2 in Europe and #3 in the US systemic cold and flu brand); Otrivin (the world’s leading nasal decongestant); and Centrum (the world’s leading multivitamin). Other brands include Nicorette, ChapStick and Panadol (Haleon’s manufacturing plant in Dungarvan in Ireland produces six billion Panadol tablets annually!).

Management rationalised the portfolio over 2019-21, selling “approximately 50 non-strategic and growth-dilutive OTC and skincare assets to raise £1.1bn of net proceeds”. As a result of these disposals, the share of revenue accounted for by the nine power brands has grown from 44% in 2015 to 58% in 2021.

Haleon has also streamlined its manufacturing (from 41 locations in 2015 to 24 in 2022), distribution (c.200 warehouses in 2015, 90 in 2022) and R&D (from 9 centres in 2015 to 4 in 2022) footprint.

Haleon has a number 1 or number 2 OTC/VMS presence in countries representing over 70% of the global OTC/VMS markets.

Financial information provided in the prospectus shows some very encouraging trends. Revenue rose from £8.5bn in 2019 to £9.5bn in 2021. Gross margins expanded from 57% in 2019 to 62% last year. And the Group has a strong cash generation profile – net cash from operations was £1.4bn in each of the past two years, representing more than 80% EBIT conversion. Unaudited Q1 (to end-March) 2022 results show continued strong top-line growth (revenues +14% y/y to £2.6bn) and operating leverage, with EBIT rising 34% y/y to £466m. Net assets, adjusting for minority interests, were £26.7bn at end-March, or £15.6bn pro-forma for the pre-IPO dividend payable to Pfizer and GSK. A trading update is due to be released ahead of the publication of HY results in September.

In terms of governance, Haleon will be led by CEO Brian McNamara (CEO of GSK Consumer Healthcare since 2016); CFO Tobias Hestler (CFO of GSK Consumer Healthcare since 2017); and Chairman Sir Dave Lewis (former Tesco CEO).

M&A History

This IPO might never have seen the light of day. In January it emerged that Unilever had made a £50bn approach for the business, but GSK rejected its overtures. In May it was reported that Nestle had considered teaming up with Reckitt for a joint bid for Haleon, although nothing came of this. Apart from trade interest, I suspect that PE firms would also be interested in Haleon given its strong brands and cash generation. These qualities (brands and cash flow) are supportive in terms of valuation – HLN would be a lovely fit for some of its largest peers.  

Prospects

Haleon estimates that its addressable market was worth “over £160bn” in 2021, growing at 3-4% p.a., giving HLN a blended market share of nearly 6%. This leaves plenty of room for expansion both organically and through M&A. There are clear structural drivers for the OTC/VMS market, namely: (i) ageing populations; (ii) expanding middle class populations; (iii) growing self-care; and (iv) premiumisation. Presumably the future will see a higher weighting to digital sales, which is a further tailwind to margins – the prospectus notes that online delivered c.8% of Haleon’s revenue in 2021, up from c.4% in 2019.  

Haleon guides to medium-term organic revenue growth of 4-6% p.a., ahead of the market average. The Group delivered organic (LFL) volume growth of 2.8% in 2020 and 3.8% in 2021 but this growth rate is expected to quicken post-COVID-19.

As discussed above, Haleon management has made impressive progress in consolidating its manufacturing, distribution and R&D footprints, which surely will lead to strong economies of scale arising from top-line progression. The prospectus notes that around a fifth of the £600m of cost synergies from the Pfizer-GSK consumer health merger will be delivered this year, presumably providing a tailwind to earnings.

As part of the pre-separation dividend exercise, GSK Consumer Healthcare issued £10bn of bonds with coupons ranging from 1.25-4.00%. Finance costs (just £19m in 2021) will ratchet higher for 2022 and beyond, reflecting this step-change in net debt.

Haleon has a target dividend range of 30-50% of net earnings, although initial distributions are guided to the lower end of this range.

Valuation thoughts

In the opening section I noted that at least 38% (i.e. Pfizer and GSK’s shareholdings) and potentially up to 45.5% (adding in the SLPs) of the initial share register was going to be ‘loose’. It’s also likely that some of the 54.5% of the rest of the share register (shares held by current GSK shareholders) may also be offered for sale if they don’t wish to retain their stake in the Group. An orderly marketing agreement has been struck between GSK, Pfizer and the SLPs where they will notify each other of planned disposals. A lock-up deed has been entered into by GSK, Pfizer and SLPs meaning that they cannot sell any shares until the earlier of (i) 10 November 2022; or (ii) the release by HLN of a trading update for Q3 (i.e. 3 months to end-September 2022). Nonetheless, with the lock-up expiring in (say) 4 months, this is likely to be viewed by investors as a technical overhang on the stock.

We don’t yet know what valuation HLN will come to the market at. But we do know a few things. Firstly, the pro-forma (for the pre-IPO dividend) shareholders’ funds at end-March 2022 were £15.6bn. The SLPs holding 7.5% are linked to £1.08bn of pension liabilities, implying an absolute minimum (bear case) valuation of £14.4bn on admission. And then we know that Unilever was prepared to pay up to £50bn for the business, so we can view that as a bull case valuation. It would seem reasonable to assume that GSK and Pfizer will seek an enterprise value that is as close to the bull case as possible to avoid shareholder disquiet regarding the rejected Unilever approach.

I built a basic HLN model which assumes topline growth of 4.0% p.a. (the lower end of management guidance); broadly stable margins (so, giving no credit for the operating leverage noted above); a step-up in finance costs to reflect the dividend and a 25% tax rate. I’ve also assumed 9.2bn shares outstanding (as set out in the prospectus). My model seems to be more than a little conservative, for example, it gives the net debt / EBITDA multiple as 4.2x at end-2024, whereas management guides <3x. Nonetheless, I’m happy to err on the side of caution. The model produces long-term average ROE of 6.0%, and plugging in growth (g) of 4.0% (in-line with the low end of management guidance for the top-line) and an assumed cost of equity of 5.0% (which seems reasonable for a globally significant portfolio of household name brands) coincidentally suggests a 2.0x net asset multiple is appropriate. This produces an equity value of £32.8bn to which we add (say) £11bn for net debt, producing an enterprise value of c.£44bn. This is not too far off the £50bn that Unilever offered for the Haleon business – and it is quite clear that Unilever’s bid would have reflected the synergies it expected to extract from combining the Haleon assets with its own operations. Another consideration is that stock markets have become choppier since Unilever reached out to GSK, which makes a £50bn initial enterprise value (market cap + net debt) look far less likely.

As an aside, is a 6.0% ROE too low? Over the past three years Haleon has only produced average ROE of 4.0%. While the dividend payment knocks £11bn off the denominator, the interest costs on the £11bn of borrowings to finance the dividend will also pare the numerator. Interest costs may rise over the coming years as Haleon refinances borrowings, although this may be offset depending on the pace of deleveraging. There is also upside risk from operating leverage if the top-line grows in line with management expectations, although restructuring / IPO costs may dampen performance in the short term. If my ROE of 6.0% proves to be too low then the equity value of £32.8bn should be nudged up, although I’m happy to err on the side of caution given the uncertain macro backdrop.

An equity value of £32.8bn equates to £3.55 a share, on the basis of the 9bn shares quoted in the prospectus (if the share count ultimately proves to be different, then disregard the £3.55 and focus on the absolute equity value). On my very basic model, this suggests (emphasis) a forward (2023) PE of 33x and 1% dividend yield – although it should be stressed that this is a crude model with simplified assumptions based off what’s in the prospectus, as opposed to a sophisticated model that’s been run past the company for their comment. Nonetheless, valuing a portfolio of power brands growing at 4-6% p.a. at 33x next year’s earnings doesn’t seem excessive to me. And, of course, GSK argued that a higher enterprise valuation (the Unilever bid) wasn’t enough for it to sell.

In the short term, the overhang from (at a minimum) Pfizer and GSK stock will likely weigh on the share price, as indeed will a more uncertain macro (and associated market) backdrop. I think that will be reflected in the price that GSK and Pfizer list the business at, while a share sale programme involving one or both of those two will likely hold back the shares until their combined stake falls to a more modest level. This could create a decent opportunity to top-up the position I’ll inherit by virtue of my GSK shareholding in due course. On the other hand, recent events show that the emergence of another takeover bid for HLN cannot be ruled out, and any potential acquirer may run the rule over all of Pfizer’s stake to put themselves in the driving seat from an M&A standpoint. Bringing all of that together, my instinct is that the way to play this one is to hold on to my ‘inherited’ (former GSK) shares in HLN when it lists, and look to top up the position in due course if large shareholder sell-downs weigh on the share price after the expiry of the lock-up arrangements.  

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