We think Glaxo has the best pipeline in the sector

GlaxoSmithKline reported third-quarter results that largely met our expectations, and we don't anticipate changing our fair value estimate. Even with tough generic competition to neuroscience drugs Imigran, Lamictal, and Requip, Glaxo still squeaked out 3% operational sales growth from the prior-year period. We expect generic competition to antiviral drug Valtrex in 2010 will lead to continued muted growth through 2010.

While near-term growth remains challenging, Glaxo is making strong progress with its pipeline, which should return it to more robust growth over the long term. The recent approvals of human papillomavirus vaccine Cervarix and oncology drugs Votrient and Arzerra should give Glaxo several potential blockbusters. In our opinion, Glaxo has the best pipeline in the pharmaceutical group. Glaxo is also one of the best-positioned companies to benefit from heightened concerns about the H1N1 flu. While vaccine sales in the quarter were slightly down year over year, we expect a large uptick in the fourth quarter when the company's vaccine production yields should increase. Further, we expect the increased awareness surrounding the H1N1 flu will lead to strong sales of the company's other seasonal flu vaccines. Additionally, Glaxo's antiviral drug Relenza is one of only a handful of drugs that have shown some efficacy for people who come down with the flu. As a result, this drug has shown a major resurgence, with sales more than doubling year over year to almost $300 million in the quarter. We expect continued stockpiling of Relenza throughout the year.

The majority of the company's costs grew at a surprisingly fast rate. On a constant currency basis, cost of goods sold along with marketing and administrative expenses outpaced sales growth by more than 6% from the prior-year period. While we continue to project that the company will reach its goal of $2.7 billion in annual cost savings by 2011, the recent quarter leads us to believe Glaxo is struggling to improve efficiency after a strong start to restructuring efforts in 2008. However, we believe the generic head winds facing the company will create opportunities for further cuts, as marketing efforts can be pulled from drugs losing patent protection.

Fair value estimate: 1,490p ¦ Fair value uncertainty: Medium ¦ Economic moat: Wide

Thesis
(Last updated 17-07-2009)

As one of the world'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. [Read this article to understand how Morningstar measures moats]. Glaxo's diverse operating platform should more than offset patent expirations for neurology drug Lamictal 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 17% of total revenue. As a result, patent losses and drug-specific problems are unlikely to cause the roadblocks seen at other large pharmaceutical companies.

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 £2 billion annually in cash flow, which could be used for external growth opportunities.

Valuation
We are maintaining our fair value estimate of 1,490p per share. We forecast average annual sales growth of 5% 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 30p 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 120p. 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.

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 £2 billion in cash flow annually.

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.

Profile
Within the pharmaceutical industry, Glaxo 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.

Growth
New pipeline drugs should more than offset drugs lost to generic competition. We estimate average annual revenue growth of 5% 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 £2 billion in cash flow annually and closed 2008 with just under £7 billion in cash, putting it on solid financial ground.

Bulls Say
1. Using effective product life cycle planning, the company introduced Coreg CR, an extended-release formulation of Coreg IR, which lost patent protection in 2007.

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 has shown success in expanding its product lines through external partnerships, including Boniva and Alli with Roche RHHBY and Lexiva with Vertex VRTX.

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 Lamictal and Valtrex could weigh on near-term growth.

3. Cervarix and Synflorix lost the first-mover advantage to Merck and Wyeth, 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.