3 Reasons GlaxoSmithKline Will Survive the China Scandal

Anjum is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

GlaxoSmithKline (NYSE: GSK) has been accused of the violation of Chinese laws wherein the company’s key officials have used around 700 agencies and firms for increasing the sales and prices of drugs by bribing hospitals and doctors in China. The company has transferred around $489 million to these agencies. Four of the company’s executives are detained. This includes the vice president, the legal affairs director, the business development manager and the human resource director.

However, this should not be much of a concern as the company is in continuous process to rectify its fault and cut down the prices. Also, this is more of an inborn problem of China, rather than the company itself. It is the management of Chinese hospitals and the government who are responsible for such a shameful event.

Low prices for hospital services, as enforced by government, leaves no option but to keep the price of drugs high to make a profit. Instances such as these make it clear that it is not the drug making company, but individuals involved in the process that are responsible, and this should not have any long term effect on the functioning of the company.

Let us have a look at some of the key points that will help Glaxo come out of this short term problem.

Strong fundamentals

Half yearly results for 2013 have shown an increase in EBITDA by 13% to £3997 million. EBITDA margin for the period increased by 400 basis points to 31% compared to the first half of 2012, indicating increased operating efficiency. Operating and free cash flows have been positive in the past five years. The debt component in the capital structure is higher than its peers. Yet a high interest coverage ratio of 72 indicates that the company has managed its debt very efficiently and is generating enough revenue to meet its debt obligation. Investment returns are also very high with ROE and ROA being 54.5% and 10.1%, respectively, as compared to the industry average of 11.2% and 5.7%, respectively.

<table> <thead> <tr><th> </th><th> <p>Interest Coverage</p> </th><th> <p>Leverage</p> </th><th> <p>D/E</p> </th><th> <p>Current ratio</p> </th><th> <p>ROE</p> </th><th> <p>ROA</p> </th></tr> </thead> <tbody> <tr> <td> <p>GSK</p> </td> <td> <p>72</p> </td> <td> <p>6.4</p> </td> <td> <p>2.6</p> </td> <td> <p>1.2</p> </td> <td> <p>54.5</p> </td> <td> <p>10.1</p> </td> </tr> <tr> <td> <p>JNJ</p> </td> <td> <p>14.5</p> </td> <td> <p>1.8</p> </td> <td> <p>0.2</p> </td> <td> <p>2.1</p> </td> <td> <p>16.3</p> </td> <td> <p>8.8</p> </td> </tr> <tr> <td> <p>MRK</p> </td> <td> <p>23.3</p> </td> <td> <p>2</p> </td> <td> <p>0.3</p> </td> <td> <p>2</p> </td> <td> <p>11.2</p> </td> <td> <p>5.7</p> </td> </tr> <tr> <td> <p>Industry average</p> </td> <td> <p>28.4</p> </td> <td> <p>2.3</p> </td> <td> <p>0.4</p> </td> <td> <p>1.7</p> </td> <td> <p>19.4</p> </td> <td> <p>8.8</p> </td> </tr> </tbody> </table>

 Fair Valuations As Compared to Peers:

On a relative basis, Glaxo is trading at PE of 19, compared to Johnson & Johnson (NYSE: JNJ) and Merck & Co. (NYSE: MRK), which are trading at a PE of 25 and 24, respectively. In terms of PEG valuation, Glaxo is trading at a PEG of 2.3, which is lower than peers as shown in the table below. Further, the company is trading at a price to sales ratio of 3.2, which is again relatively less than peers. Glaxo’s current dividend yield is 4.2% compared to Johnson & Johnson’s 2.9% and Merck’s 3.6%, making it lucrative for investors.

<table> <thead> <tr><th> <p>Company</p> </th><th> <p>Earnings</p> </th><th> <p>PE</p> </th><th> <p>PEG</p> </th><th> <p>P/S</p> </th></tr> </thead> <tbody> <tr> <td> <p>GSK</p> </td> <td> <p>8.2</p> </td> <td> <p>19.2</p> </td> <td> <p>2.3</p> </td> <td> <p>3.2</p> </td> </tr> <tr> <td> <p>JNJ</p> </td> <td> <p>6.6</p> </td> <td> <p>25.1</p> </td> <td> <p>3.8</p> </td> <td> <p>3.8</p> </td> </tr> <tr> <td> <p>MRK</p> </td> <td> <p>7.1</p> </td> <td> <p>24.3</p> </td> <td> <p>3.4</p> </td> <td> <p>3.2</p> </td> </tr> </tbody> </table>

Drugs in pipeline

Glaxo’s near-term growth potential relies on Breo, the company’s new treatment for the respiratory disease COPD, and skin cancer drugs Tafinlar and Mekinist, which have received U.S approval. There are three more drugs, which according to the company will receive approval by the end of the year. Thirteen more products are in late stage clinical trials, whose results are expected in next eighteen months. An increased number of approvals is what the company is aiming at, as it is the revenue driver for any pharmaceutical company.

Comparative analysis

Johnson & Johnson can make major advances in care and provide a treatment where no adequate therapy exists. Johnson & Johnson is in $1 billion deal with Aragon Pharmaceutical for its prostate cancer drug ARN-509. A similar move in 2009 for Zytigia treatment was a blockbuster in two years time. It is expected that with the development of ARN-509, it could make a market more than Zytigia.

But recent news in India has left a sour taste for investors. The company has been reported to use ethylene oxide; a substance which is used to sterilize medical equipments, to kill bacteria in baby powder. Even after that, JNJ has not conducted mandatory tests to make sure that no traces of the substance were left as it is a cancer causing agent.

Merck financials show 9% decline in total sales with pharmaceutical decline of 12% in the fiscal 2012. Singulair, which was company’s second largest selling drug globally, saw its patent expire in the U.S in August 2012, leading to a 75% decline in sales. The patent has also expired in number of other European countries further affecting the company’s revenue.

Maxalt too lost its protection in December 2012 in the U.S, and it will continue to lose its market share in many of the European countries as the patent will expire by August.

Another problem associated with Merck is the ongoing case over the painkiller Vioxx. The painkiller was promoted as a treatment of rheumatoid arthritis, but the drug has shown substantial evidence of heart attacks. The drug was pulled out of the market, yet the company is facing its consequences. Merck has already paid $4.85 billion to resolve the lawsuits. This is not the end as Merck has further paid $950 million as a part of criminal fee and has agreed to pay $220 million against consumer fraud lawsuits.

The bottom line

Fair valuations, good financials and a large number of drugs in pipeline surely do not give a bearish outlook to this stock for the long-term. China’s issue might have some short term impact on the company’s price but this will be offset by the company’s strong performance. Overall, investors can consider exposure to the stock for a healthy dividend yield associated with robust earnings growth.

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Anjum Khan has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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