GlaxoSmithKline (GSK) recently reported a 13% fall in its fourth quarter sales due to increased competition from generic drug producers and low H1N1 vaccine sales. You can find the relevant analyst note here and read our latest equity analysis of the firm below.
Fair Value Estimate: 1462p | Uncertainty Rating: Medium | Economic Moat: Wide
Thesis (Last Updated 11/11/10)
As one of the word's largest pharmaceutical companies, GlaxoSmithKline (GSK) 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 10 major drugs in Phase III development. Further, the company has compiled more than 100 early-stage compounds in its pipeline. 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 human papillomavirus vaccine, Cervarix, holds blockbuster potential and should compete well with 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 1,462p per share, based on an exchange rate of 62.2p per US dollar as of Nov. 10. We forecast average annual sales growth of 2% over the next ten years, with new products offsetting patent losses. We expect slight declines in operating margins over that period as the company loses patents on high-margin branded drugs. We estimate a 9.5% cost of equity, in line with the peer group. 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 34p 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 128p. The minor changes in fair value in response to severe scenarios are evidence of the company's diverse operations.
The fair value estimate for this share class is derived using a model in the firm’s reporting currency, and applying the applicable exchange rate for the share. Any differences between the fair value estimate shown in the valuation section and the fair value displayed elsewhere in this report is a function of a more recent exchange rate.
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
Financial Health: Glaxo generates about £7 billion in operating cash flow annually and closed 2009 with just under £7 billion in cash, putting it on solid financial ground.
Profile: In the pharmaceutical industry, GlaxoSmithKline ranks as one of the largest companies by 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.
Bulls Say
-- Glaxo is well positioned in developing orphan drugs, which tend to carry strong pricing power and usually face less competition.
-- Glaxo holds a strong foothold in the vaccine market thanks to its blockbuster potential vaccines, Cervarix for HPV and Synflorix for pneumococcal disease.
-- 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.
-- Glaxo does a good job of obtaining insurance coverage for its drugs--a critical step for marketing success. Typically, the company generates more than 80% Tier II coverage in managed-care access.
-- Glaxo is one of the best-positioned pharmaceutical companies to emerging markets, which should help drive growth over the long term
Bears Say
-- The cardiovascular side effect concerns with Avandia could escalate if the product is removed from the market, creating a Vioxx-like litigation nightmare.
-- Even though device patents may hold off generic Advair competition until 2017, these patents are weaker than composition of matter patents, which opens the door to generics in late 2010.
-- Cervarix and Synflorix lost the first-mover advantage to Merck and Pfizer, respectively.
-- While diverse operating platforms insulate the company from product-specific problems, this safety comes at the cost of slower growth potential.
-- In the past few years, major patent losses for antidepressant Paxil and anti-infective Augmentin have drained resources from the company
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