Political Factors
Safety Control and Regulation
Recently the EU have launched several proposals aiming to uplift the legislative control over the pharmaceutical industry since 2008, mainly focusing on medicines safety inspections, improved civilian acquire of trustful medical information and eventually the strengthened EU laws which could provide better shelter for consumers against counterfeit drugs.
Price Control
The pharmaceutical products are on sale under the price control of the government. If necessary, the government would also manipulate the prices within the involvement of national healthcare organizations, NHS in UK i.e., which absorb a large proportion of the medical costs offering to consumers.
Economic Factors
With the fame of world’s leading pharmaceutical market, UK attracts many multinational and domestic companies with close links with the Brown government. Meanwhile, since the world is facing the financial crisis and recession, NHS is having a shrinking budget and could cut the fund as a result.
Numbers of layoffs have been announced by many pharmaceutical companies recently, aiming to reduce costs while affecting many UK-based staff as well. Due to the pessimistic prospect of the economy, together with merging challengers the companies are facing, such as expiration of patents, accelerated peer racing and lagged innovation, did the board made the decision throughout the country.
Social Factors
Cost Concerns
It is universal that price is a predominant factor that influences the consumers’ choice among healthcare and medicines. Other issues they concern are the safety of the drugs, effects the products could bring and the quality comparing with price.
Equal Opportunities
There is solid evidence that patients demonstrate unsatisfied attitude towards current access to medicines and availability of full scale of newly developed drugs, so they lose confidence with the prescribing process. It is also confirmed by patient sampling that they are willing to attend clinical trials or other medical research, with a lack of opportunity reported as well.
Technology Factors
High-tech Pool
UK’s highly trained workforce benefits numbers of the world’s most active companies on innovation to set up R&D centers here. A high-talent pool is offered with more than 100 universities and institutions, including top universities in Europe and the world.
Government Support
Domestic R&D could search support from the UK Government. £10 billion was spent to uplift the workforce quality on training programmes. By using policy tools such as R&D Tax Credits and Allowances, Grant for Research and Development, EUREKA and the European Commission framework programme does the UK Government provide financial assistance to companies carry out R&D with different ownerships.
Divisional Analysis
Based on the data from 2007~2008, graphs about some important changes on the performance of two segments could be extracted as:
For pharmaceutical segment, its turnover increased by 6.36% while its profit decreased by 7.94%. The reason why profit margin decreased by 13.46% is that the cost of sales increased by 26.3%. So we can get a conclusion that the profitability of pharmaceutical segment is becoming lower because even it has an increase about £ 1218 million on turnover, its profit reduced £546 million.
As far as Consumer healthcare segment, it experienced a big growth during the financial crisis. Its turnover increased £418 million by 11.76% and profit increased by 13.13%. However, the profit margin decreased slightly by 1.24%, which means that the profitability remains the same level during the two years. ROCE decreased by 9.33% because the net asset of the segment increased by 24.77% from £2281 to 2846 million.
In 2008, pharmaceutical segment was impacted by expected generic competition to several mature brands and further declines in Avandia sales in US market and by lower government orders for Relenza and the impact of pharmaceutical price cuts in Japan. Furthermore, products of Metabolic and Central nervous system suffered a big sales decrease by 21% and 13% and the two kinds of products used to have high profitability. Vaccines which grew 27% on world market have a high potential in the future and may become the segment’s major profitable products. Consumer Healthcare segment was not influenced by financial crisis because it had a growth both in turnover and profit, especially the oral and nutritional healthcare products. Facing the strong competitors like Johnson & Johnson, the segment still conduct a great performance, showing that the segment has a high potential for growth because now it just contribute 16.3% of the total turnover.
SWOT Analysis (divisional):
S1: Strong Profit Margin
Although the profit margin decreased by 13.46% and 1.24%, it still remains a higher level than sector’s average profit margin. After the increase on costs of sales and world economy gets better, the high level profit margin will provide the company with more profits.
S2: Strong Product Portfolio
The pharmaceutical segment has diverse product portfolio from central nervous system to vaccines. Especially the vaccines products, it has over 30 vaccines for diseases (See the chart below). Consumer Healthcare segment is comprised of oral care, OTC medicines and nutritional healthcare products which experienced positive increase in 2008 and it holds the third position in the market of OTC and oral medicine and the leading position in UK Nutrition market.
We can see that GSK’s vaccine products grew quickly in 2008 and in the second position of the market.
W1: Patent Expiry Problems
Pharmaceutical segment contribute over 80% turnover of GSK. However, many profitable products like Advair, Valtrex and Lamictal have problems of patent expiry. For example, Advair, which accounts for £ 4.1 billion on profit in 2008, will expire on 2010, thus making the profits reduce heavily. Most of the products which will expire on 2009 and 2010 are key products and major parts of the segment’s profits. So the problem of patnet expiry will definitely and negatively affect GSK’s profits and financial performance.
O: 1 New Product of Two Segments
With the huge investment on R&D, the pharmaceutical segment has 150 projects in human clinical trials and more than 20 vaccines in clinical development. The new products will provide the company with potential high growth in the near future. And consumer healthcare segment also has a full and diverse product development pipeline.
O2:Fast-Growing Vaccine Market
GSK is the leading company in vaccine market and the market has a bright future and will keep high-speed growth according to the The Vaccines Market Outlook by Business Insights.
T: 1 Competition
Both the two segments face fierce competition in their markets. For example, in pharmaceutical market, GSK’s competitors are Merck, AstraZeneca, Pfizer and so on. In consumer healthcare market, its competitors are Johnson & Johnson, Procter & Gamble. The intensive competition will make quick technological changes and limit the marketability of the products thus making companies grow slowly.
T: 2 Price Control over Pharmaceutical Products
The policy on price control has been used in US and other countries. The policy will definitely affect the segment’s profitability and make GSK’s financial performance worse.
Geographical Analysis
Analysis of the data:
Based on the data from 2007~2008, we can get an analysis table about changes by geographical view:
From the table, US market shrank in 2008 for the fact that its turnover, profit and margin profit decreased a lot. The profit of USA market fell by 31.52% because some major and profitable products’ sales decreased heavily. Although the whole US pharmaceuticals market grew by 1% in 2008, GSK’s performance in US is not good, which means GSK losing its competitiveness and leading position in US. Furthermore, the profitability in US is also get weaker because the profit margin decreased by 28.55% to 0.2 which is a low level compared with other market.
Concerned to Europe market, it experienced a high rate growth in turnover. Despite for the fact that both the profit and profit margin fell in 2008, they are still at a high level and Europe market has taken over US market to provide most profits with GSK. The reason why ROCE is low is that GSK’s core business departments such as R&D and Govern are in UK, thus making GSK has large assets which continue to grow in Europe.
The markets in the rest of world are the emerging markets like China, Japan and Asia Pacific. The market has a great growth in 2008 especially the profits and profit margin. From the growth of ROCE and Profit margin, we can make a conclusion that the GSK has become efficient and profitable in the market. The emerging market has become the most potential market for GSK and will be the major market in the future because of its high margin and high speed development.
SWOT Analysis (geographical):
S1: Strong business fundamentals
GSK has strong business fundamentals in US and Europe market so that the two markets can still provide large profits with GSK for a long time. And strong fundamentals in the markets do good to GSK’s brand value which will affect its marketing performance in emerging market. The strong business fundamentals will also provide the company with good management, marketing experience and R&D ability, which help GSK’s development in emerging market.
S2: Global Presences
GSK has business across 117 countries in seven continents and entered the Asia market in early time. Because of the early global strategy, GSK has more assets, brand influence and marketing experience than other competitors and experienced high rate growth in 2008. Furthermore, GSK’s global presence will limit the negative effects of concentration in any particular economy. By this strategy, we can see the fact that GSK’s turnover still grew in 2008 though GSK’s US market shrank a lot.
W1: Too dependent on US and Europe markets
The US and Europe markets contribute about 80% turnover to GSK while US and Europe’s economy developments are closely jointed. Once the US experienced economic crisis, GSK will lose its major profits from the two markets.
O: 1 Expansion in emerging markets
In 2008, only emerging markets have growth in profits and the markets’ profit margins are at high level which means very profitable. Now, the turnover in the markets is still very low concerning the large population of Asia so the markets are very potential. The opportunity for GSK is to invest more assets and put more emphasis on the emerging markets while the operating assets in the markets are just 23.6% of US and Europe markets.
T1: Stringent Regulatory Market
US FDA and European Medicines Agency have set more stringent regulation on pharmaceuticals companies and products thus making the fiercer competition, higher costs and more risks to GSK than ever before because US and Europe are major markets for it. In the two markets, GSK has to be in compliance new more stringent standards in the future.
Turnover and profit analysis
Although the company was experiencing a positive average annual growth rate in the past five years on turnover, in the year of 2007 GSK had actually a negative growth in the turnover. That means GSK had a fluctuate growth in the past few years, leaving some uncertainty to the estimation of the future growth rate. It is also obvious that GSK had problems to maintain its profit level from 2006.
Acquisition/Disposal influence
Prospects for turnover and profits based on activities
Although some of the acquisitions reduced the profits on a temporary base, it could be predictable that the decisions would do positive contribution to future turnovers and profits. However, with economy recession uncertainty of further profitability should be taken into account.
Financial Statement Analysis
The object of the following section is the evaluation of the financial performance and position of GlaxoSmithKline plc (GSK). To achieve a valid and meaningful interpretation the authors defined a peer group. This peer group consists of the following companies: Pfizer Inc, Sanofi-Aventis, Novartis AG, Astrazeneca plc and Roche Holding AG. Those companies were chosen as they are the main competitors of GSK in the pharmaceutical market. In order to get a peer group average, we weighted the ratios of each of the five competitors according to their market capitalisation. It is remarkable that the market capitalisation of Pfizer, Roche, and Novartis is within a range of €93.7 bn and €94.1 bn. GSK is valued with a market capitalisation of €71.5 bn (£64.7 bn). We will hereinafter refer to those four companies as the “big four”.
The first step in evaluating the financial performance is the interpretation of the following profitability ratios.
The first impression is that GSK operates very profitable. While the net profit margin is comparable with the peer group, GSK outperforms its competitors in particular in the relation of return to the employed (equity) capital.
In comparison with its competitors, GSK demonstrates the ability to produce high earnings before income and tax from its employed capital. A detailed analysis delivers two reasons for the exceeding ROCE. The first explanation concentrates on funding differences between the companies. In the past (2004 to 2007) GSK operated on an asset base which was financed to a large extent by current liabilities (between 31 % in 2005 and 41 % in 2004; average of the peer group in 2009: 21.2 %). Consequently, the calculated capital employed, the difference between assets and current liabilities, was small and the relative return high. Beyond that however, GSK demonstrated also the ability to generate a significant higher return on asset (RoA) than all its competitors. So, its both: a high extent of assets financed with current liabilities and competitive earnings produced with the assets. Furthermore, the RoA figure, as well as the ROCE shows, that the profit produced from the capital/ asset base declined in the last five years while the competitors were able to keep their level relative stable. The sharp decline in 2008 was thereby caused by the expansion of the capital base (+27%) and a decline in the EBIT figure (- 5%)
For a valid assessment of the outstanding ROE it is necessary to compare the common equity and the profit attributable to shareholders in absolute figures (see table). This demonstrates that the magnitude of the ratio is more due to leverage effects than to exceeding net earnings. This depicts the ability of GSK to deliver high profits to the shareholder compared to the total claim of them. Otherwise, this figure also shows the vulnerability of the GSK due to the relative small capital basis. The extent of the vulnerability will be evaluated when discussing the gearing and liquidity situation of GSK.
It is notable, that GSK prove the ability to generate a very competitive operating margin from a high gross profit margin. But it is necessary to critical assess the outperforming in the operating profit margin.
A main contributor to the operating expenses is cost due to research and development activities. While GSK spends a proportion of just 14 per cent of its sales in R&D (the level varied over the last five years within an interval of 13.8 and 14.8 per cent), the entire competitor spend a larger proportion on their research activities.
The comparison of the operating margin and the net margin leads to a second critical issue. The above average operating margin of GSK results just in an average net profit. The reason for this is that GSK faces high tax charges. (29 per cent compared with e.g. Pfizer’s 17 per cent). Accordingly, the wealth contributable to the shareholders is significantly reduced by tax expenses.
Finally, we have to point out that GSK had problems to maintain its 2007 margin levels. This is to some extent due to the diversification strategy of GSK, reducing the business proportion in the high margin pharmaceutical business and widening its involvement in the healthcare market. The main reason, however, is the weakness in the US market. The strong competition by generic products as well as the further decline in Avandia sales reduced turnover and profit margins. Additionally, indirect cost accruing from the restructuring programmes in 2008 further pressured the profit levels.
For the evaluation of the financial stability of GSK it is necessary to analyse the capital structure.
All the presented gearing ratios are characterized by a sharp increase in the last two years. The increase from 2006 to 2007 of the debt/equity, the debt/capital and the gearing ratio was driven by borrowing money from the capital markets mainly through issuing corporate bonds. The further increase from 2007 to 2008 was caused by the ongoing issuing of mid- and-long-term bonds, as well as the refinancing of is short-term debt positions and, with less impact, by the repurchasing of own shares in the amount of £ 1.7 bn and the subsequent reduction of the equity base.
The comparison of gearing ratios demonstrates that the competitors choose a much more conservative funding strategy and rely to a significant higher proportion on equity capital. However, while continental Europe based companies such as Sanofi-Aventis, Roche and Novartis operates at a debt/equity ratio between 9.2 and 14.6, Pfizer runs its operations at a ratio of 30.1. The other UK-based company, Astrazeneca, even possess a ratio of 74.5.
The sharp increase in the interest cover ratio, despite the almost constant earning level, discloses the risen dependence on outside funds and the accompanied increase in interest expenses from 2006 to 2008. Furthermore, the actual interest expenses in the amount of £1.2 bn point out the necessaty to closely monitor the development in this ratio and, in order to secure the low equity base in the long- and mid-term, the need of a constant high EBIT.
However, the interest cover also indicates the actual ability of GSK to meet the increased interest expenditures. It is furthermore worth mentioning, that, despite the risen gearing ratios, GSK demonstrated the ability to issue a mid-term bond in 2008 with a maturity of 5 years for (nearly) the same conditions then in 2003.
While the financial stability in the long and mid-term has degraded due to the high reliance on outside funds, GSK improved its liquidity position in 2008.
The static balance sheet measurements such as quick ratio and current ratio demonstrate that GSK can cover its maturing obligations from its cash and “near cash” assets. The observable improvement is ascribed to enhancements in the current assets positions mainly financed with long-term borrowings (as showed before).
With a quick ratio of 1.29 and a five year average of 1.10 we can assert, that GSK has a convenient liquidity position to meet its short-term business obligations. The comparison with the competitors underlines this statement. If you adjust the given peer average by eliminating the outstanding ratio of Roche (2.66) the new weighted average is 1.09. Thus, GSK is operating at a quite sufficient liquidity position in the short-term.
The same assessment is valid for the current ratio. With a current ratio of 1.72 in 2008 GSK has improved this ratio about 40 basis points. If you compare GSK with its competitors you can state that GSK is outperforming them with exception of Roche (Current ratio: 3.19). In the literature a ratio of 2 is often stated as a sufficient number. But, supported by the hereinafter discussed cash generation power of GSK in 2008, we valuate the ratio of 1.72 and the achieved improvement as sufficient to avoid financial distress in the short-term.
GSK strengthens its liquidity by generating cash its operations. While the turnover increased 7.2 per cent in 2008, the operating cash flow went up about 17 per cent. The improvement of the OCFMO ratio is alike not a result of reduced maturing obligations but of the improvement of the cash generation power of the turnover.
On the other side, the annual report 2008 also discloses some weaknesses. Although GSK started a programme aiming to reduce the working capital and therewith deliver cash flow benefits for strategic priorities, the annual report shows further potential. This potential is getting obvious in the increase in the GSK inventory level in 2008 (WiP +68 %; finished goods: +38%) and through a comparison of inventories with its main competitors (see table). We think it is mandatory that GSK intensifies its working capital programme focussing on the inventory level and by doing so to further strengthen the cash positions. The high inventory level also influences the following activity ratios.
For the Evaluation of the efficient use of resources we concentrate on the following ratios.
The activity ratios display another weakness in the balance sheet of GSK. While the debtor’s days are in the same range like those of the peer group, the creditor days are significantly lower. This demonstrates that the competitors are more able to defer their payments and therewith conserve their cash positions. GSK, in contrast, did not understand to use later payments as a kind of the short-term financing. This ability is particularly important, since the credit given by trade partners is considered to be a cheap funding possibility.
Evaluating the sales to capital employed figure, GSK outperform the peer group. As mentioned when discussing ROCE, GSK shows the ability to use its capital base more efficiently to generate sales and profit and rely remarkable more on short-term liabilities. However, the observable trend in the asset turnover shows a sharp decline. When examining the figures behind the ratio, you can determine that the sale growth could not keep up with the growth in the asset base. There are two main reasons for this: Firstly, the growth in the asset base predominantly takes place in the current and therefore unproductive assets. Secondly, the acquisitions in 2007 and 2008 have a lower asset turnover and therefore negatively influence the consolidated ratios. Furthermore, the asset turnover is also an indicator for the change in the business strategy of GSK, concentrating more on the healthcare products with a lower asset turnover.
The stock day ratio is the affirmation of the stated critics about the inventory management. The comparison between 2007 and 2008 is expression of the high increase in the inventories, the relation to the peer group confirm that the overall inventory level is too high.
In the past two years GSK contributed a growing amount of its earnings to the shareholders. The dividend payout ratio was increased in 2007 and 2008 to an actual level of 64 %. This resulted also in an increase of the dividend yield to a level of 4.44 % in 2008, after 4.14 % in 2007 and 3.57 % in 2006. The reduction of the outstanding shares could not compensate the decline in the net income (-11, 5 %) and the EPS decreased consequently about 6.14 %.
The stock in GSK showed an average performance during the last year. This was mainly due to the fact that the pharmaceutical sector performed worse than the overall market.
The increase of the EPS ratio, as well as the decline in the P/E figure are expression of the analyst believe, that GSK will be able to boost its earning level. The sharp movement from 2008 to 2009e shows that the financial sector is especially optimistic for the year 2009. It is also common sense that GSK will slightly raise its dividends in the upcoming years providing an average dividend yield of about 5 per cent. However, the analysts expect that GSK will distribute a smaller proportion of the net income to its shareholder. This expectation leads to an increase in the interest cover rate.
When comparing the 2009 forecast with the competitors you can describe GSK as a shareholder friendly company contributing a higher proportion of income to its shareholders. The share is also expected to deliver an above average dividend yield. Furthermore it is also notable, that investors are expected to pay a higher price for shares in the Novartis and Roche. This may be an indicator for investors believe in a higher earning growth potential of those companies. In contrast to the good prospects for GSK in 2009, the analysts expect a lower EPS for Pfizer in 2009.
However, there are large differences in the forecasts. While some analysts expect an EPS level of 136 for 2009 and 144 for 2010, others are more sceptical and forecast EPS of just 103 for 2009 and 83 for 2010. The deviation is getting smaller in the year 2011 where the estimates are within a range of 112 and 147.
Risk Analysis
The beta value in the pharmaceutical industry is lower than that of the overall market, which means the pharmaceutical industry is less volatile than the market. Even more, GSK is enjoying a lower beta value comparing with the pharmaceutical sector, promising itself a more conservative stock if investors are seeking for less risk. It may happen that GSK offer a lower expected return, but it could be compensated by stability.
The specific risk in GSK is lower than the sector and the market specific risks, thus an unexpected event such as a sudden strike or a new governmental regulation would cast smaller influence in the stock of GSK.
With a low R-square, GSK doesn’t act much like the index. Thus, to make a more precise estimation of GSK people should mainly focus on the specific risk other than beta value.
Over all, an investment in GSK can be considered as a conservative one. It is therefore a good defensive addition to portfolios and especially suitable for investors like pension funds.
Forecasts
The YTD figures show a rather disappointing development of the pharmaceutical markets. As explained before, this is mainly due to the conservative character of investments in the pharmaceutical market.
The forecast overview demonstrates the broadly optimistic outlook for 2009, while the scepticism for 2010 is also evident. On average the analysts expect a pre-tax income growth of about 30 % to a level of £8.6 bn.
The growth rates are mainly driven by temporary factors like the demand for flu vaccines which ameliorate in 2010.JP Morgan also stated the growth in flu related products as important contributor for future sales and profit growth.Furthermore, some analysts are quiet optimistic about the changes in resource allocations and the implemented cost reduction programme.The started cost reduction programme is announced to deliver pre-tax savings of £1.7bn. The analyst of Credit Suisse also stated that GSK will be able to “reap the benefits of recent investment in Emerging Markets.” In addition, Credit Suisse is convinced that GSK´s high vaccine exposure will drive a uniquely stable top line and a superior long term EPS.
However, there are also critical analyst votes. JP Morgan for example expects a lower trading margin and a decline in the gross profitability in the upcoming years due to change in the strategy of GSK focussing more on long-term value by diversifying its product portfolio.The analysts of Society Generale are sceptical about the raised generic competion and expects in particular earning risks due to the expire of GSK largest drug Advair in 2010.
The before mentioned deviation in the forecasts figures, as well as the different review of further risk and opportunities of GSK results consequently in varying analyst recommendations. The most recommendations are arranged in the area between hold and moderate buy.
Prospects and Conclusion
In conclusion, we believe in the diversification strategy of GSK. GSK is becoming less dependent of the success of particular pharmaceutical products. Consequently, we expect a lower risk for the margin, however, accompanied with lower margin level. Despite of the expected lower margin level, we think, the return for the shareholder should be quite competitive. We are sure, that the low level should be compensated by the high gearing ratio. Considering the actual gearing level, as well as the demonstrated cash generation power of GSK, we value GSK as solid financed and do not expect any financial distress in the mid-term. Furthermore, we believe that GSK can provide in the short-term especially from its evolvement in the vaccine market and the government swine flu programme. Finally, we see the willingness of GSK to tackle detected weaknesses through its cost reduction and working capital programme as well as the recently announced initiative to cut drug production waste. And the comparison with the P/E ratios of competitors like Roche and Novartis show that GSk is a fairly cheap priced.