GlaxoSmithKline - Legal Side Effects

With restructuring charges and legal provisions hitting the second quarter, Glaxosmithkline (LON:GSK) recently announced a slight loss. However, the double-digit dividend increase shows confidence in the future which is underpinned by, amongst other factors, five key drugs in the late stage pipeline.

Whilst Glaxo’s legal settlements are an effort by CEO Andrew Witty to put a line under its legacy product issues, the group’s restructuring efforts should benefit future results. When non-recurring charges are excluded the performance for Glaxo was sound especially given some of the headwinds that the group faces.

Despite a number of one-off or short-term factors impacting the group’s bottom line, net cash inflow from operating activities in the first half rose by 21% in sterling terms to £4.2bn. Thus the underlying momentum of the business still looks sound.

Turning to the legal charges, a £1.57bn charge is clearly not inconsequential.  Avandia, the diabetes drug, is the highest profile of Glaxo’s drugs under the spotlight and has been associated with an increase risk of heart disease.

It should be noted though that Avandia goes off-patent in 2012 and sales have already fallen significantly due to negative press. Thus in the worst case scenario that Avandia sales disappear completely in 2011 the hit to earnings will be about 7%.

The history of concerns on the drug dates back to 2007 when an academic journal showed a 43% increased risk of heart attacks associated with the drug. However, Glaxo maintains that it is safe and will continue to sell the product although despite this sales have fallen from £1.4bn in 2006 to £462m in 2009 which compares to sales of £28.4bn in 2009.

Anti depressant Paxil meanwhile was marketed as non-habit forming… but this appears to be incorrect. Clearly drugs companies are often over-zealous in the promotion of their products and the large charge to make amends for this illustrates that it doesn't pay. However, litigation will always be a feature of the pharmaceutical industry especially as patented products have such high margins.

Turning to the new drugs on offer and Glaxo has pursued a policy of what works is what counts. Thus of the five drugs in late stage of the pipeline one is from an external company and one is from a partnership venture.

Although CEO's are typically ebullient in their analysis of their company's operations it is notable that Andrew Witty, Glaxo's CEO, describes having five drugs at this late stage as an "unprecedented achievement". This appears to show the benefits of Glaxo's approach to de-risking and increasing the productivity of its research and development facilities.  The hiring of a heavy weight M&A guru from Goldman Sachs as Chief Financial Officer also appears to be a strong move.

The key growth areas for Glaxo remain to sell these products in emerging markets as well as the demographic trends for an aging population.  Legal issues are a common occurrence in the pharmaceutical space and more attention should be paid to success in product development where Glaxo is fast becoming extremely productive.