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Executive summary:

Over the past few years, GSK has been quietly executing on an impressive pipeline, with 15 new medications and vaccines launched in the past 5 years - 6 within the past year. These new drugs are expected to generate an additional $5 billion in revenue over the next 3 years, leading to an annual revenue increase of 3% for the pharmaceutical and vaccines divisions. Combined with continued cost-cutting, share buybacks, and a steady consumer health division, the company should be able to grow EPS by 6%-8% annually for the next 3 years. With a current P/E of 15 and a 5% dividend that management is committed to increase, GSK is a stock that should provide a solid return for value investors for the next several years.

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Over the past 5 years' bull market, GlaxoSmithKline (NYSE:GSK) stock has underperformed the S&P 500, as well as several big pharma companies, including Astra-Zeneca, Pfizer, Merck, and Novartis. Much of this can be attributed to highly-publicized negative news about the company:

- the withdrawal of Avandia due to heart risks (later shown to be unsubstantiated)

- payment of a record $3-billion fine in the US in 2012 for unethical marketing practices

- the bribery scandal in China in 2013

However, the company has been quietly executing on the best late-stage pipeline in the industry, that has resulted in the launch of a number of potential billion-dollar drugs. These new medications should lay the groundwork for GSK to grow revenues by 3% annually and EPS by 6%-8% over the next 3 years. With a 5% dividend, which management has increased annually by 6% over the past 5 years, this is a solid core holding for a conservative investment portfolio.

Key Revenue Driver - New Drugs Launched in the Past 5 Years

Table 1 displays 12 products GSK has launched in the past 5 years, with anticipated revenues for 2016. These estimates are derived from analyst consensus estimates published primarily by Evaluate Pharma or Fierce Pharma, and will no doubt be subject to many revisions over time, but offer a perspective on potential revenue growth for GSK.

Breo Ellipta and Anoro Ellipta. GSK dominates the $33 billion global respiratory market, primarily asthma and allergy treatments, with a 34% market share. With the recent approvals of two inhaled products, Breo Ellipta and Anoro Ellipta, GSK is now aiming to gain market share for chronic obstructive pulmonary disease (COPD), which is expected to grow to a $16 billion market by 2020. Both drugs employ the dry inhaler system, named Ellipta, co-developed with its partner, Theravance. The company is promoting Anoro as the first once-daily COPD treatment to combine two long-acting bronchodilators in a single inhaler, while Breo is indicated for once-daily maintenance treatment of airflow obstruction and for the reduction of COPD exacerbations in patients with a history of exacerbations.

As reported in PharmExecBlog, GSK believes only half of the 27 million Americans with COPD are currently diagnosed, noting that COPD is the third leading cause of death in the US. In addition, in countries where smoking is still popular, COPD is likely a significant unmet medical need that will offer GSK a sizable opportunity.

Anoro, which will launch in early 2014 after approval in Dec 2013, could have sales of $231 million in 2014 and $1.74B by 2018, according to estimates compiled by Evaluate Pharma. Based on consensus estimates, Bloomberg has estimated sales of Anoro at $1.2 billion in 2016. For the purpose of this exercise, we are estimating a slightly more modest estimate of $1.0 billion, based on the slow launch of Breo, as discussed below.

Breo Ellipta consensus estimates for 2014 are $400 million, but some estimates have now dropped to just $100 million after a sluggish launch of just $13 million in 4Q13. Evaluate Pharma is pegging sales in 2018 of $1.89 billion. Some analysts attribute the sluggish launch of Breo to GSK simply waiting until Anoro was also approved in Dec 2013 to initiate a marketing campaign for both. After the $3 billion fine for unethical marketing practices, which included promoting Advair for unapproved indications, the company will be embarking on a completely new course for marketing both drugs in the US.

Two major risks may limit revenue growth for Breo and Anoro. First, according to a report from Bloomberg, Express Scripts, the biggest U.S. pharmacy-benefits manager, excluded Breo from its list of medicines covered by insurance companies. Second here has been concern over side effects with Breo brought up at the FDA advisory committee, most worrisome of which was the increased risk of pneumonia that caused hospitalizations and some fatalities. The real key for these drugs will be the balance of safety and efficacy in the COPD population. If the concern with the increased risk of pneumonia, a serious disease for COPD patients, is realized as these drugs are introduced to a much wider patient population, then Breo could have very limited sales. Anticipating that no serious safety issues arise, we are using a $1.0 billion estimate for Breo Ellipta for 2016, slightly below the consensus of $1.2 billion.

Tivicay. GSK's new integrase inhibitor, Tivicay, is also expected to reach >$1 billion by 2016. Evaluate Pharma is estimating revenue of $2.1B by year 2018. The key product for the company will be its combination product of Tivicay with abacavir and lamivudine (filed in the US and EU), which provides a convenient dosing regimen for HIV treatment. The major risk to a rapid uptake by Tivicay is the 7-year headstart by Merck's Isentress (sales of $1.6 billion in 2013) and the reluctance of patients and physicians to change meds when current therapy is working fine. In addition, Tivicay faces competition from Stribild, a combination of 4 drugs, which includes the integrase inhibitor elvitegravir. Launched by Gilead in late 2012, Stribild achieved revenue of $539 million in its first full year on the market in 2013. The rapid uptake by Stribild is actually a good sign for GSK, since it indicates new combination therapies are meeting a medical need in the HIV community. Perhaps an underappreciated advantage of Tivicay is its low dose (50 mg) that has made it possible to combine it with two high-dose drugs, abacavir (600 mg) and lamivudine (300 mg). In contrast, although Merck has been on the market for 7 years with Isentress (400 mg BID), the company has yet to commercialize a combination product. Although Gilead has commercialized its integrase inhibitor as part of a combination product, its dose of 150 mg and the requirement of a booster medicine Cobicistat (also 150 mg) to inhibit liver enzymes, which would otherwise rapidly metabolize elvitegravir, limits its combination to relatively low-dose HIV medications. Tivicay is the best-in-class integrase inhibitor, with a low dose that does not require a booster medication, and should become a top seller for the company.

For the other new products outlined in Table 1, the 2016 forecasts are based either on consensus estimates, where available, or projections from growth in previous years. As outlined in the Table, these 12 products are expected to grow from $2B in sales in 2013 to >$7B in 2016, providing most of the revenue growth for the company.

Table 1. 2016 Revenue Estimates for Drugs Launched from 2009-2013

Drug

2013 Revenue ($ millions)1

Annual Growth Rate (%)

2016 Revenue ($ millions)2

Anoro Ellipta

0

--

1000

Tivicay

30

--

1000

Breo Ellipta

13

--

1000

Votrient

520

15

800

Synflonix

636

5

750

Duodart

328

30

700

Benlysta

229

45

700

Arzerra

118

55

450

Prolia/Xgeva

91

50

300

Mekinist

16

--

200

Tafinlar

25

--

200

Nimenrix

19

50

70

Total

2024

--

7170

1. Based on exchange rate of 1.57 (used by GSK for 4Q13 report)

2. Composite estimate from several sources: Evaluate Pharma, Fierce Pharma, Analyst reports

Revenue from New Product Launches in 2014-2016

Tempering the success of GSK's pipeline over the past 5 years has been the disappointment of some key potential blockbusters that are currently in Phase III, as discussed below. Revenue from new launches over the next 3 years, excluding those discussed above, is only likely to be in the $500-million range for 2016.

Respiratory products. GSK is truly aiming to cover all bases in the respiratory marketplace. In addition to Breo and Anoro, the Phase III portfolio also includes vilanterol monotherapy, fluticasone furoate monotherapy for asthma (filed in the US), and umeclidinium monotherapy (filed in the US and EU for COPD). For the purposes of this review, no revenue will be modeled for the mono-therapies for COPD, as we can assume they are folded into the very high estimates for the combo products, Breo and Anoro. Fluticasone furoate is already marketed as a nasal spray (Veramyst) for allergies, and the company is now seeking approval for use in asthma using the Ellipta dry inhaler. This could be a significant product, but the field is crowded, plus it could cannibalize Advair, but we will include $200 million for sales in 2016. Finally, GSK is conducting Phase III trials of its anti-IL5 MAb (mepolizumab) antibody (IV or subcutaneous delivery once-monthly) for the treatment of severe refractory asthma. The company continues to expect data on this program in 2014. Assuming Phase III is successful and launch occurs in 2015, we would expect limited sales of about $100 million by 2016.

Eperazan (abilglutide). This drug candidate, which came into the GSK portfolio with its purchase of Human Genome Sciences, is a once-weekly subcutaneous GLP-1 agonist for type II diabetes. The FDA moved back its PDUFA date 3 months to April 15, 2014. The company has received a positive opinion from EU regulators, indicating likely approval in the EU. If approved, GSK faces competition from Novo Nordisk's Victoza and Astra Zeneca's Bydureon, as well as what appears to be a best-in-class drug, dulaglutide, an Eli Lilly drug nearing commercialization. Evaluate Pharma is estimating 2018 sales of $400 million. Given a POS of 80% of FDA approval, we will model 2016 revenue of $200 million.

Darapladib. This cardiovascular drug, one of the crown jewels in the HGS portfolio, failed in its first 16,000-patient Phase III trial, showing no benefit in reducing heart attacks or stroke for patients with acute coronary syndrome. A second study is ongoing in patients who have already had a coronary event, but it is not clear what the path forward would be for approval if the 2nd trial is successful. We are modeling no revenue for this drug candidate for 2016.

MAGE A3 immunotherapy cancer vaccine. This is another key drug candidate in GSK's late-stage portfolio that may not reach commercialization, as it failed in its first Phase III cancer study in melanoma. Read-out in a 2nd study in non-small cell lung cancer is expected in early 2014. For modeling purposes, we are not including any revenues in 2016.

Sirukumab. This is an antibody for arthritis, but the Phase III studies are long and read-out is not expected until 2016. This could be a blockbuster if Phase III is successful, but quite a ways to commercialization.

Revenue from Established Products That Are Growing

GSK has a large number of established products that are continuing to grow, as outlined in Table 2. The 2016 projections are based on analyst projections, where available, or using revenue trends from the past 3 years. Overall, this group is expected to grow about 6% annually and add $2 billion to revenue by 2016.

Table 2. 2016 Revenue Estimates for Established Drugs that are Growing

Drug

2013 Revenue ($ millions)1

Annual Growth Rate (%)

2016 Revenue ($ millions)2

Pediarix

1353

7

1650

Flovent

1250

0

1250

Ventolin

1008

2

1100

Augmentin

989

4

1100

Rotarix

589

5

700

Boostrix

452

15

700

Promacta

292

25

600

Veramys

391

5

450

Volbris

231

20

400

Fluvarix

394

0

400

Xycal

215

10

300

Wellbutrin

152

9

200

Zyrtec

119

5

150

Metabolic - other

273

4

300

Respiratory - other

141

0

150

Anti-virals - other

132

15

200

Dermatology - other

942

0

950

Rare Disease - other

384

10

500

Pharma - other

1256

6

1500

Total

10563

6

12600

1Based on exchange rate of 1.57

2Revenue growth projections based on performance trend over past 3 years

Revenue from Established Brands in Decline

GSK has many older drugs that are off-patent and in decline. It divested two of these in 2013, Arixtra and Fraxaparine, two anti-clotting drugs, and will likely continue doing so as it focuses on its core franchises.

The average annual decline for this group, which represents nearly half of GSK's revenue, is 6% and will reduce GSK's revenue by about $4.5 billion in 2016.

Table 3. 2016 Revenue Estimates for Established Brands that are Declining

Drug

2013 Revenue ($ millions)1

Annual Growth Rate (%)

2016 Revenue ($ millions)2

Advair

8280

-3

7000

Avodart

1017

-8

800

Lamictal

874

-7

700

Hepatitis

988

-5

850

Lovaza

917

-7

750

Imitrex

295

-4

250

Valtrex

352

-25

150

Paxil

447

-15

250

Fraxiparine

347

Divested most regions

20

Serevent

203

-20

100

Flonase

173

-3

150

Hepsera

151

-2

150

Zeffix

286

-30

100

Zovirax

127

-15

80

Requip

196

-20

100

Arixtra

262

Divested most regions

20

Coreg

206

-5

180

Tykerb

325

-15

200

Bactroban

154

-10

100

Duac

113

-15

70

Flolan

103

-15

60

Cervavix

270

-25

100

Antibacterials - other

956

-4

850

CNS - other

363

-5

300

Cardio - other

438

-30

150

Oncology - other

204

-10

150

Vaccines - other

688

-4

600

ViiV

2176

0

2200

Total

20911

-6

16430

Trouble Ahead for Advair/Seretide. Advair (US brand name)/Seretide (ex-US brand name), an inhaled combination product for the treatment of asthma and COPD, is the 3rd-largest selling drug worldwide, with sales in 2013 topping the $8-billion mark and accounting for 20% of GSK's revenue. Both drugs in the combination product have been off-patent since 2010, but due to the complex nature of an inhaled drug device, no generic drugs have yet been launched. However, the company's monopoly on this asset will soon be under attack by credible challengers, and revenue can be expected to decline significantly over the coming years. The risks to revenue are summarized below.

1. The company's patent on the inhaler device, Diskus, expires in 2016, providing an opening for generic copycats. In September 2013, the FDA published guidelines outlining what generic companies must do to get FDA approval to sell the generic equivalent of Advair in the US. First, a bioequivalence study must show that both drugs give equivalent (80%-125%) pharmacokinetic parameters (area under the curve (AUC) and maximum concentration (Cmax) in plasma) in healthy subjects. Second, the generic company must carry out a 4-week efficacy trial to show similar improvement in lung function (FEV) of their drug combination vs. Advair. Successful completion of both of these trials should be possible, especially if the companies run large enough trials to ensure statistical equivalence can be attained by leveling out subject-to-subject variability. Even by copying the device exactly, however, duplicating the delivery of this drug combination is still a significant challenge given the manufacturing trade secrets of the drug and device - but the pay-off is so large that generic companies have been working for years to make this happen.

2. Sandoz and partner Vectura have launched a copy of Advair that goes by the tongue-twister AirFluSal Forspiro, which was first approved in Denmark in Dec 2013 and has subsequently been approved in Germany, Sweden, Hungary, Romania, Bulgaria, Belgium, South Korea, and Norway. This is not a generic, but will be competing directly with Advair as a branded product in the countries where they can garner approval. The reported clinical trial involved 279 asthma patients treated for 12 weeks with either Advair or AirFluSal Forspiro. It is not clear what strategy Sandoz is contemplating for the US, either as a generic entry or as their branded drug, but it appears they may already have enough data from this trial to pass the generic requirements published by the FDA.

3. According to a Bloomberg report, Express Scripts , the biggest U.S. pharmacy-benefits manager, excluded Advair from its list of covered medicines in favor of cheaper Dulera and Symbicort. Advair grew 4% in 2013, primarily by price increases in the US, since volume decreased worldwide. Price pressures around the world, including the US, will likely put additional pressure on sales of Advair.

4. GSK will likely aggressively market Breo and Anoro for the treatment of COPD, cannibalizing sales of Advair for this indication.

Now for some good news. Assuming a few generics do make it to the market, the price reduction will not be the same as for other generics, where a dozen or more competitors drive down the price. In the case of Advair, a price reduction of 20%-30% is likely, rather than the 80% normally seen. In addition, the drug continues to have modest growth in the EMAP and ROW regions.

Our take. Advair is likely to drop modestly in 2014 (-2%), then drop more rapidly in 2015 (-5%) and 2016 (-10%) as branded products and generics enter the market, giving an estimate of sales of $7 billion in 2016. This is roughly in line with the Evaluate Pharma estimates of $5.7 billion in 2018, a drop of 6% annually for the next 5 years.

Avodart. This medication for BPH will lose patent exclusivity in the US in 2015 and Europe in 2017. We are modeling a loss of 90% of US sales in 2016 (-$270 MM), very common for drugs facing generic competition these days. Meanwhile, GSK will be marketing its combination product, Duodart, and likely abandon Avodart in the US.

Consumer Healthcare

The Consumer Healthcare division had sales $8.1 billion in 2013, about 20% of total revenue, which was up 2% on a reported basis but 4% accounting for divestments. Divestments will likely continue as the company focuses on its core brands, so we can continue to expect reported 2% annual growth and slightly better numbers accounting for divestments.

Sales in Asia Pacific and Emerging Markets (EMAP) Should Rebound in 2014

With the bribery scandal slowly receding in the rear-view mirror, expect GSK to rebuild its marketing effort in China and start to grow revenue again in this critical market. GSK does not break out China sales specifically, but CEO Witty noted China sales in 2011 were about 3% of total revenue. This would be $1.3B based on 2013 revenue of $42 billion. The company reported a drop in sales of 18% in China in 2013, which corresponds to a $230 million loss of revenue.

Some indication China sales may be rebounding comes from the 4Q13 earnings report, where the EMAP region grew 5% in the quarter, while only growing 1% for the year. Also, this region grew 10% in 2012 and has been a steady driver of increased sales for most of large pharma in the past few years. Look for this region, which accounts for 20% of GSK revenue, to rebound to significant growth again in 2014 for GSK. These are especially important countries for the off-patent branded market (a large portion of GSKs portfolio), since established brands are valued in these markets relative to generics.

Dividend

GSK has a dividend yield above 5%, and the company has increased the dividend at a compounded rate of 6% over the past 5 years. In 2013, GSK used 80% of its free cash flow to support the dividend. Divestments brought in an additional $2.5 billion that the company used to buy back shares and further support the dividend. The company is very committed to increasing the dividend, and there is very little risk to this stable dividend over the foreseeable future.

Conclusion

Since the start of the current bull market on 10 Mar, 2009, GSK stock has underperformed, advancing 1.62-fold from 01 Mar, 2009 to 28 Feb, 2014, an annualized rate of 10% based on share price alone. However, adding in the dividend, the actual gain is 2.09-fold, or an annualized rate of 15%. Over the same period, the S&P 500 gained annually 22% (or 24% with dividends). With the current bull market due for a correction, GSK represents an excellent investment for the value investor, with EPS earnings growth expected to be 6%-8% for the next 3 years and a growing dividend of >5%. Sales in China should rebound as the company rebuilds its efforts in that country. In 2013, half of its total revenue came from products that are declining, which makes it very hard to grow revenue, but 15 drugs approved in the past 5 years are fueling modest growth of 3% annually (see Table 4) over the next 3 years. Advair/Seretide has been a tremendous product for the company, accounting for 20% of revenue in 2013, but will undoubtedly decline as competitors enter the market and as GSK shifts its marketing efforts to new products in the respiratory area.

Table 4. 2016 sales projections

2013 revenue ($ billions)

% growth

2016 projected revenue ($ billions)

% of 2016 revenue

2014-2016 launches

0

--

0.5

1

2009-2013 launches

2.0

53

7.2

16

Growing established products

10.6

6

12.6

28

Declining established products

20.9

-6

16.4

36

Consumer Health

8.1

2%

8.6

19

Totals

41.6

3%

45.3

The company will likely continue to divest older brands to focus on newer products and will use the proceeds to support the dividend, buy back shares, and make acquisitions to bolster the pipeline. With a secure 5% dividend, GSK is a core holding for conservative and value investors.

Source: GSK - The Quiet Turnaround