StreetTalk: Banking on a Pharma Giant

Legendary Fidelity Investments portfolio guru Peter Lynch used to spend his Saturdays following his wife around the Chestnut Hill Mall in suburban Boston. While his wife shopped for clothes and household knickknacks, Lynch was shopping for a different product—shoppers.

Brian O'Connell

Let me explain. Lynch theorized that stores that attracted the most foot traffic must be companies that did a good job in creating demand for their product. After all, you'd have to have a great product to make people jump out of their beds in the morning and drive down to the mall to give you their money.

Thus Lynch's portfolio wound up chock full of profitable companies like The Gap, Target and Home Depot. His mutual fund—Magellan—prospered accordingly.

I took a page out of Lynch's book last weekend, meandering through a CVS Pharmacy waiting for a prescription to be filled. I've been anxious to write about GlaxoSmithKline (GSK), one of the largest pharmaceutical companies in the world and a dominant force on drugstore shelves across North America and Europe.

In the big pharma world, drugstore aisle space is every bit as important as Times Square is to New York real estate developers. And few pharma giants fill that space as well as GlaxoSmithKline, with global brands like Aquafresh, Tums, Abreva, Polident, Panadol, and—as a result of a recent purchase—Breathe Right nasal strips. It's a veritable "who's who" of pharmacy aisle mainstays.

This month's article will build a case for investors to consider adding Glaxo to their portfolios. Granted, the healthcare and healthcare products sectors have been under the weather pretty much all year. The Standard and Poor's Health Care Index (HCX) is barely up 6% for the year and the biggest laggards have been the pharmaceutical companies.

THAT IS, EXCEPT FOR GLAXOSMITHKLINE

Glaxo has had a strong year, reporting revenue increases (through August) of about 10% on robust sales of the company's asthma and diabetes drugs, and from its solid line of consumer staples and vaccines. Net profit margins are hovering around the 14% mark, and the company recently hiked its estimated growth rate to 12%, up from 10% earlier this year (Wall Street analysts refer to expected growth rates as "guidance" numbers, because the numbers provide them with a blueprint for a company's fiscal future).

Most companies are conservative with their guidance numbers. Fearful of falling afoul of federal regulators in the era of Sarbanes-Oxley and corporate accounting scandals, publicly traded companies would rather err on the side of over-caution than be caught "promising" investors returns that may not materialize. This impacts the projections that companies give to Wall Street analysts.

THE ANALYSTS AWAKEN

Even so, many analysts are waking up to Glaxo's potential. When you bottom-line Glaxo you see a pharma giant definitely on the upswing. Its products are selling like hotcakes. Advair for asthma and Coreg for cardiovascular disease, are seeing sales growth of 25% to 35% annually. Citigroup analyst Kevin Wilson says product sales will boost Glaxo annual sales to $41 billion in 2006 and $42.5 billion in 2007. He pegs the company's stock price target at $58 per share, up from $54 in mid-October.

He is hardly alone. Wendell L. Perkins, chief investment officer at Johnson Asset Management (Racine, WI) and comanager of the Johnson Family International Value Fund, predicts that Glaxo shares will rise to $68 in the next year-and-a-half. His fund began buying at $43 in early 2004 and continues to snap up shares. "Glaxo has an attractive valuation and generates about $5 billion of free cash flow annually that it can use to buy back stock and pay its 3.0% dividend," Perkins told Morningstar, Inc. (Chicago) in September 2006."We're still seeing strong growth from a number of drugs in the current product line, and hopefully a number of key drugs will come to market in the next couple years," he said.

Morningstar adds that Glaxo has an excellent record of value creation. Return on invested capital has exceeded 15% every year since 1999, and cash flow from operations has consistently generated approximately $3.00 per ADR share. The analyst group estimates the 2006–2007 growth rate for Glaxo at about 9%. Long-term growth averages out to 5% annually through 2015—as good a group of numbers as you'll see in the biopharm sector these days.

FLYING HIGH

I suspect that Glaxo executives know much more about their future fortunes than any dozen Wall Street spreadsheet spouters do. Because of guidance that is likely understated, that tells us that the company is probably undervalued in the marketplace.

That's one reason among many to give full weight to Glaxo. Another is the strong possibility that the company will have, sometime in 2007, a widely available human vaccine for the H5N1 bird flu. That hasn't hit a mainstream news media consumed, right now, by the November elections. Morningstar says that Glaxo's avian flu drug should be a "major seller" for the company in 2007. So when the news does hit, it will likely drive Glaxo's stock price up as bird flu fallout takes the place of Congressional scandals and bomb-crazy North Korean dictators on the front pages of our nation's newspapers, magazines, and news broadcasts.

More good news? Glaxo's product pipeline is chock full. As of Spring 2006, the company had approximately 250 pharmaceutical and vaccine projects in development, and, as we've already established, a dominating presence already on both sides of the pharmacy counter.

Company stock is trading at roughly a $55-per-share level in autumn 2006, up from a low of $35 in 2003; $40 in 2004, and $48 in 2005. Market capitalization is solid at $164 billion, and the stock pays a nice dividend yield of $1.67 (about 3%)—a nice bonus on top of solid stock performance.

Glaxo is also getting good news from the judicial bench. This summer, the EU's Court of First Instance told EU antitrust regulators to check agreements between Glaxo and Spanish wholesalers to limit resale of drugs abroad. Glaxo claims that wholesalers are packaging Glaxo drugs at a low price and then shipping to other EI countries at higher prices. It is a practice that Glaxo wants stopped and the EU courts apparently agree. The court ruled that wholesalers engaging in such practices are breaking antitrust laws, but the court said the pharmaceutical sector was unique because the prices of medicines are not freely determined.

POTENTIAL BARRIERS

Sure, Glaxo is not without its headaches. The Internal Revenue Service is challenging the company's tax statements from 1989 to 2000. If any IRS judgment goes against Glaxo, that could result in billions in back tax payments and interest. And three of Glaxo's most profitable drugs have lost their patent protection in the past two years (antidepressants Paxil and Wellbutrin, and anti-infective Augmentin).

But that news is more than outweighed by news that Glaxo is rolling out a new vaccine (Cervarix) for the HPV virus, which Morningstar predicts will generate billions in potential sales. Meanwhile the company's cardiovascular hypertension drug, Coreg, is seeing its sales surge. Consequently, Glaxo, the number two producer of vaccines in the world, is poised for some serious growth in 2007.

With apologies to Peter Lynch, you don't need a stroll through the pharmacy aisle to tell you that.

Please note that I am not an owner of Glaxo stock and, in the interests of objectivity, won't buy any company stock for one year after this column is published.

Celebrity author and business/finance commentator for CNN and Fox News, Brian O'Connell has written for The Wall Street Journal and Newsweek, 79 Radcliffe Drive, Doylestown, PA 18901, 267.614.1992, fax 267.880.1939, brian.oco@verizon.net