Wide-Moat Glaxo Is Undervalued

As one of the largest pharmaceutical companies,

The magnitude of Glaxo’s reach is evidenced by a product portfolio that spans several therapeutic classes as well as vaccines and consumer goods. The diverse platform insulates the company from problems with any single product. The highest revenue generator, Advair, represents just under 10% of total revenue. However, the complexity in approving a generic version of an inhaled drug like Advair has held off significant generic competition well past the drug’s 2010 patent expiration, where approvals for generic inhaled drugs are particularly difficult. Further, the company’s advancement of its next-generation respiratory drugs should help Glaxo maintain its entrenchment in both asthma and chronic obstructive pulmonary disease as generic Advair competition likely increases in late 2018.

On the pipeline front, Glaxo has shifted from its historical strategy of targeting slight enhancements toward true innovation. Also, it is focusing more on the immune system, with genetic data to help develop the next generation of drugs. The benefits of this strategies are showing up in Glaxo’s early-stage drugs. We expect this focus will improve both approval rates and pricing power.

From a geographic standpoint, Glaxo is strategically branching out from developed markets into emerging markets. Its consumer and vaccine segments position the firm well in these price-sensitive markets. While this strategy is likely to create some challenges, like the potential legal violations that arose in early 2013 in China, we believe the fast-growing emerging markets will help support long-term growth and diversify cash flows beyond developed markets.

Strong Pricing Power Patents, economies of scale, and a powerful distribution network support GlaxoSmithKline's wide moat. Glaxo's patent-protected drugs carry strong pricing power, which enables the firm to generate returns on invested capital in excess of its cost of capital. Further, the patents give the company time to develop the next generation of drugs before generic competition arises. While Glaxo holds a diversified product portfolio, there is some product concentration with the company's largest drug, Advair, representing just under 10% of total sales, but we expect new products will mitigate the eventual generic competition that will probably be more gradual, given the complexity of creating generic respiratory drugs. Also, Glaxo's operating structure allows for cost-cutting following patent losses to reduce the margin pressure from lost high-margin drug sales. Overall, Glaxo's established product line creates the enormous cash flows needed to fund the average $800 million in development costs per new drug. In addition, a powerful distribution network sets up the company as a strong partner for smaller drug companies that lack Glaxo's resources. Glaxo's entrenched vaccines and consumer healthcare franchises create an added layer of competitive advantage stemming from cost advantages in creating vaccines and brand power in the consumer group.

We believe GlaxoSmithKline has a stable moat trend. While the company’s main near-term generic competition focuses on Advair, the complexity of the inhaled delivery of the drug will partially limit generic entrants. We see this negative headwind balanced by increasing strength in gaining cost advantages in the vaccine business with the recently acquired Novartis vaccines. Further, consumer healthcare goods should enable the firm to leverage branding power from this segment. We believe the net impact is relatively consistent funding for research and development, which should create a stable lineup of next-generation drugs.

Turning to the macro environment, several headwinds face Glaxo, but the company is making solid strategic moves to address the challenges. On the negative side, the risk-sensitive U.S. Food and Drug Administration is generally only approving very safe drugs, or drugs in high-need areas such as cancer. Also, managed care and pharmacy benefit managers have consolidated over the past decade and are now using their growing size to demand lower drug prices and reduced coverage for less innovative drugs, forcing drug firms to push for true innovation and reducing the power of Glaxo’s distribution networks. Further, the U.S. government is evaluating comparative effectiveness programs and more aggressive price negotiations, raising the bar for future innovation. While Glaxo faces several headwinds, its pipeline is focused on more innovative treatments in areas of unmet medical areas such as severe asthma where payer coverage and pricing power remain strong. Outside the pipeline, strong entrenchment in vaccines and consumer goods gives the firm some relief from the pricing pressures in the pharmaceutical group.

Regulatory Issues and Competition Are Risks Like all drug companies, Glaxo faces risks of drug delays or nonapprovals from regulatory agencies, an increasingly aggressive generic industry, and competition in the pharmaceutical industry. Specific to Glaxo, increased generic competition could come at any time for leading drug Advair, which could be detrimental to the company as the drug represents just under 10% of the top line and a higher portion of the bottom line because of its high margins. Further, the success of Glaxo's recent expansion into vaccines and consumer products with assets from Novartis is largely dependent on margin expansion, which may be challenging given the high level of competition in these markets.

Glaxo remains on solid financial footing. While the company carries more debt than several of its peers, it generates relatively strong cash flows that should be stable despite increased pressure on its leading drug, Advair. We expect the company will be able to fund its dividend payments over the next decade, but we don’t expect much of an increase to the dividend over this period as earnings growth is limited to a largely low-single-digit rate annually on average.

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