GSK, a world leading healthcare company specialized in research and manufacturing of pharmaceutical and consumer health related products, operates through two main business segments in over 114 countries. One is the Pharmaceuticals segment which includes prescription pharmaceuticals and vaccines and the other is the Consumer Healthcare segment which provides OTC medicines, oral care and nutritional healthcare products.
In 2008, the pharmaceutical segment contributed 83.7% to GSK's turnover. However, the contribution of the Healthcare products has been rising over the past years, now responsible for a turnover of 16.3%.
In the gobal pharmaceutical market, GSK posses a market share of 4.0%. Based on the UK market, GSK has a market share of 8.9%. The two graphics presented below show the market shares and the key competitors in the pharmaceutical market.
With a marketshare of about 15%, GSK is the third largest player in the vaccines market behing Sanofi-Aventis (21%) and Merck & Co (16%).
Overall, GSK is one of the TOP6 pharmaceutical companies in the world, with the main competitors Pfizer, Roche, Sanofi-Aventis, Novartis and AstraZeneca.
The market environment is determined by political, economic, social and technological factors.
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.
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.
With the fame of world's leading pharmaceutical market, UK attracts many multinational companies with close links with the government. Meanwhile, since the world is facing 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, aiming to reduce costs while affecting many UK-based staff as well.
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.
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.
International companies benefit from UK's highly trained workforce. A high-talent pool is offered with more than 100 universities and institutions, including top universities in Europe and the world.
Domestic R&D could search support from the UK Government. About £10 billion was spent to uplift the workforce quality on training programmes. By using policy tools such as R&D Tax Credits and Allowances, EUREKA and the European Commission framework programme the UK Government does provide financial assistance to companies carry out R&D with different ownerships.
Although the company was experiencing a positive average annual growth rate over the past five years on turnover, GSK had negative growth rates in the last two years. This leaves some uncertainty to the estimation of the future growth. It is also obvious that GSK had problems to maintain its profitability from 2006. The following divisional and geographical analysis, as well as the subsequent ratio discussion will provide explanations for this development.
GSK distinguishes between the dominant pharmaceutical segment and the consumer healthcare division.
Despite an increase in the turnover, the pharmaceutical segment generated less profit. The turnover increase of 6.4% was vanished by the sharp decline in the profit margin, resulting in a profit decline. Due to an expended asset base, the ROCE fell even sharper than the profit margin.
With a turnover growth of over 11% the healthcare segment further gained in importance. The importance for the aimed risk reduction in the GSK portfolio is shown by the fact, that the Healthcare segment could slightly improve its profit margin and therewith deliver an absolute profit of £810 mn. However, alike the Pharmaceuticals, the ROCE declined underlining that GSK had problems with the effective use of its enlarged asset base.
Assuming a rising contribution of healthcare products to the turnover of GSK, a weaker overall profit margin is likely, since the profit margin of the pharmaceutical segment still remains significantly higher.
Although the profit margin decreased in 2008, GSK still operates at a highly competitive operating profit margin. Furthermore, the diversified product portfolio will lower the dependence on particular products. Especially the prosperous vaccines portfolio and the good position in the consumer healthcare market will stabilise the income foundation.
Many profitable products like Advair, Valtrex and Lamictal are facing patent expiry. For example, Advair, which accounts for £4.1 billion on turnover, will expire in 2010. It is uncertain, whether the successive products can offset the expected sales decline. Furthermore, GSK is facing a harsh generic competition to several mature brands especially in the US and European markets. The most recent example is the decline in Avandia sales in the USA. The Advandia impact on the turnover (-£522mn) shows that GSK is still very dependent on certain products.
The pharmaceutical segment has 150 projects in human clinical trials, more than 20 vaccines in clinical development and the healthcare division prepares to launch new healthcare products like alli in Europe. GSK should be able to generate growth and profit from this large product pipeline in the mid-term.
According to The Vaccines Market Outlook by Business Insights the vaccine market will keep its high-speed growth. The strong involvement in the market should help GSK to benefit from this growth.
Both segments face severe competition in their markets wheter through established competitors or upcomming generics and biotechnology companies. The intensive competition may lead to quick technological changes and limit the marketability of products.
Furthermore, the upcoming price control policies of governments may have lasting influence on the margins of pharmaceutical products.
The divisional analysis shows severe problems in the established markets Europe and USA.
Although the US pharmaceuticals market grew by 1% in 2008, GSK's turnover shrank by over 4%. Without exchange rate effects, this decline would have reached approximately 10%. The profit and the margins in the US market deteriorated dramatically.
GSK was able to offset the turnover decline in the US market by strong growth in other markets. However, evaluating the profit in Europe, the growth was achieved at the expenses of a large double-digit profit decline. The location of GSK's core business departments such as R&D and administration in the UK, and the subsequent concentration of assets there, leads to a lower ROCE in Europe compared to the US segment.
The Emerging Markets, China, Japan and the Asia Pacific region provided an exceeding and very profitable growth. This demonstrates both the good position of GSK in those markets and the importance of those countries for the futher sales and profit growth of GSK.
GSK has strong business fundamentals in the US and European market. Its market exposure, the proven R&D ability and the established brands are the foundation for long-term profits.
Due to its early global strategy, GSK has more assets, brand influence and marketing experience than other competitors in the Emerging Markets. This global presence will furthermore limit the negative effects of problems in particular economies.
Despite the early focus on Asia and Emerging Markets, GSK is still dependent on the US and European markets. Those markets are still responsible for about 80% of the turnover of GSK.
The divisional analysis already demonstrated the importance of Emerging markets. However, the turnover of western companies in those markets is still very low compared with the large population. GSK should skim this market potential, investing a higher proportion of its assets in these markets.
The internationality of its operations makes GSK vulnerable for foreign exchange risk and may threat its profits. The hedging strategy of GSK, produce in the country of sale, may not be practicable in the Emerging Markets.
FDA and European Medicines Agency have set more stringent regulation on pharmaceuticals companies. These higher standards may result in higher research cost, higher product failures and reduced margins.
Although some of the acquisitions reduced the profits on a temporary base, it could be predictable that the decisions contribute to future turnovers and profits. However, with economy recession, uncertainty of further profitability should be taken into account.
The object of the following section is the evaluation of the financial performance and position of GSK. To achieve a valid and meaningful interpretation the authors defined a peer group consisting the main competitors Pfizer, Sanofi-Aventis, Novartis, Astrazeneca and Roche. In order to get a peer group average, we weighted the ratios of each of the five competitors according to their market capitalisation.
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 employed (equity) 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, GSK also demonstrated the ability to generate a significant higher return on asset (RoA) than the competitors. So, its both: a high extent of assets financed with current liabilities and competitive earnings produced with these assets. However, the figures show, that the profit produced from the capital/asset base declined in the last five years while the competitors were able to keep their level relatively 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. 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.
It is notable, that GSK proved the ability to transfer high gross profit margins to a very competitive operating margins. The R&D expenses, a main component of the operating expenses, deliver an explanation.
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), 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% compared with e.g. Pfizer (17%) or Novartis (15%)]. 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 leverage ratios 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 bonds, the refinancing of its 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 the 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 competitors operate 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 £1.2bn point out the need to closely monitor the development in this ratio and, in order to secure the small equity base in the mid- and long-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. And, despite the risen gearing ratios, GSK issued a mid-term bond in 2008 for (nearly) the same conditions as in 2003.
While the financial stability in the long- and mid-term has degraded, GSK improved its liquidity position in 2008.
The balance sheet measurements such as quick 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.
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. Hence, 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. In comparison, GSK outperforms the competitors 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 from its operations. While the turnover increased 7.2% in 2008, the operating cash flow went up about 17%. 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.
Although GSK started a programme aiming to reduce the working capital and therewith deliver cash flow benefits for strategic priorities, the annual report discloses further potential for improvements. This potential is getting obvious in the increase in GSK inventory level in 2008 (WiP +68 %; finished goods: +38%) and in a comparison of inventories with its main competitors. 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 critical issue. While the debtor 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 efficient to generate sales and profit and relied 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 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 movement 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 larger proportion 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, as well as the pharmaceutical sector, performed worse than the overall market, achieving just a small capital gain.
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 analysts are 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%. 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 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.
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. GSK is enjoying a lower beta value comparing with the sector, promising itself a more conservative stock. 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 would cast smaller influence in the stock of GSK.
GSK's R-square means that 20.6% of the price movements are explained by overall market movement. To make a more precise estimation of GSK people should mainly focus on the specific risk other than beta value.
Over all, the share of GSK can be considered as a conservative one and be appropriate for risk averse investors because of the low Beta and low Specific risk.
The YTD figures show a rather disappointing development of the pharmaceutical stocks. As explained before, this is mainly due to the conservative character of investments in the pharmaceutical market.
The forecast overview displays the broadly optimistic outlook for 2009 and the rising scepticism for 2010. 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. Credit Suisse is also convinced that GSK's high vaccine exposure will drive a uniquely stable topline and a superior long term EPS. 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 further stated that GSK will be able to “reap the benefits of recent investment in Emerging Markets.”
However, there are also critical votes. JP Morgan for example expects a lower trading margin and a decline in the gross profitability due to changes in the strategy of GSK focussing more on long-term value by diversifying its product portfolio. The analysts of Societe Generale are sceptical about the raised generic competition and expects earning risks due to the expire of GSK's 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 in varying analyst recommendations. The most recommendations are arranged in the area between “hold” and “moderate buy”.
In conclusion, we believe in the diversification strategy of GSK. We share Witty's view that this will lead to a reduction in risk and sustainable development. By this strategic shift, GSK will be less dependent of the success of particular pharmaceutical products. Consequently, we expect a lower risk for the profit accompanied, however, with a lower margin level. Due to the high leverage, we are convinced that even a lower margin level can provide a competitive return to the shareholders. 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.
In the mid- and long-term, GSK should benefit from the high entry barriers in the vaccine market and the long lifecycle of those products. Furthermore, recent market forecasts show a growing optimism for the overall pharmaceutical market expecting a market growth up to 7%. We assess that as an environment in which we are convinced that GSK should be able to generate growth and profit.
In the short-term, GSK should benefit from its involvement in the vaccine market and the government's swine flu programmes.
Finally, refering to the chief Executive Officer's Statement we see the willingnes 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.
Compared with the P/E ratios of competitors like Roche and Novartis, GSK is fairly priced. We therefore value GSK as “BUY”.
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