(*excluding exceptional items) (**nine months to Sept 2003) (***estimated)

GSK's cash generation is emphasised by its sizeable share buybacks. In 2001, GSK spent £1.3b on share repurchases, with a further £2.2b spent in 2002. Furthermore, during the first three quarters of 2003, another £836m was used. There seems to be plenty of excess cash swilling around in GSK's coffers, with management allocating it wisely.

GSK has no trouble with debt. At the end of September 2003, net borrowings were £1.4b. In comparison, underlying after-tax profits for the preceeding twelve months were £5.0b. Indeed, net interest payments of £154m are tiny when set against annual trading profits of £7.1b.

Accurately gauging GSK's incremental return on equity is a Herculean task. The merger to form the company throws up numerous complications, not least the £2.4b of exceptional costs charged since 1998. According to GSK's 2002 annual report, 'adjusted' earnings for the merged group increased from £2.9b to £4.6b between 1998 and 2002, while shareholders' funds went from £4.2b to £6.6b. If the exceptional costs are capitalised, the resultant incremental return on equity comes to a very sound 35% (£4.6b - £2.9b)/(£6.6b - £4.2b + £2.4b). Though this calculation is rough and ready, GSK's generally low asset requirements does imply the potential for superior profit reinvestment returns.

GSK's FRS17 pension deficit stood at £1.2b at the end of 2002. Not that great a worry, since annual earnings of £5b should reduce the shortfall over time without too much trouble. Even so, GSK made a special £320m contribution to the fund in the year before last and pension service costs increased by more than £100m in 2003.

Management

The 'fat cat' label has often been applied to GSK boss Jean-Pierre Garnier. Countering some of the brickbats, GSK announced new executive remuneration arrangements last month. Highlights included reducing contract notice periods from 24 to 12 months and comparing total shareholder returns to 15 pharmaceutical rivals for bonus awards.

Garnier's basic salary has risen by 25% (to £967,000) between 1999 and 2002, in which time his role as chief executive of SmithKline Beecham (SKB) evolved into the chief executive of GSK. Garnier also collected £5m in bonuses over the same period. But in comparison, adjusted GSK earnings increased 35% during the those three years, the average GSK worker has seen his wage improve by 28% to around £46,000, while the boss of Pfizer (LSE: PFE) received a basic £1m in 2002. It seems some of the obese feline jibes may be misplaced.

In terms of experience, Garnier has held boardroom positions at SKB and GSK since 1992, as has chief financial officer John Coombe. Tadataki Yamachi, GSK's only other executive director (the other nine are non-executives), has enjoyed senior SKB roles since 1994. While shareholders can be comforted by their executive's industry experience, the ordinary shareholdings of the three amount to a relatively small £4m.

Summary and Valuation

GSK scores well on the Qualiport's check list. A proven track record, a sustainable competitive advantage (until the patents expire, that is), familiar consumer brands, repeat/predictable revenues, high margins, super cash flows and sizeable share buybacks all make for a 'quality company'.

There is, however, a circle of competence issue: GSK is not the easiest firm to understand. For instance, investigating the medical strengths of Seretide, Seroxat and Avandia, assessing the validity of current patents and judging how well the pipeline treatments will do are all well beyond the Qualiport. Keeping a constant eye on a dozen global rivals will also prove impossible.

Any portfolio investment will therefore be 'big picture' stuff. Simply, the pharmaceutical sector has good long-term growth prospects and, as the industry number two with a near £3b research and development (R&D) budget, GSK should do as well as the sector.

Another issue for buy and holders is GSK's prevalence for corporate activity. Mergers have kept the earnings momentum going in recent years, but they come with operational risks and their cost cutting can only go so far. Only growth in sales will ultimately reward patient investors, with much hope resting on the pipeline developments. No guarantees here of course, but it's difficult to envisage the billions spent on R&D failing to find a few money-spinning compounds over the next few years. If, however, the laboratories fail to deliver, the merger and acquisition activity could well resurface.

For all the high-profile patent threats, GSK is still growing. Total turnover increased 3% (or 7% on a constant currency basis) and operating profits 9% in the nine months to September 2003. For a £72b company operating in a tricky economic/low inflation climate, such a performance isn't too bad. More so when you consider some of the firm's best-selling names have begun to endure severe competition.

Using current broker forecasts, GSK shares at 1,220p stand on a forward price to earnings (P/E) ratio of 14.5 and offer a prospective dividend yield of 3.5%. During the twelve months ending September 2003, GSK generated earnings of 87.9p per share, which can be taken as a genuine proxy for free cash flow. The shares therefore offer a free cash flow yield of 7.1%. An entry price of 1,172p would give a free cash yield of 7.5%. (Note: this valuation excludes a possible £2.9b (or 50p per share) payment relating to additional US taxes and interest payments). It's worth remembering GSK shares traded on a free cash flow yield of under 4% between 1997 and 2001, which shows the re-rating potential if some of the pipeline compounds come good.

More: Glaxo Joins The Watch List | GSK website | GSK Company News | The Ideal Qualiport Share

The author owns shares in GlaxoSmithKline.