MARKET COMMENT
GlaxoSmithKline Is Cheap

By David Kuo (TMFDragon)
July 24, 2002

GlaxoSmithKline (LSE: GSK) faces quite an uphill battle if it is to return to mid double-digit earnings growth. The drug maker has been beset with problems over its patents for the antibiotic Augmentin and also by legal wranglings over its antidepressant Paxil. Both these issues could affect the company's top line revenues and in turn impinge on its bottom line profit. GSK reckons that, as a result of generic competition for Augmentin, earnings growth would now be about 10% in 2002. That is some way off the mid-teens growth that the company indicated at the time of its full-year results in February. But these things happen in the investing world. Companies can, and do, lower earnings guidance as a result of unforeseen events. GlaxoSmithKline believed in February that its patents for Augmentin were valid but the courts saw otherwise later on in the year.

GlaxoSmithKline is keen to pursue the patent cases through the courts in an effort to protect its intellectual property. However, there is no guarantee that anything beneficial will come from these legal squabbles. What is more important now is not whether GSK can win its court battles against the generic drug makers but instead what the company is doing to drive its business forward. Generic drugmakers feed off the drug developers and this has always been a feature of the drug industry. Patents have a given lifetime and during the period when drug are protected by patents drug developers can make a substantial return on their investment. For this reason GSK's competitive advantage lies in its laboratories and not in the courtroom.

There are a number of ways that GSK can improve its competitive advantage. One obvious method would be to participate in the consolidation that is going on within the industry. There has been some talk that Bristol-Myers Squibb (NYSE: BMY) and Eli Lilly (LSE: LLY) are on the company's radar screen, though the company denies this. Merger rumours started to do the rounds again shortly after the announced merger of Pfizer (NYSE: PFE) and Pharmacia (LSE: PHA). Another major pharmaceutical merger cannot be ruled out since this is a well-accepted generic strategy for companies to defend their positions in a maturing market.

Whilst mergers are always an interesting side issue, financial results are what really matter. Today GSK posted second quarter numbers that showed pre-tax profit improved 7% to 1.8b. Revenues were also higher, up 6% to £5.4b. The figures reported today do not reflect the effects of competition from generic Augmentin just yet. This is not likely to be in evidence until next quarter after Novartis launches its own version of the antibiotic. The company's said its new medication for asthma, Advair, is doing well with sales more than doubling over the same period last year. The late stage drug pipeline looks healthy with vardenafil, a treatment for erectile dysfunction due to be launched next year. Free cash flow in the quarter was £1.6b and the interim dividend has been maintained at 9p.

Whether you value the company on the basis of the price-to-earnings ratio, which currently stands at 13 times, or on its dividend yield of 3.7% the shares do not look that expensive. Whether the shares will get any cheaper is an entirely different issue but, of course, no one will be ringing a bell to let you know you that the shares have bottomed.

The writer has a beneficial interests in GlaxoSmithKline.