(*Underlying)
(**Nine months to Sept 2003)

The pharmaceutical industry possesses many attractive features for the long-term investor. For a start, demand for medication is unlikely to decline. They'll always be people falling ill and requiring treatment. What's more, in subdued economic times like the present, people rarely cut back on their pills and medicines. Repeat prescriptions also go a long way to underpinning the industry's steady income stream. In addition, aging populations, at least in first-world countries, bolster the general growth prospects of all pharmaceutical businesses.

In 2002, total pharmaceutical sales woldwide increased by 11% to £268b, after growing 9%, 11% and 12% in 1999, 2000 and 2001 respectively. The US remains the most important market. During what was a tough time for the American economy, industry sales went up from £78b in 1999 to £126b in 2002.

Plenty of ailments still require attention. For instance, cancer, HIV, obesity and mental disorders remain areas for further exploration and provide plenty of scope for new, lucrative treatments. Human bacteria have a habit of evolving over time as well, again creating demand for new products.

One major competitive advantage enjoyed by GSK is the patent. After developing a new treatment, patent protection restricts competition and allows industry participants plenty of scope for premium pricing. Another important barrier to entry is the enormous amounts of capital required to develop a new treatment, jump over all the regulatory hurdles and fund an effective salesforce. As many biotech punters know, start-ups hoping to produce the next wonderdrug often run out of cash beforehand. It's fair to say the best-selling treatments of the future will almost certainly be launched by big-spending industry behemoths such as GSK.

Patent problems

The downside to GSK centres on generic substitutes. When a high-flying product sees its patent expire or invalidated by a courtroom, sales dry up quickly. GSK's Augmentin, a 'broad-spectrum antibiotic', is a good example. In 2002, a US judge found various patents relating to the treatment invalid, while a recent appeal also went against GSK. US competitors launched their generic alternatives during the third quarter of 2002 and Augmentin revenues slumped:

GSK's strategy with Augmentin (and other treatments coming to patent expiry) is simple: release new versions with updated patents and encourage as many people as possible to switch before the competition gets a foothold. Some 35% of all Augmentin-type prescriptions are now of GSK's newer ES and XR variety. But their revenue contribution is a shadow of what the old product could generate pre-generics. Indeed, it remains to be seen whether legal challenges against the enhanced versions will emerge.

Another treatment under fire is Seroxat (or Paxil as it is called in the US), an anti-depressant and until recently GSK's biggest-selling product. Following protracted legal battles, generic competition in the US started during September 2003. Latest figures show the generics have garnered 72% of all Paxil-type prescriptions. In the nine months to September 2003, US Paxil revenues represented 6.4% (£1b) of group turnover and this figure will reduce sharply from Q4 2003 onwards.

The cases concerning Paxil rumble on, with GSK pursuing litigation against other alleged breaches of intellectual property. Nevertheless, GSK has launched an upgraded Paxil CR treatment to try and keep one step ahead of the copycats.

It's worth noting too that Wellbutin, an anti-depressant, and Zyban, a treatment for smoking addiction, are also at the centre of legal contests. In 2002, a rival generic product was ruled not to have infringed a GSK patent that covers both remedies (and expires in 2013). Again, the case goes to appeal but as yet, there's no imminent sign of a generic threat to either treatment.

Sales under threat

The next table puts the expiry and legal threats to GSK's pharmaceutical patents into perspective (the expiry date used for the European Union is that applicable to most European countries):

In total, some 24% of total group sales are in danger of short-term patent expiries or unfavourable legal rulings.

New developments

But for all the anxiety about patent expiries and generic competition, new developments do emerge from the labs and onto the market. Excluding those treatments acquired via SmithKline Beecham, the next table outlines how GSK's product line-up has changed since 1996:

Of those pharmaceutical products whose sales were disclosed in 2002, eight had sales of zero in 1996. Importantly, turnover from new products can grow extremely quickly -- aggregate revenues from the eight treatments introduced since 1996 contributed 17% of GSK's revenues in 2002.

In less than two years, Seretide/Advair, a treatment for asthma, has come from nowhere to become the US market leader. Its sales improved by nearly 100% during 2002 (to £1.6b) and soared a further 36% in the nine months to September 2003. Other highlights from GSK's third-quarter figures included Wellbutin, with nine-month sales up 14% to £726m, and Lamictal, a medicine for epilepsy, which improved revenues by 29% to £410m.

Another big winner of late has been Avandia, a treatment for diabetes. Originally a SmithKline Beecham product, Avandia revenues jumped from £89m in 1999 to £809m in 2002, with nine-month 2003 figures showing a further 18% rise.

Current pipeline

Last month GSK hosted a R&D day. The company informed shareholders that 147 projects were in clinical development. These comprised of 82 new chemical entities (compounds where the application has yet to be determined), 20 new vaccines and 45 line extensions (existing products that could treat another ailment).

Compounds highlighted included treatments for tumours, heart disease, cervical cancer, depression, blood clots and bowel paralysis. Also in the GSK pipeline are developments based on the successful Seretide/Advair asthma product, which are planned to treat other respiratory conditions.

As Seretide/Advair has demonstrated, there's always the possibility a new product can generate notable revenues. But to be frank, it's anybody's guess as to the future performance of the pipeline treatments. As such, buy and hold investors ought to take the 'big picture' approach. Thus, as one of the world's leading pharmaceutical businesses -- spending £2.7b on R&D in 2002 alone -- there's no reason to believe GSK can't come up with more big winners over time. In fact, there's always the outside chance of discovering something radical. Pfizer only stumbled upon the basis for Viagra during trials for a completely different ailment.

However, there is an obvious shareholder risk: few of GSK's pipeline trials may come good. There are just no guarantees with pharmaceutical research and everything in the laboratories could well flop.

More: Glaxo Joins The Watch List (Part 2) | GSK website | GSK Company News | The Ideal Qualiport Company

The author owns shares in GlaxoSmithKline.