We're initiating our credit rating for GlaxoSmithKline at AA-, one notch lower than most of the firm's large pharmaceutical peers. This differential reflects Glaxo's higher relative leverage, especially compared with firms that haven't completed a transformational acquisition recently. At the end of March, Glaxo held £7.2 billion in cash compared with £16.2 billion in debt. Total debt/EBITDA of 1.5 and midteen interest coverage ratios put Glaxo near the bottom of its peers. Also, its practice of paying out substantial dividends (dividends paid out during the past three years averaged just over half of free cash flow) could constrict its ability to repay debtholders. While we don't anticipate any refinancing risks at Glaxo within the next five years because of those activities, the firm's cash flow cushion ranks among the worst of its peers.
Our rating mostly reflects our positive view of Glaxo's business quality, though, which keeps its creditworthiness high. Glaxo boasts a wide moat in the attractive pharmaceutical industry. In the highly uncertain race of pharmaceutical development, manufacturing, and sales, the company's vast resources have created multiple opportunities for new blockbuster drugs. Glaxo's deep pockets are funding more than 10 major drugs in Phase III development. Further, the company has compiled more than 130 early-stage compounds in its pipeline. Also, the recently approved cancer drug Tykerb and bleeding disorder treatment Promacta should become blockbusters, in our opinion. Glaxo's going to need drugs like those to offset patent expirations, though, including a key expiration related to its biggest revenue generator Advair in 2010. While expirations like that will put pressure on Glaxo to execute, we expect cash flow to remain strong, similar to the past three years when it generated more than £5 billion in free cash flow on average.
Fair Value Estimate: 1,626p ¦ Uncertainty Rating: Medium ¦ Economic Moat: Wide
Thesis (by Damien Conover, CFA, last updated 15/03/10)
As one of the word's largest pharmaceutical companies, GlaxoSmithKline has used its vast resources to create the next generation of medicines. The company's innovative new product lineup and expansive list of patent-protected drugs create a wide economic moat, in our opinion. Glaxo's diverse operating platform should more than offset patent expirations for respiratory drug Advair and antiviral drug Valtrex.
Glaxo's size ranks in the top tier of the pharmaceutical industry. This enormous bulk creates economies of scale in developing new drugs. In the highly uncertain race to drug development, the company's vast resources have created multiple opportunities for new blockbuster drugs. Glaxo's deep pockets have funded more than 20 major drugs in Phase III development. Further, the company has compiled more than 130 early-stage compounds in its pipeline. Also, the recently approved cancer drug Tykerb and bleeding disorder treatment Promacta should go on to develop into blockbusters.
The magnitude of the company's reach is further evidenced by drugs that span all major therapeutic classes, as well as vaccines and consumer goods. The diverse platform insulates the company from problems with any single product. For example, in mid-2007, a dip in Avandia sales because of concerns about side effects had no material impact on company projections. Additionally, the highest revenue generator, Advair, represents less than 18% of total revenue. While we expect generic Advair competition in late 2010, we believe growth from other products will offset the lost Advair sales.
The firm's consumer and vaccine segments round out its growth opportunities. Using the consumer business as a stepping stone into developing countries, the company is entrenching itself in these high-growth markets. The vaccine business should drive strong returns as fewer competitors remain in the market, increasing the pricing power for new vaccines. Specifically, the company's new human papillomavirus vaccine, Cervarix, holds blockbuster potential and should compete well against Merck's Gardasil on the basis of price.
We believe the diverse platform of Glaxo's operations can withstand generic competition and declining Avandia sales. Additionally, the firm should generate close to £7 billion annually in operating cash flow, which could be used for external growth opportunities.
Valuation
Our fair value estimate is 1,626p per share based on an exchange rate of 66.4p per US dollar as of March 15. We forecast average annual sales growth of 2% over the next 10 years, with new products offsetting products lost to generic competition. We expect operating margins in the low 30s to stay consistent over that period. We estimate a 9.5% cost of equity, in line with that of other major pharmaceutical companies. We ran two scenarios addressing Avandia and the company's pipeline. Although the side effect concerns about Avandia have caught the media headlines, the fair value of the company would be reduced by only 33p per share if Avandia sales dropped to zero in 2009. Of bigger concern to our valuation is new pipeline products. If we were to decrease our sales estimate for pipeline products by 30%, our fair value estimate would fall by 133p. The minor changes in fair value in response to severe scenarios are evidence of the strength of the company's diverse operations.
Risk
Like all pharmaceutical companies, Glaxo faces risks of drug delays or nonapprovals from regulatory agencies, an increasingly aggressive generic industry, and competition in the pharmaceutical industry.
Management & Stewardship
Glaxo selected the president of its European pharmaceutical business, Andrew Witty, to succeed Jean-Pierre Garnier as CEO in June 2008. Witty's leadership in increasing sales in a cost-conscious European environment should be an asset in the United States, where cost-containment pressures are rising. Further, Witty's experience overseeing operations in Asia signals the firm's interests in expanding its presence in developing countries. Witty has shaken up senior management, bringing in top talent from competing firms and the Food and Drug Administration. We are pleased to see the split of the CEO and chairman roles. Chairman Christopher Gent brings an independent voice to the board, but not much pharmaceutical experience. We like the firm's share-ownership guidelines for senior management. The CEO must own an amount of stock equivalent to 4 times his salary, with other executives having a requirement of 2-3 times salary; options don't count under the guidelines.
Overview
Growth: New pipeline drugs should more than offset drugs lost to generic competition. We estimate average annual revenue growth of 2% over the next 10 years.
Profitability: The company benefits from the strong pricing power of branded drug products. We estimate Glaxo's attractive operating margins in the low 30s should continue over the next 10 years.
Financial Health: Glaxo generates approximately £7 billion in operating cash flow annually and closed 2009 with just under £7 billion in cash, putting it on solid financial ground.
Profile: Within the pharmaceutical industry, GlaxoSmithKline ranks second only to Pfizer in market capitalisation. The company wields its might across multiple therapeutic classes, including cardiovascular, metabolic, respiratory, neurological, and antiviral, as well as vaccines and consumer products. Prescription drug and vaccine sales account for more than 80% of total sales.
Strategy: Glaxo operates across all major therapeutic classes, as well as in the vaccine and consumer businesses. The multiple operating platforms provide more opportunities for growth and insulate the company from overdependence on any particular drug. The company has grown internally as well as through acquisitions, which will probably continue as it generates close to £7 billion in operating cash flow annually.
Bulls Say
1. Glaxo is well-positioned in developing orphan drugs, which tend to carry strong pricing power and usually face less competition.
2. Glaxo is well-positioned in the vaccine market thanks to its blockbuster potential vaccines, Cervarix for HPV and Synflorix for pneumococcal disease.
3. The consumer business line is poised for continued growth led by weight-loss product Alli, which could eventually generate several hundred million pounds in sales.
4. Glaxo does a good job of obtaining insurance coverage for its drugs--a critical step to achieve successful drug launches. Typically, the company generates more than 80% Tier II coverage in managed-care access.
5. Glaxo is one of the best-positioned pharmaceutical companies to emerging markets, which should help drive growth over the long term.
Bears Say
1. The cardiovascular side effect concerns with Avandia could escalate if the product is removed from the market, creating a Vioxx-like litigation nightmare.
2. Generic launches of Advair and Valtrex could weigh on near-term growth.
3. Cervarix and Synflorix lost the first-mover advantage to Merck and Pfizer, respectively.
4. While diverse operating platforms insulate the company from product-specific problems, this safety comes at the cost of slower growth potential.
5. In the past few years, major patent losses for antidepressant Paxil and anti-infective Augmentin have drained resources from the company.
Damien Conover, CFA is a senior equity analyst with Morningstar.
