This report considers GlaxoSmithKline (GSK) in the context of the pharmaceutical industry. The report aims to consider the risks associated with GSKs product development and sales with regard to their shareholder value. Shareholder value is difficult to measure as different shareholders find value in different areas (Froud, Johal, Lever and Williams 2006, p.36). This report will define shareholder value as activities that create wealth for the company's owners (Smith 2015). There are a number of commonly used measures which have various flaws, but this report will look at annual revenue and dividend growth, sales revenue and earnings per share (EPS). These are straightforward indicators of a company's success and attractiveness on the stock market. The product development of a drug now takes up to 15 years (AMBS 2018, p.3). This process is important to consider as the productivity of research and development has decreased. As a result, pharmaceutical companies like GSK have been exposed to more pressure and risk of falling sales. The increasing risk to their sales revenue is a prompt for strategic changes explored in the report.
The report will examine GSK from the 1980s onwards, focusing primarily on the time between the 1990s up until the financial crisis in 2008. Over this period, GSK, as with many other successful big pharmaceutical companies, had to adopt their strategies to both internal and external changes in their environment. Between 1981 and 2002, Glaxo went from being the 20th to the 2nd largest pharmaceutical company by sales (Froud, Johal, Lever and Williams 2006, p.180). This growth was initially organic and then later continued through mergers.
The report will, firstly, consider the effects of managing the crucial balance between good and bad pharma strategies, and how they underpin strategic decisions. The production of ‘blockbuster' ethical drugs sustained GSKs success against generic rivals by allowing them to monopolise a therapeutic segment. This strategy, known as the blockbuster business model, ensured high sales revenues and will form the second section. In the 1980s, Glaxo was seen as the most successful European company based on excess profits (Froud, Johal, Lever and Williams 2006, p.149). The model faced a number of threats which will be explored in the first section of this report. The risks of both internal strategic threats and external environmental threats are inextricable. Over time, these threats rendered the blockbuster business model unsustainable. As a result of changing industry, GSK was formed through two mergers: from Glaxo to GlaxoWellcome in 1995, to GlaxoSmithKline in 2000. This merger activity allowed for cost cutting and diversification, which mitigated the effect of patent expiry on their sales revenue and share price. Accordingly, these mergers will be the focus of the third section of the report. Lastly, the report will consider more recent changes in strategy and restructuring of the company. The argument proposed is that GSK has continually failed to address its long-term risks to shareholder value and consider whether shareholder value should be their focus.
The Risks of Good vs Bad Pharma
The balance between good and bad pharma is crucial to consider when looking broadly at shareholder value. Glaxo aims to create large revenues and profits in order to satisfy its shareholders, but too much of a focus on this can, instead, offset shareholder returns. Good pharma refers to research driven, innovative activity, where bad pharma pertains to marketing driven profit-making. The equilibrium between the two leaves a firm like Glaxo open to reputational risk and any resulting regulatory pressure (Froud, Johal, Leaver and Williams 2006, p.150). Regulatory interference can result in fines and/or reformation that make it more difficult for pharmaceutical companies to achieve high sales revenues. In his research, Kefauver found that just 6 per cent of industry spending was in R&D, yet 25 per cent was spent on marketing (Kefauver 1965, p.68). From this, he was able to state that advertisers create ‘new discoveries' that are not materialized from the corporation's labs. Kefauver's problem definitions have continued to influence criticisms of pharma. However, the problems continue to exist as the imbalances between marketing and R&D are still seen today.
Additionally, reputational damage can deter investors causing share price, therefore shareholder value, to fall. Pharma has been condemned a number of times in history, not only for charging customers high prices, but also excluding people who cannot afford their drugs. The result of this exclusion is often fatal. This is particularly evident in developing countries. In 2001, GSK finally gave the South African Company, Aspen Pharmacare the right to produce cheap copies of their anti-Aids drug (Bosely and Vasagar 2001). 87% of people surveyed thought it right that people living with HIV/AIDs in poorer countries should pay less for their drugs (Bosely and Vasagar 2001), so this move was reputationally beneficial.
Pharmaceuticals and the Blockbuster Business Model (1982-1994)
Glaxo's first phase of growth was fortified by the blockbuster business model. Blockbuster drugs, whose patents protect them for 20 years, are ethical drugs earning a billion dollars or more per year (AMBS 2018, p.3). Patents are a pharmaceutical companies' intellectual property rights, which eliminate competition for their duration. This restriction protects prices and margins from erosion (Froud, Johal, Leaver and Williams 2006, p.154). Ethical drugs are prescription only, patented drugs and due to their high margins, they are very profitable for big pharmaceutical companies. In the early 1990s, Glaxo's products were exclusively ethical drugs which generated huge revenues (Froud, Williams, Haslam, Johal and Willis 1998, p.579). Glaxo's most notable product was the blockbuster drug Zantac. Glaxo's strategy, like many other big names in the pharmaceutical industry during this period, focused on developing and marketing blockbuster drugs. This focus resulted in incredibly high sales revenue. In 1994, Zantac alone made $2.44 billion (Froud, Johal, Leaver and Williams 2006, p.189), making Glaxo very attractive to shareholders. This section will first provide internal and external context to explain the success of the blockbuster business model and then demonstrate why this success was unsustainable.
Despite being a me-too copy of SmithKline's Tagamet, the first effective anti-ulcerant, Zantac was able to command a higher price in the market for a number of reasons. By adapting the molecular structure, hence removing some side effects, Glaxo clinically improved Tagamet to create Zantac. This enabled them to patent and market it for for fifteen years. Additionally, successful marketing distinguished Zantac from other drugs in its therapeutic area (Froud, Williams, Haslam, Johal and Willis 1998, p.575). Glaxo invested considerably more into marketing and sales, than research and development which proved incredibly successful for them. Zantac allowed average real annual revenue growth of at least 10 per cent (AMBS 2018, p.9). Whilst research and development at Glaxo employed just 14 to 15 per cent of their work force, between 40 and 50 percent of employees were engaged in sales and marketing (AMBS 2018). In the 1970s and 1980s, a typical employee in the pharmaceutical industry was a sales representative as opposed to a laboratory researcher (Froud, Williams, Haslam, Johal and Willis 1998, p.571). This reinforces how shareholder value's success is due to marketing and, at best, development of existing drugs, as opposed to research into new drugs. From 1980 to 1994, Glaxo dividends increased from less than 100 million dollars to over 800 million dollars. Furthermore, their dividends increased from around 3 per cent of sales to 14 per cent. (Froud, Johal, Lever and Williams 2006, p.185. This exemplifies the generosity of Glaxo to its shareholders during this period of success.
Glaxo's success in the 1980s and early 1990s can also be attributed to the payment structure in the pharmaceutical industry. The separation between the patient, and the pharmaceutical company creates price insensitivity in the market (Froud, Johal, Leaver and Williams 2006, p.155). The prescriber is an intermediary between the two which means that firms like Glaxo can increase their margins. Additionally, public health care industries are not as sensitive to drug prices, both due to their public nature and due to the higher cost of labour being the focus. Shareholders can expect these high prices to be beneficial to them. Arguments about regulatory capture also clarify why prices are allowed to be so high. Abraham, in his 2008 paper recognized the favourable regulatory conditions in the industry which saw regulators beginning to share the perspectives of the industries their regulating (Abraham 2008, p.873). This occurs particularly as regulators have often worked in the industry or hope to. Regulation often fails to maximise the interest of patients and public health (Abraham 2008, p.882), which, compounded with the lack of pharmaceutical development, works in the favour of pharmaceuticals' shareholder value.
The success of the blockbusters began to decline for a number of reasons. Glaxo and other pharmaceutical companies argue that patents, and the high margins that accompany them, support research and development of new medicines to benefit society (AMBS 2018, p.17) However, it has been proven that far more money is spent on marketing opposed to innovation. This strategy lacks the creativity required to secure sustainable growth. The best way of making money at Glaxo was to spend more money on Zantac ((Froud, Johal, Lever and Williams 2006, p.183). Given that within two years of patent expiry, ethical drugs lose up to 50 per cent of their sales revenue (Froud, Williams, Haslam, Johal and Willis 1998, p.578), strategic myopia exposes shareholders to future risk. By 2003, Zantac had lost 84 per cent of its maximum revenue (Froud, Johal, Lever and Williams 2006, p.189). Without management of this huge risk of revenue loss, Glaxo's shareholder value would have fallen dramatically.
Blockbuster drugs are also very hard to come by, particularly as many therapeutic areas have already been treated. The remaining areas are increasingly difficult to treat, both due a decline in the productivity of research and development and the lack of innovation (AMBS 2018, p.7). This is characterized as increasingly expensive but fewer drug approvals. The drug development process is more and more uncertain, with only 0.0001 per cent of pre-clinical drugs making it onto market (Tamimi and Ellis 2009, p.125). In addition to this, it can now take between 10 to 15 years for a drug to be approved leaving 5 to 10 years left of a patent to sell the drug, meaning a lower sales volume. Moreover, as the time between the pre-clinical phase and drug approval get longer, positioning and repositioning of the drug get more difficult more marketeers. This may compromise the success of future marketing and therefore sales. The risks posed a real threat to Glaxo's shareholder value, meaning they had to act before the end of the Zantac patent.
GSK Mergers & acquisitions (1995-2002)
Due to the problem of patent expiry, pharmaceutical companies began to confront their problems through mergers and acquisitions (James 2002, p.302). Glaxo was the first mover with respect to this strategy, only followed by Pfizer many years later (Froud, Johal, Leaver and Williams 2006, p.188). This second phase of Glaxo's growth was inorganic. This type of growth was needed to keep financial statements afloat by cutting some costs and adding dollar value to the company. In 1994, Glaxo acquired Burroughs Wellcome for £9.1 billion, to become GlaxoWellcome (James 2002, p.302). The merger was of opportune timing as Zantac's revenue peaked at £2.44bn in 1994 and fell to £1.93bn by 1996. (Froud, Johal, Leaver and Williams 2006, p.189). Despite this, GlaxoWellcome maintained their growth rate and prevented a collapse in sales revenue. This was due to the opportunity to rationalise operations, resulting in a maintenance of margins. 11.6% of employees were made redundant and salaries fell in real terms from £41,164 in 1996 to £36,202 in 1999 (based on 2003 prices) (Froud, Johal, Leaver and Williams 2006, p.188). A critique of this cost cutting method is that GlaxoWellcome lost some staff it may have been better to maintain, due to the generous redundancy package (James 2002, p.303). Despite the discovery of two new blockbusters, there was no overall push to improve R&D (Froud, Johal, Leaver and Williams 2006, p.190), thus, the pipeline remained weak between 1995 and 1999.
Predictably, Glaxo's strategic problems were left wholly unsolved by this merger. The defensive restructurings from the merger allowed for cash generation and short-lived revenue maintenance. Burroughs Wellcome's blockbuster as the time, Zovirax, was also close to patent expiry. The merger did not increase the number of new drugs in the pipeline and although it did buy GlaxoWellcome time (Froud, Johal, Leaver and Williams 2006, p.189), it did not guarantee a prosperous future. This exposed GlaxoWellcome to the risk of shareholders pushing for dividends and buy-backs, instead of investing for menial returns (Jack 2012). To avoid this, GlaxoWellcome had to quickly look for a second merger, so in 1998, they began to publicly target SmithKlineBeecham.
July 1997 brought about the expiry of Zantac and saw GlaxoWellcome's first drop in nominal sales in over 17 years (Froud, Johal, Leaver and Williams 2006, p.189). To avoid a significant loss of shareholder value, GlaxoWellcome began to target SmithKlineBeecham (SKB) for a merger. This process did not run smoothly as their deal fell through and was further postponed twice. This merger was surrounded by the risk of cultural differences between the companies, making integration more difficult and acquisition costs more expensive (Lordorfos and Boateng 2006, p.1412). The collapse of the deal was, therefore, incredibly damaging to both companies share price (Froud, Johal, Leaver and Williams 2006, p.190). Upon the successful merger, GSK became the largest pharmaceutical company in the world and the second largest on the UK stock market. (Froud, Johal, Leaver and Williams 2006, p.191). The merger in 2000 differed from the first one, in that it resulted in a diversified company, whose portfolio extended to six different therapeutic areas within 2 years (Froud, Johal, Leaver and Williams 2006, p.171). This spread the risk of patents expiring, either on time or early due to legal battles with generics. Kandybin and Genova highlight the important of diversification and the resulting reduction in volatility of revenue and earnings (Kandybin & Genova 2012, p.4). Investors have rewarded companies such as GSK for diversifying (Jack 2012). This merger was far more promising for a long-term future of GSK.
Mergers as a risk management strategy, despite being popular, do not necessarily create shareholder value. More than two thirds of large merger deals fail to create shareholder value beyond the short-term (Lodorfos and Boateng 2006, p.1405). Doubts over whether a company can successfully diversify, whilst focusing on patented drugs, still exist (Jack 2012). In the case of GSK, the pipeline was still left unimproved as SKB was just as underproductive as GlaxoWellcome had been. Between 1995 and the merger in 2002, SKB had only produced a single blockbuster (Froud, Johal, Leaver and Williams 2006, p.192). Additionally, GlaxoWellcome spent four times more on acquisitions than R&D. (Froud, Williams, Haslam, Johal and Willis 1998, p.576). This type of investment is not as meaningful to shareholders in the long run, as, ultimately, it is successful drugs that reap large sales revenue and, therefore, shareholder value. Moreover, 37 per cent of expenditure went to marketing and just 13 per cent to R&D (AMBS 2018, p.18). This is an incredibly unsustainable way of operation. By 2002, blockbusters accounted for just 55 per cent of GSK's sales revenue (AMBS 2018, p.14), so reliance on ethicals was prevalent in the industry. In 2002, 85 per cent of sales revenue in the industry came from ethicals (Froud, Johal, Leaver and Williams 2006, p.154).
As fewer unaddressed therapeutic areas exist, most new drugs are competing with existing ones, so pharmaceutical companies' response should be to invest in innovation. With that in mind, 50 per cent of drug tested in phase three of clinical trials fail, largely due to efficacy or safety issues, which should be solved before this phase (Grignolo and Pretorius 2012). These failures are expensive, so, to avoid high costs, pharmaceutical companies should avoid putting mediocre drugs up for testing in the first place. GlaxoSmithKline has restructured its organisation to improve their return on investment, changing their goal from 11 per cent to 14 per cent (Stovall 2011). The R&D budget has been detached from being a percentage of sales because sales today relate to R&D from a decade or more before (Stovall 2011). Drug performance units have been introduced where chemists and biologists work together and use their diversity in expertise to improve the drug development pipeline. The drug performance units then undergo a ‘Dragon's Den' style proposal to ensure rigor in the decision to make an investment (Goodman 2011). Deutsche Bank expected this to reduce waste and identify valuable investments earlier on (Deutsche Bank 2008, p.3). Due to the time lag on drug production, it may be too soon to tell whether this is the case. Deutsche Bank's 2008 financial report showed a growth in earnings per share from £81.98 in 2005 and £96.55 in 2007, with an expectation of that to continue beyond 2008 (Deutsche Bank 2008, p.2). This looks like a positive indicator for shareholder value but was more to do with the share buy-backs than operations.
The lack of investment in R&D has persistently plagued the industry. GSK has been allowed to neglect their fundamental problems due to the capitalist focus on maximising shareholder value. This brings into question whether maximising shareholder value is what companies should truly be focused on. In a changing industry context, GSK has been able to dynamically adapt its strategies to mitigate its risks, without solving any underlying problems. The pharmaceutical industry, as a whole, restructures defensively when growth slows (Froud, Williams, Haslam, Johal and Willis 1998, p.554). This has mitigated urgent risks without addressing real issues. To avoid future volatility, GSK should shift their focus from short run profitability to long term.
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