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Glaxo Stung by Legal Bill

Posted by shutah on January 19, 2011

GSK shareholders are hit by costly legal settlements.

If big really is beautiful, then you don’t get much more attractive than pharmaceutical giantGlaxoSmithKline

Glaxo the global giant

By any measure, GSK is a powerhouse. The world’s fourth-largest drug-maker recorded annual sales of over £28 billion in 2009 and posted a post-tax profit of £5.7 billion. GSK employs nearly 100,000 people and paid over £2.2 billion in corporate taxes last year, so it’s one of the biggest corporate contributors to HM Treasury’s coffers.

Furthermore, with a market capitalisation of over £61 billion, the blue-chip firm’s shares are very widely held, featuring at the heart of many UK-focused portfolios, both private and institutional. So, when GSK stumbles, it has an impact on millions of investors.

A £2 billion setback

One such stumble happened earlier this week, after it was announced that GSK is to record a charge of £2.2 billion (or £1.8 billion after tax) due to additional legal costs incurred in 2010.

This legal charge relates largely to an ongoing US investigation into the sale and promotion of diabetes drug Avandia. Following concerns about raised cardiovascular risk among Avandia patients, the drug has been largely withdrawn from prescription in America and Europe. As you’d expect, this partial withdrawal has triggered a flurry of product-liability lawsuits, especially in the famously litigious US.

Legal side effects

Of course, this isn’t the first time that GSK has had to dig deep to meet big bills arising from legal disputes and regulatory fines. In the world of ‘Big Pharma,’ multi-billion-dollar settlements for product-liability cases are almost as common as the side-effects these drugs sometimes cause.

In common with other regulators, the US Food and Drug Administration (FDA) and the European Medicines Agency have become far more hands-on when enforcing pharmaceutical safety. Hence, recent years have seen a notable increase in the number of enforced product withdrawals, ‘black box’ safety warnings, and huge fines for regulatory breaches.

Indeed, in its last set of annual results, GSK had already set aside nearly £1.6 billion for legal charges covering Avandia and antidepressant Paxil. This sum also included £500 million stemming from manufacturing problems at a former GSK plant in Puerto Rico which was closed in 2009.

A bitter pill to swallow

In some pharmaceutical circles, such legal charges are seen as an almost inevitable price of launching blockbuster drugs into the lucrative US and European markets.

Obviously, GSK shareholders will welcome the company’s attempts to make proper reserves for new Avandia claims in the US. Then again, £2.2 billion before tax is a bitter pill to swallow, as this record-breaking charge will wipe out Glaxo’s fourth-quarter profit. What’s more, this charge is only a ‘reasonable estimate,’ so it could rise or fall in future.

Nevertheless, GSK’s shares closed at 1,182p on Tuesday, down almost 5% from the 1,240p they traded at before this surprise announcement. This represented a £3 billion drop in GSK’s market capitalisation.

Has Mr Market over-reacted?

Given that the drop in GSK’s value exceeds the expected loss by a wide margin, some investors will take the view that the market has over-reacted. On the other hand, critics will argue that announcing such a large loss provision out of the blue suggests that, at best, GSK needs to improve its communication. At worst, investors will fear reputational damage to the company from yet another run-in with the FDA.

Even so, on a price-earnings ratio of around 10 and a dividend yield above 5% (covered twice), GSK displays some well-worn value characteristics. In addition, the company has a rock-solid balance sheet and throws off cash in the billions.

However, this charge — approaching a quarter of 2010’s total profits — could spell an end to GSK’s aggressive share-buyback scheme, during which the company has retired hundreds of millions of shares. Likewise, lower cash reserves could lead GSK to trim its dividends, although I don’t expect this to happen. After all, GSK’s annual dividend climbed by 36% between 2001 and 2009 and rose in each of these years.

In my view, this legal setback, while non-trivial, is only a small part of the big picture. Far more important is GSK’s cost-cutting and its stated goal to move away from ‘white pills and western markets’. If these initiatives succeed by growing earnings, then we should see an upward re-rating of GSK shares.



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