Britain's GlaxoSmithKline (NYSE:GSK) is relatively unusual among drug companies today. Not all that much revenue is left vulnerable to patent expirations, the company has a deep pipeline balanced between potential home runs and solid singles and doubles, and only one drug accounts for more than 10% of pharmaceutical sales. While the Street has already rewarded Glaxo with a healthy valuation, there is still a great deal of debate as to the potential of key pipeline candidates and shareholders could yet see upside here if a few key drugs exceed expectations.
A Mediocre First Quarter
While Glaxo may score well on its future promise, current results are nothing special. Revenue fell 1% as reported and rose 2% on a constant currency basis, as pharmaceutical revenue growth (1%) missed the target by more than 3%.
Advair, which makes up nearly a quarter of drug sales, saw 2% growth, while Ceravix grew 20% (but is less than 3% of drug revenue). Glaxo's HIV partnership saw revenue fall 5%, but the real disappointment was in vaccines, which were flat year on year. Timing issues on vaccine tenders seems to be at least a partial culprit, but I'm sure the benign flu season didn't help. It's also worth noting that worse-than-expected price cuts in Europe (a function of austerity measures) also impacted revenue.
Profitability was decent, all things considered. Gross margin fell more than a point, but operating income did rise 1% on a reported basis and the company saw some modest margin improvement. It's worth noting, though, that Glaxo doesn't really have a reputation for ferocious cost efficiency, and its margins do trail the likes of Merck (NYSE:MRK) (on an adjusted basis) and AstraZeneca (NYSE:AZN).
Will Management Find A Middle Ground With Human Genome Sciences?
Glaxo shook up the biotech space a bit when it made an unsolicited $13/sh ($2.6 billion) offer for Human Genome Sciences (HGSI) - Glaxo's partner on drugs like Benlysta (lupus), Syncira (diabetes), and Tyrisa (cardiovascular disease).
Human Genome Sciences believes it's worth more, but it may have a hard time finding a better bid, given that pretty much everything of value at HGSI (except mapatumumab) is already tied to Glaxo. What's more, while HGSI management may be right insofar as the company is worth more to Glaxo, the case for a higher bid outside of that is less compelling.
Here's what I mean. If Glaxo would buy HGSI, that would give it some cost improvement options that would likely allow it to cut the price of Benlysta - a drug that was celebrated as the first new lupus drug, but that has been a disappointment from a revenue perspective. Likewise, Glaxo may be able to find a niche for the less-than-impressive Syncria by pricing it aggressively against competing drugs from Novo Nordisk (NYSE:NVO) and Amylin (AMLN).
So while Human Genome shareholders are partially right that these drugs could be worth a lot more, that potential may never develop if the deal with Glaxo doesn't happen.
Huge Unknowns In The Pipeline
There's always a certain amount of differing opinion as to the value of drugs in a company's pipeline (Lilly (NYSE:LLY) is a great case in point), but it seems a little outsized in the case of Glaxo.
Low to high estimates for pipeline contributions in 2017 vary by as much as 100% between analysts, with some analysts predicting a little over $1 billion for Relovair ]a new COPD drug that will presumably compete with drugs from Forest Labs (NYSE:FRX) and Novartis (NYSE:NVS)], and others predicting over $4 billion in sales. Likewise, some believe Benlysta and Syncria can be solid drugs, others predict perpetual disappointment.
Arguably the biggest deltas to watch are Tyrisa and MAGE-A3. In the case of Tyrisa, the market has been looking for an effective anti-atherosclerosis drug for a long, long time, and a safe and effective drug could be worth billions. In the case of MAGE-A3, this is a cancer vaccine with modest potential in its initial target (melanoma), but potentially blockbuster potential if it proves effective across a range of cancer types (a broader prospective list of follow-on applications and easier manufacturing process than Dendreon's (NASDAQ:DNDN) well-known Provenge).
Experience tells me not to get too excited about cardiovascular drugs or cancer vaccines, but the fact remains that there could be real upside to Glaxo's out-year revenue growth expectations if these work out.
The Bottom Line
While I like a lot about Glaxo, so too does the Street and these shares are not particularly cheap. That said, they do seem about 20% undervalued today and offer a relatively large dividend (and one that should be well-covered by cash flow even if the pipeline disappoints). Glaxo wouldn't be my first pick in the pharma space today, but if the shares sold off in the low $40s, it would be a much more difficult decision.
Disclosure: I am long AMLN.