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GlaxoSmithKline (NYSE:GSK)

Q2 2012 Earnings Call

July 25, 2012 8:15 am ET

Executives

Andrew Philip Witty - Chief Executive Officer, Executive Director, Member of Corporate Administration & Transactions Committee and Member of Finance Committee

Simon Dingemans - Chief Financial Officer, Executive Director, Member of Corporate Administration & Transactions Committee and Member of Finance Committee

Moncef Slaoui - Chairman of Research & Development, Executive Director, Member of Corporate Administration & Transactions Committee and Member of Finance Committee

Analysts

Tim Anderson - Sanford C. Bernstein & Co., LLC., Research Division

Graham Parry - BofA Merrill Lynch, Research Division

Andrew S. Baum - Citigroup Inc, Research Division

Alexandra Hauber - JP Morgan Chase & Co, Research Division

Gbola Amusa - UBS Investment Bank, Research Division

Jo Walton - Crédit Suisse AG, Research Division

Brian Bourdot - Barclays Capital, Research Division

Andrew Philip Witty

Good afternoon, and thank you very much for joining me by link today. I'm sorry we're not doing this face-to-face. But I'm sure you'll understand, we're trying to avoid everybody being caught up in Olympic lane. And hopefully, this works for you in terms of avoiding being trapped in traffic.

We're going to review the Q2 results for GSK. And with me today, I've got Simon Dingemans, our CFO, who'll make some comments in a few minutes. And also, Moncef Slaoui, who will join Simon and I for question-and-answer at the end, so you'll have an opportunity to ask about pipeline assets, if you'd like.

Let me start by making a few general comments about the quarter. It's been an interesting quarter for the company, a very busy one, really a couple of big dynamics. The first is some very, very good progression of the advanced pipeline. We'll talk a little bit more about that. But clearly, during the quarter, we've seen a lot of very encouraging data, particularly around some of the bigger potential assets in the pipeline. While there still so much to do to bring those assets to the marketplace, it's clearly coming into shape as a potential driver of enhanced organic growth going forward.

Secondly, again, the quarter has been characterized by a continued deterioration in the external environment, especially in Europe, where we took a 7% negative price hit during this quarter. We think to some degree, that may be the worst it gets, but that all depends on government policy. So if nothing new comes out from now on, we think it starts to ameliorate going forward. But it all depends on the events coming out of the Italian, Spanish and other governments over the next few months. We'll have to wait and see. So this has been a quarter really with some short-term, tough external pressures, really offsetting some of the growth opportunity that we have in our investment markets and the quarter, where we've seen good progression on pipeline.

Overall, strategically, we feel that we've made good progress. And in terms of heading towards where we want to be, delivering sustainable sales growth and driving leverage in our margin, over the medium to long-term, over the next few years, we feel we made good progress. And I wanted to just review some of the headlines of that.

First of all, just to reiterate, the strategy remains exactly the same. This is something which has guided us well. And I think we have exactly the alignment we need within our organization, to deliver the focus on our investment businesses, the growth of our Emerging Market business, the strengthening of our Japanese business. All of that has really helped to deliver for us this year. It's interesting, even in this quarter, this time last year, our reported sales were falling about 4%. We're now moving into a period where we see this year coming out in line with last year. So that minus 4%, back to level this year. We would've liked it to be a little bit better than that. But within the scope of the pressures we see, we still think that shift or turn in momentum of the organization is really a key signal of what we're building toward over the future. We've got to this point because of the performance of our investment businesses, little bit offset by the pressures in some of our more mature businesses.

R&D continues to be a major focus for us in delivering now major changes in how we operate, major changes in how we make decisions. It is what has put us in the position we're in today with really an unprecedented potential opportunity in our pipeline, really key for us in terms of the medium-term opportunity of the company.

The portfolio as a whole, really helped along by the continued growth of our Consumer business, the cleaning up of that portfolio. The divestment of the products are really helping to release the energy and the focus, delivering a 7% growth during the quarter against a market growth of about 4%, very nice recovery in the U.S. for us on the Consumer business and really across all of our key categories of oral care, particularly the Sensodyne business, nutrition, particularly the Horlicks business, and of course, wellness, particularly in pain, very good performance during the quarter from Consumer.

We also continue to be very positive about our Vaccine business. And while it's very lumpy and causes all of us, including yourselves, real challenges in forecasting because the tenders come in, in such unpredictable ways, and therefore, creates and amplifies quarter-to-quarter volatility, you can see during the year the continued development of this business, tremendous continued rollout of Synflorix across the world, particularly in emerging markets, continued good growth of Rotarix, Boostrix, as well as the base businesses, very strong performance during the quarter from emerging markets. And we continue to expect during the rest of this year, although it will be variable between Q3 and Q4 because of prior year comparisons, we continue to expect our Vaccine business to be extremely robust driven by those new products.

Now I want to dive very quickly into the 2 mature markets and to give you a sense of some of the puts and takes there. But before doing that, just give a little bit of a sense of the overall movements in the business this year at the sales level. So what you can see from this slide is a simple bridge from where we were last year Q2. You can see the impact of the divestments of the various businesses. So this is the Vesicare divestment in particular, as well as the Consumer brands. You can then see the headwinds of the U.S. and European pharma businesses, which I'm going to touch on in a second, really completely overwhelmed by the growth being delivered by the Emerging Market, Japan and Consumer businesses. And I think this slide more than any I can show you demonstrates why the investments we've made in these businesses has been worth it. Because even in this much more difficult than unexpected environment for the developed markets, our new businesses have been able to neutralize that impact.

You, then, see a little bit of the impact from ViiV genericization, particularly of the older HIV products, takes us to where we are on CER and just for completeness I've shown you the currency headwind as well. But really, what you see here is a story of really 3 parts, a piece of divestment, headwinds in Europe and U.S., countered by continued strong performance in those growth businesses: Emerging Markets, up 9%; Consumer, up 7%; Japan, up 6%, all 3 performing extremely well.

Now let's look quickly at Europe. We talk a lot about price, but I wanted to share with you volume because I think volume just gives us a sense of how well we're doing competitively in this marketplace. This is an IMS-derived slide. You see 3 lines on this slide. The top line is the overall market. The middle line, if you will, and there, from the left-hand side, the middle line is the peer group of major multinational companies, and they're highlighted at the bottom for you in the footnote. And then the more variable line is GSK. Now 2 or 3 messages in this slide: this is volume; this excludes Avandia as a discontinued business but includes everything else; includes Vaccines which are picked up in retail but not Vaccines which are picked up through large government tenders. So just for completeness to give you a sense of what this data shows.

2 takeaways I think you can see from this. Number one, the overall market is pretty slow anyway in volume, and if anything, just gradually slowing. And you can see that top line just trending slightly down from an average of about 1% to somewhere in the middle of a 0 to 1% range. So whole European market volume, not terrible but certainly not dynamic. What you see within the GSK versus peers is 2 phenomena. In the early part, great volatility around the winter quarters. Why is that? 61% of GSK's European business is either in respiratory or antibiotic. So what you see there is the phenomenon of the light flu seasons that we've been going through in the last few years. More importantly, as you look at the more recent quarters, over the last several quarters, you see that GSK is performing either ahead or in line with the peer group for volume growth in the marketplace.

It's important to keep an eye on this. It's very easy when we look at price to draw conclusions about competitiveness. Actually, what the business does is generate prescriptions, it generates use. And that of course, is a good measure of our competitiveness. And you can see that through the volume slide here.

If we go now to U.S. very quickly, this just reconciles for you what's going on in the U.S. U.S. is a less of a fundamental issue than I think Europe. Europe is very much about this price adverse against the volume pitch that I've just shown you. U.S. is a little bit more a series of one-offs. And what you can see here, 86% of the U.S. business is in promoted brands, so the business we promote. As you know, most of the old business disappears quite quickly anyway. You see that, that business grew 4% in the quarter. There are really 2 one-offs, which are really then influencing our quarterly performance in America. First of all, at the extreme right-hand side, you can see that we have an impact of discontinued businesses. This is the Avandia, the Vesicare business disappearing, took about 3 percentage points of growth away. And you can see that there was a stock impact and shift compared to last year, particularly in the 3 Respiratory products of Advair, Flovent and Ventolin, which took about 2 percentage points of growth off.

Those really tell you that, overall, this business in the U.S. is about flat, maybe down 1%. And that's where we think more or less our underlying performance is in the U.S. on a longer term -- on an annual basis rather than on a quarter-to-quarter basis. So you can see there that the puts and takes between the promoted growth, the genericization drag, which of course, gets smaller year-on-year, important for next year to remember, and then you've got these 2 one-offs, which essentially then drives the minus 6% performance for the quarter.

I think this is less concerning to me than the European picture. European picture, I can't do much about the price pressure. What we know is that these one-offs in the U.S. will work their way out of the system pretty quickly. And the focus for us, obviously, is putting more products into the promoted box as we see the size of the genericization box shrink. And so again, the U.S. continues on quite a good journey in terms of transitioning from a business dominated by businesses which would decline, into a company which is dominated by businesses with the potential to grow. And that's exactly how we'd like to see things go forward.

So to summarize, where are we at the half year for GSK in terms of performance? Sales, you see. And we've guided today that we expect the year to be in line with last year in terms of our sales performance. We'd love it to be a little bit quicker than that, but the reality is the pressures from pricing in particular have knocked off that small amount of growth, which we'd originally hoped to deliver. Nonetheless, as I've said, getting back to that level compared to where we were last year remains a good milestone on the path to getting to sustainable sales. And you can see that beginning to come into sight for the company.

Continued to react to that sales pressure by taking costs out of the business. This is a really important thing for us to get right. We are not going to cut costs for the sake of cutting costs because we know there is so much value to be created in 2 key areas: number one, making sure that we support our investment businesses like Japan, Emerging Markets and Consumer; and number two, we need to get our pipeline right so that when we bring those assets to market, they fully deliver a return for shareholders. It would be crazy to make short-term cost reductions now, which would damage either of those 2 potential long-term value generators. And we're not going to do it. What we are going to do is continue to look for efficiencies in our administration organization and, where possible, continue to tighten up our selling and advertising expenditure. We've done some of that during this quarter. And you can see that we've been able to offset some of the negative impact of the sales picture and the mix picture but not all of it. And that's because we're determined to stay committed to developing the long-term value proposition that we've described.

Cash production, as Simon will describe to you, has continued to be very robust, very strong. And during the half, we delivered GBP 3.2 billion to our shareholders. Pipeline, very exciting. At least 8 new products capable of being launched in the next 24 months. And within that portfolio, an extremely interesting mix, ranging from some very novel, exciting, rare disease assets, all the way through to major new programs. And I just want to touch on some of the progress we've made here.

We promised you that we would work on essentially 15 programs during 2011 and 2012. We're keeping a very close eye on this scorecard. Of those 15 programs, 12 of those programs have reported data already. 10 of them have reported positive data. This is a slide which just reflects where we were a year ago. We had data back on just a handful, a green bar means that we've had good news, a red bar creatively enough means we have bad news. And that really reflects to you where we were a year ago. If we just fast-forward then through to the end of last year, you can see the progress we were making through the portfolio. And where we are today, you can see that we've had the majority of the data back on the majority of these programs.

So of the 15, 12 have essentially given us substantial data, 10 of which are positive. And you can see there that the only 2 which really disappointed were otelixizumab in Type 1 diabetes, which was ironically the first data we got back 2 years ago and failed. We're relooking at that molecule in other potential indications. And then we've been disappointed, as you've seen, in the various announcements we've made during this year around the potential expansion of Tykerb, particularly into adjuvant breast cancer.

Outside of that indication and otelixizumab, you can see that across the board, we've continued to deliver very positive results. And what's exciting within that portfolio, as you read down the list, the UMEC/vilanterol combination, so-called program Zephyr, a very exciting, a very significant opportunity. And you've seen how we've been able to essentially overhaul the competition, particularly with regard to the U.S. market. And you know that we're heading towards filing there. We've already filed Relvar, new name for RELOVAIR. And as you go down the list, you can see the progress that we're making.

What's very important is that we're delivering these assets, many of which clearly have substantial potential. Because they go into major areas, you're seeing some real points of differentiation being elucidated in the trials. And crucially, they go into fields where we're already established. So as an organization, you can start to see a focus developing around what the next generation of GSK is going to look like. This isn't about GSK drifting into hundreds of different therapeutic areas. It's about a GSK which delivers substantial portfolio opportunity into franchises in which we already have established expertise, established sales and marketing operations and networks, and therefore, will not need in many cases to build massive incremental cost bases to take these assets to market.

The drugs I've just described to you on the prior page really fall into these boxes neatly. And you can see, read for yourself, the various opportunities which are coming along. I just want to mention to you, we actually filed the BRAF inhibitor yesterday in Europe. The slide says it's imminent. It's more than imminent, it was yesterday. And you will see over the next few weeks, the completion of the MEK, BRAF filings both between Europe and the U.S. Again, a remarkable fast development program, very exciting opportunity. Just yesterday, we got news that the Promacta hep C thrombocytopenia indication will receive FDA priority review. Again, a very good signal. What does that mean? It means that within this portfolio of assets, some of these assets have the potential, if the reviews go well, if we're able to complete the process successfully, to start to bring these assets into our business line, much more quickly than I think many people had expected. And I think over the next 2 years, there is a real picture emerging of a pretty constant stream of new product opportunity being delivered to GSK into areas where we already have the capability and the competence in place.

So to summarize, where are we? Look back since we really embarked on this journey in the middle of 2008. A lot has been achieved at GSK. You see on the left-hand side the 2008 to where we are today, very aggressive effort to rebalance the company geographically, opening up the new growth businesses of EMAP and Japan. And I've shown you the way in which they have contributed even in a tough environment for the West. You've seen the way in which we've built the world's leading Vaccine business, and we brought to life probably one of the world's leading Consumer Healthcare businesses at a time when many of our competitors in that field are having a dreadful time of competing in the marketplace.

We've delivered a significant increase in efficiency in the cost base. The R&D organization has relentlessly focused on improving its quality of decision-making, which is driving the improvement in return on investment. We remain, I think, the only company to publicly talk about return on investment. And we're proud of the fact that we're making the progress that we are, and we'll be updating you again on that next year. We'll also, from an R&D perspective, be holding an R&D day before the end of this year, which will come on top of all of the data releases we're making at the various conferences during the year. And of course, we've increased the focus on cash generation.

What that's done over the last 4 years or so is allowed us to pay to our shareholders GBP 22 billion of dividend and share repurchases. That really demonstrates the absolute commitment that the board has at GSK to make sure that the performance of the company is translated into cash. And then the cash is repatriated to shareholders as rapidly as possible through a growing dividend and a sustained share buyback program, which we remain fully committed to. And I'm delighted that today we were able to increase the dividend again by another 6%.

Now going forward, on top of all of those things. So on top of the growth that we believe that our investment markets can give us, on top of the delivery of the pipeline, we expect to now start to see that pipeline converted into a growth driver for our business over the next couple of years. That clearly is going to be an enhancer of our growth. It clearly is going to be a mechanism through which we will be able to drive leverage in the business as we start once again to bring higher-margin products into the portfolio.

We will also be making sure, as we have done with Human Genome Sciences, that we seek to maximize the economic share to our shareholders of GSK. Obviously, one of the direct consequences of the acquisition of HGS is 100% now of the economic benefit of Benlysta and albiglutide, and if successful, eventually of darapladib, will now accrue to the shareholders of GSK. That's an important part of shaping our business. We will continue to sensibly look at how we can do those sorts of transactions in the last quarter in addition to HGS by increasing our shareholding of Theravance. In a different way, we achieved a very similar goal. We will also, though, be very focused in continuing to streamline and clip off from the business low-margin businesses and noncore businesses which we don't believe ought to be part of the long-term future of the group.

So as we move forward, the picture of the group becomes much clearer. It becomes a group which is absolutely global in terms of its U.S. competitiveness, its European position, Japanese position now strengthened, the Emerging Market position now strengthened. That is the group through which the pipeline will be deployed. But we will continue to look for ways in which we can drive focus into that opportunity by looking for businesses which are either low-margin and/or noncore. And good examples of that have been the disposal of the tail of our Consumer business and the regular disposal of tail assets in our American business, whether that be Wellbutrin or Vesicare, most recently. So we will continue to look for those opportunities as we seek to really drive a focused organization going forward.

With that, I'm going to bring my comments to a close and ask Simon to come up to describe in more detail the quarter.

Simon Dingemans

Thank you, Andrew. And just like to add my thanks as well to everyone on the webcast, on the phones for helping us avoid some of the Olympic congestion that's just beginning to build up in London.

A year ago, we implemented a new financial architecture for the company, really designed to drive a different level of focus around implementation of the strategy and make sure that we were driving the right returns from that strategy and sustainably so over time. As Andrew has highlighted for you, I think we really feel that the quarter, despite its challenges, shows some real progress on that strategy. And I'm confident also that the financial architecture is contributing to that delivery.

The ways in which it's really making a difference in the short term is in helping us allocate our resources more effectively and helping us look at the choices and the decisions we're making so that we're improving the returns and making sure that we're driving investment behind the best-returning and highest-growth opportunities that we have across the company and reallocating resources away from those where we see less opportunity. And I think thirdly, what it's really done is drive a focus on those returns across the company so that decision-making is really now much more consistent, much more comparable between the businesses than perhaps it has in the past. And you can see that in some of the cost measures that are contributing to the company in this more challenging quarter. But over the last several quarters consistently, where we're reallocating those resources to help drive the investment businesses.

I think the last area where it's become most visible in the last several quarters is in the focus on cash. We've improved our working capital performance. We've improved our return and profile of our investments. And by getting the organization to think about cash flow generation in a very different way, we've been able to support the dividends and buyback commitments that we've made and the programs we have going forward with much greater room for maneuver, as well as continuing to invest in the business, do bolt-on M&As and secure the long-term future of the company.

But if we're really to make this sustainable, we also have to deliver on the fourth pillar, sales growth. And clearly, in the second quarter in particular, we've seen a number of challenges which have become more acute during that quarter as Europe has raised additional challenges, additional austerity measures and slowed their approval of new launch products, which has led us to the 8% performance that you've seen in the quarter. This is compounded in our other mature business in the U.S, where the portfolio we have has certainly seen, as Andrew has described, some additional pressures. That is more than offset us as we've been through the growth that we are seeing back from our strategic investment markets of Japan, Vaccines, Consumer and the Emerging Markets, where we saw a good recovery from the first quarter. Overall, however, despite those growth engines really beginning to come through, the pressure that we saw in the quarter more than offset that, as well as the currency drag that we've reported.

To really make those more mature businesses move forward, we need new products, and Andrew has described how the quarter has seen some good progress on that. But in the meantime, given that the product approval processes and the run-up to launch will take some time, we have to work with the portfolios we have with the investment markets we've targeted. And we're continuing to look at how we can continue to generate additional growth opportunities going forward. But against the more challenging environment that we now face, we do expect that for 2012 as a whole, that sales will be in line with last year.

When we look at that environment, we're clearly also reacting in terms of the cost profile. There is a balance that has to be struck, however, in terms of how we think about investing behind the opportunities that the strategy presents going forward, as well as reacting to those more challenging environments. And so in delivering against that balance, we do expect that the operating margin for 2012 as a whole will also likely be in line with last year, consistent with the top line performance. And unless we see a significant improvement in the top line performance, then I think we believe that, that is the right balance to strike in securing the long-term optionality around the pipeline and some of the other growth investments that we've made. And so overall, as we look at the year going forward, we're still confident in the strategy and its delivery and the execution that has been recorded in the first couple of quarters of the year. But clearly, the environment is presenting a number of challenges.

If over the balance of the year we're expecting sales to be flat, the one other marker that I would just put down is you should remember the comparability with Q3 last year, where we had a very strong performance from our Japanese business, given the Cervarix inoculation program. But we also saw a very strong performance out of the U.S. on the back of some accelerated flu deliveries. That's going to make the Q3 comparator quite tough. And so if sales overall for the half are flat, then you should probably expect that Q3 will be negative, Q4 will be positive to leave us flat overall in terms of comparability for the year as a whole.

And with that, let's turn to the headlines of the results. And we've been through most of these, so I will keep this brief. Turnover down 2% at the top line. The core operating profit down 7%. This was really driven by the shift in the sales line but also by 2% swing in cost of goods. And I'll come back to that in a minute. And then we're recovering at the EPS line a couple of percentage points, really reflecting the earlier delivery of the financial efficiencies that we've targeted, the share buyback program and the continuing cash generation to leave us down 5% at the bottom line. Cash generation of GBP 1.3 billion in terms of free cash flows, excluding legal in the quarter, GBP 2.1 billion over the half, securing and underpinning the dividend and buyback that we've announced.

As Andrew has highlighted, the principal drivers behind that top line performance are really the offset of our mature markets to the growth drivers of EMAP, Japan and Consumer. And I think Andrew has taken you through the detail of what's really behind the U.S. and European performance. But I think it is worth just highlighting the robustness of the growth markets' performance in the quarter and over the half as a whole, where EMAP after a tough first quarter, with particular issues in the Middle East, has seen a strong recovery to be up 9% during the quarter. Middle East, up 5% in the quarter, reflecting both good contributions from the Pharma business and the Vaccines business in the region, which is now nearly GBP 300 million for the quarter, so a significant contribution.

But across the EMAP region, we've seen good growth from the Pharma business in both innovative and classic brands but also from the Vaccines business, which does produce some relatively lumpy performances quarter-to-quarter, up 15% this quarter. But we've also seen consistent delivery on a number of the tenders that we've identified at the beginning of the year that were going to drive the growth in the Vaccines business overall. And so from an execution and delivery point of view, I think we're feeling very comfortable about how the Vaccines business is delivering consistently across EMAP. Japan also up 6%, and that's despite even in Q2 a significant drag on their Vaccines business from Cervarix, which had already started to ramp up in Q2 2011. Their Pharma business in Japan, up 10%, really reflecting the breadth of new product introductions that we're bringing to that market, which really gives us a very robust base going forward. And Consumer, while we've called it out in the green line, remember, this year is really contributing very little growth to the overall group position, given the washout of the disposed businesses that we've sold off over the last 12 months. But the underlying performance of that business, about up 7%. And I think most encouragingly, very broadly based, with not just Emerging Markets but also the U.S. and Europe contributing but also the categories that we've now identified as our key focus areas for Consumer both on the wellness side, on nutrition, with India again a very strong grower and Horlicks contributing nearly 15% growth in the quarter, so a very good base there.

And also, building up new categories of investment. And lastly, the oral care business, which is continuing to be a major growth driver, not just in some of our newer markets but continuing to maintain momentum even where the products, such as Sensodyne, are more established. And I think if you think about that base contribution and you move past the disposal process, you can see that we expect Consumer to come back to be a major contributor.

One small point on Consumer. We have, in the process of running the disposals, looked a number of times at whether we can dispose of alli, as we've commented before. We were affected by supply problems with one of our suppliers letting us down such that the product was effectively withdrawn from the market over the last quarter and almost 0 sales. Given that position, we've decided that we would not be generating the right value for shareholders if we proceeded with the sale. We're going to take the business back in hand and rebuild that brand in a much more focused way and see how that plays forward from here. So if you adjust back in for the quarter the alli sales, the 7% will become about 5%. I think that over the second half of the year, that difference diminishes very, very rapidly, given the trend in alli's business over the last 12 months. But that just gives you a sense of how the shape of the Consumer business will look going forward. But I think there's nothing to undermine the long-term potential of that business.

Currency has been a more material factor in the quarter than it usually is, and that shouldn't be a surprise given the volatility we've seen. We have about a 2% drag at the top line, much less and close to flat at the bottom line. That's unusual in that we have a number of currency credits on intercompany transactions. I think if you roll present rates through into your forecasts for the full year, what we're expecting is that currency would be about a drag of about 1.5% at the top line and maybe 2% at the bottom line. And that's much more consistent with our normal pattern and reflects more accurately our mix of cost and revenues.

Turning to costs. The margin is down 1.2% over the quarter. And that really reflects the sales drag, but it also reflects the mix within that drag. Mix is an issue we've been dealing with for some time and really is a function of shifting the footprint of the company to grow in the emerging markets, Consumer businesses, which are lower margin than perhaps some of our more mature markets. But given the downswing in the U.S. and European businesses this quarter, that has added a particular pressure in terms of that mix factor. It's probably about 2% drag on the margin in the quarter.

So against that, I think we're encouraged by the ability to put back 0.8% because that's really a mix of our ongoing operational excellence benefits from the restructuring program over the last several years, contributions from a number of new initiatives that I've talked about a number of times to really add operational performance to that restructured cost base, as well as a number of one-offs that those exercises have surfaced. And they may be one-off but they still add value, and they've most importantly allowed us to invest nearly 1% of margin in the quarter in supporting the pipeline, supporting the launch preparations for those and supporting the delivery of the future strategic options that we've described. And that's exactly the sort of balance that we're going to continue to work with going forward so that we can maintain that tracking of our targets in terms of the future growth. We're not going to pull back costs to undermine those. However, we clearly will look in this environment of where we can accelerate those changes.

I think that's more likely to come at the SG&A level in the short term as that area where the drag and the mix effects are being felt most acutely is at the cost of goods. And that's really a function of our ability to move our manufacturing costs quickly, which is constrained when the lead times, the cycle times are perhaps not as short as we would like. We're working to improve that. But in the meantime, certainly in the quarter, relatively little benefit beyond the operational excellence improvements that we've already built in. But we're planning and have put in place a number of measures to improve this over the balance of the year, given the environment that we're now facing. And those will come from managing the supply chains and managing our procurement and most importantly, going back to the financial architecture, really looking at where the volumes are, where the right forecasts are, how we tie those to the best returns and make sure our manufacturing businesses are focusing on those rather than areas where our returns are being pulled back and we're facing negative sales pressures. So really back to that reallocation theme.

I think in the short term, SG&A has recovered some of that drag. And we had SG&A down 4% in the quarter. As I say, that's really a mix of operational excellence, benefits, continued pressure in terms of management of our functional costs. But I think the area where perhaps we've seen the greatest acceleration in is really picking apart the A&P and selling and distribution costs to say, "Where are we allocating that expenditure? Where are really driving the right returns?" And we're seeing a lot of transfer out of our Consumer business at some of the sort of gross to net analysis that they look at, some of the A&P metrics that they're using and taking those models and transporting them into the Pharma business, particularly in our growth markets like EMAP, to say, "Okay, which markets, which products should we really be investing behind? Can we release some resource elsewhere or to help protect the overall margin or protect our future ability to invest?" And we've seen quite a lot of that starting to get going in the quarter. We'll see hopefully more benefit of that as we play through in the balance of the year. But that's really where that's playing forward.

And I think if you look at those 2 cost lines, it's also a signal of why we need to do more because the mix pressure isn't going to go away and we need to continue to invest to really drive the returns out of the pipeline and some of the future growth opportunities that we've described. And that's really why we've identified another GBP 500 million of cost savings out of the manufacturing businesses. You can see where the greatest pressure is in terms of cost of goods. And this is not really about big restructuring anymore, it's about process improvement. It's about making our manufacturing supply lines more robust, more efficient, investing in our people capabilities and taking the restructured footprint that we've developed over the last 2 or 3 years and really aligning it much more tightly to the end markets. So we've already put in place a vertical end-to-end consumer supply chain. We're now looking at how to do that much more tightly in the Pharmaceutical business. And really, by exposing those supply chains to the end markets, whether it's EMAP or the U.S. or Europe, they get a much clearer view of what cost level they have to operate to rather than operating on a broad aggregated base, what SKUs are really valuable in those markets, and that allows us to simplify the number of presentations that we're putting into the market. I was sitting with the pharmaceutical manufacturing chains the other day, looking at a particular product, where we went through a review of the SKUs. And by adjusting around 90% of the volume and maintaining 90% of the volume in its existing presentation, so you're only really touching 10%, we were able to adjust the SKUs by 50%. You can imagine what that does to your cost of goods, your speed in reaction, your speed to market. And alongside that, we can also then push back up to the upper end of the procurement lines and say, "Okay, how many presentations do we need? Can we save on packaging? Can we reduce our response time?" So you can see how it becomes a circle and a cycle that can contribute on a sustainable basis going forward, which is the most important thing.

R&D and royalties are relatively flat in the quarter, not much to report there other than, as Andrew highlighted, we're continuing to work with the R&D organization to make sure that their platforms and the infrastructure are as efficient as possible so that we can make sure we dedicate the right resource to bringing forward and completing this wave of the late-stage pipeline and also investing in the next one.

So we move beyond the operating margin. Financial efficiencies, as I said last quarter, we expected to make more progress in the short term in delivering contribution to the bottom line. And we've certainly made some progress here in improving our financing costs. We launched a $5 billion bond earlier in the year, which we completed for a range of maturities with an average financing cost of under 2%. And that compares to our average funding cost on our existing debt of over 5%. And so you can see already starting to make a significant difference there, and we're still on target to deliver overall net funding costs of around 6% by 2013. And that's going to be partly more efficient debt funding but also reducing the cash balances, as we've discussed before. And I'll come back to that.

Net debt at the end of the half was GBP 9.6 billion. We're continuing to target A-1/P-1 credit ratings. That's our anchor in terms of how we think about the balance sheet. But debt will clearly go up in the next quarter as we pay out from the balance sheet the legal charges and also pay for HGS, which we expect to complete during Q3. We've made further progress on the tax rate, where we're now at 25.5% for the quarter and we're targeting to be at 25.5% for the year. And for 2013, we're expecting now to be at 25%, which will be a year ahead of our targeted delivery.

And then on the cash flow side, share buybacks and dividends of GBP 1.1 billion in the first half and GBP 2 billion to GBP 2.5 billion still expected for share buybacks over the year as a whole. And that's really supported by the cash flow with GBP 3.5 billion coming in at the operating level. But I think the strongest indicator of the flexibility we have to support those returns is the free cash flow, which is up 4% in the quarter despite the challenges that we face -- sorry, 4% in the half despite the challenges we face and really gives us the security to make the commitments to the long-term program that we've made.

And that's really being driven by a number of factors. But the one that I'm particularly encouraged by is working capital, where we've reversed the outflows of Q1 during Q2 and we've also reduced the volatility of the cycles that we've seen in previous years. And that's partly because we've introduced a new set of incentives across the company to target people on quarterly progress for working capital rather than annual progress. But this is also back to the changes in the manufacturing cycles, the changes in the procurement process, which is allowing us better visibility, better planning and the capacity to remove some of the buffers that we otherwise had in the system. And so inventory, even though the days are flat Q1 and Q2, is GBP 300 million better than it was a year ago, reflecting the progress we've made.

We continue also to look at our receivables, and we've made very good progress across the group, not just in Europe, which has obviously been a particular focus. And in Europe, we've also managed to recover a material part of our exposures to some of the Southern European countries that are facing obviously particular challenges. And we continue to manage those very actively to make sure that we keep our exposures to the minimum, consistent with continuing to trade in those businesses and support the patients that we have in those markets.

Liquidity being a big focus in the first half of the year, given the outflows that we were expecting, we finished the quarter at GBP 7.6 billion of net cash. That reflects a gross up from the inflows from the bond refinancing, which is partly due to fund a maturity that came up in the middle of June. But we also have cash on hand now to deal with the payments for HGS. And since these figures were put together, we have also paid out the cash in terms of our government settlement, which was about GBP 2 billion. So we've got GBP 4 billion coming off out of the gross cash amounts and adding to the net debt in the next quarter. But because we're reducing the overall funding costs in terms of overall interest charges for the year, we're not expecting a significant increase.

All of that has allowed GBP 3.2 billion of cash to be returned to shareholders in the first half, split between dividends and buybacks. As we've said before, we do maintain a balance between these, dividends, important to some shareholders, buybacks, important to others. Growing dividend is our cornerstone commitment, up 6% in the quarter, consistent with the first quarter. And buybacks, again, we maintain a long-term program, we've got GBP 2 billion to GBP 2.5 billion for this year. And we've delivered around half of that by the middle of the year. And we're on track with the overall targets.

So overall, in terms of the quarter, given a more challenging environment, I think we're encouraged by the strategic progress we've made. The financial architecture is definitely contributing to optimizing the returns despite those challenges. And I think we're on track with the delivery in terms of the late-stage pipeline. And so overall, despite those greater headwinds, I think that the overall position of the company is one that we feel very confident in.

With that, I'll hand back to Andrew.

Andrew Philip Witty

Thanks, Simon. And now maybe, I guess, Moncef and Simon, to come up to answer questions or help answer questions and open up the call to Q&A. And as usual, if you can register for your question, we'll call you out in turn.

Question-and-Answer Session

Operator

And the first question is from Tim Anderson from Sanford Berstein.

Tim Anderson - Sanford C. Bernstein & Co., LLC., Research Division

A couple of questions, please. You described kind of 3 pillars to your long-term strategy, and one of those is to simplify the operating model. And I'm hoping you can crystallize what you were referring to exactly and how you can achieve this. If you plan on maintaining a global diversified business and you're doing acquisitions here and there and you continue to build out your emerging market presence, it's not really clear to me how the operating model can be simplified very much. The second question is on emerging markets. Novartis said recently that excluding the performance in China, it does not really expect that emerging markets would be able to grow by double-digits sustainably in the future. And I'm wondering if you can say what your expectations are for emerging market growth, excluding China. Do you think Glaxo's business can grow by double-digits percent in the future? Or would it be less than this, again excluding China?

Andrew Philip Witty

Okay. Tim, thanks so much for your question. So in terms of the simplified operating model, I think there are 2 or 3 dimensions that we need to be thoughtful about. So firstly, you're absolutely right. Of course, as we build out into new areas to source growth, that creates complexity. It creates new levels of how the business needs to operate. What we've been doing behind that is stripping down complexity which we don't think adds value. So over the last 3 years, we've created a core business service organization in the business, where we've taken entire organization service sectors. Everything that supports the way the business runs at the front line, we're streamlining and simplifying all of that. The same in our HR organizations, finance organizations. We're putting in place a common IT platform, whereas previously, we had dozens of different finance systems across the world. We streamlined out huge amounts of internal complexity, which wasn't visible to the outside and was really a product of the origin of the company coming through the composition of all these merged entities and from businesses which were at the very beginning really federal businesses and dominated by countries rather than the corporate entity. That's taking quite a long time. It's not all finished. There's still quite a lot of scope for us to go there. But that's been a big part of the simplification of the business model. There's much more standardization inside GSK now than there used to be. And you should continue to expect to see that's one area which is very important. The second area, we've touched on already today a couple of times, we see continued great opportunity, really very significant opportunity. And I think personally, the GBP 500 million cost reduction we've targeted in the next 3 years is probably just the beginning of what we'd be able to achieve through a properly streamlined process environment in our manufacturing arena. Taking out the SKU complexity and the implications of what that means for the business, I think, is enormous. It can't be done overnight because you have to go through a regulatory process to unlock some of that. But the opportunity I think is very material. I think the first down payment on that, we've announced and committed to today. But I'd be surprised if we weren't able to increase that as we go forward. Thirdly, we're going to continue to, I would say -- as we go forward, I'd say we were going to have a slightly different tone around our acquisitions divestments than we've had up until now. So at principle, everything stays the same, which is it's rising dividend first, share buyback second unless a bolt-on acquisition beats the metrics of the share buyback, like the HGS acquisition. But I think the type of acquisitions we're going to be looking for, our hurdle, if you will, has gone up significantly. And you will notice that we've done far fewer acquisitions in the last 12 months. We don't see the kind of opportunities we were seeing before and the valuations weren't there. We're also very much raising the hurdle around bringing in more complexity at the time when we want to focus on pipeline. So while I'm not going to rule out that we do more of the classic bolt-on acquisitions, I think in fact, it's going to be less likely than more likely going forward. And what you will see is us being more challenging around fragments of GSK, which don't really fit where we see the future of the company going forward, either because the margin is a very significant outlier or it's simply not a sustainable core part of the GSK model. So while we will continue to stay very dedicated around the core points of diversification, so having the Vaccine business, having the Consumer business, having a properly geographically exposed Pharma business, our willingness to entertain further drift is reducing significantly because we want to focus on pipeline, and our appetite to actually pull in at the margins where we think those businesses aren't truly aligned to our core is going up, as again we strive to focus on what we think could over the next few years be a dramatic contributor to organic growth in the shape of the pipeline. So the strategic nuance becomes much more around allowing the focus on the pipeline than necessarily just adding on to drive growth through inorganic means. That was a very -- it was the right thing to do over the last 5 years. It's got us into a very good place on these growth businesses. Going forward, the priority will be the organic growth opportunity. The add-ons of the type we've seen in the past are likely to become more unusual, not more common. In terms of emerging market growth rate, Tim, I think where we sit is we've seen the growth rate generally being slow, obviously, reflected by the macroeconomic trends around the world and the hangover really from the U.S. and Europe. We see the markets in which we operate roughly around 10%, 11% type of growth rate now, that's down from about 14% or 15% a year or more ago. So clearly, a deceleration, still very, very good compared to anywhere else. We strive to grow at or a bit above the market. And you've seen we've bounced back very nicely from where we were in Q1. We're up at 9% territory. I believe we're going to be in that 9%, 10% territory, maybe a bit more, maybe a bit less, but really driven by the market. And I think one of the things you've heard me say before and we all need to be just very eyes open on, is the emerging markets are likely to be quite volatile individually and also as a group. Just by nature of their cash pay dynamics, their link to GDP, there's bound to be volatility in those numbers. But over the medium run, i.e. 2 to 3 years, the fundamental demographic trends of those markets and the shifts in economic power up the pyramid of population clearly tells you those curves are going one direction. Whether they go at 10% or 12% or 8%, will be a function of flow-through from other parts of the world. But we continue to believe they're going to be very robust and we expect to grow at or a bit above that market rate over a period. Now quarter-to-quarter, our exact growth is going to be dictated, if anything, by things like Vaccine tenders, which is such a big part of our Emerging Market business. And again, you're going to continue to see a bit of intraquarter variability.

Operator

The next question is from Graham Parry from Merrill Lynch.

Graham Parry - BofA Merrill Lynch, Research Division

And just the first one is on margin and sales growth. Your latest comment suggests that they're both dependent on pipeline delivery. Previously, I think you suggested that they could still grow x pipeline but just albeit at a low rate. So wondering if you could clarify if that is the case still. Or does the impact of pricing pressure effectively mean that you're now entirely dependent on the pipeline there? And second, if could you just quantify what the one-offs in the COGS line were and is that where you see the most margin pressure this year resulting in you looking for no-margin growth now. And then thirdly, you talked previously about margins over the mid-30s would be implying underinvestment in the business. Is that still a valid number in light of your comments on the willingness to invest in commercializing the pipeline? And then just finally, on the divestments on the noncore businesses, just wondering if you could be a bit more specific about any areas that you're looking at in particular there.

Andrew Philip Witty

Okay. So in terms of growth, I'm still of the view that absent a material -- so if you think back over the last several years, Graham, we've delivered more NDA approvals in the U.S. than any other company. But they've been made up of relatively small niche products. That's been our kind of base rate of contribution from pipeline. What we're looking to potentially deliver in the next 2, 3 years is a continued flow, actually potentially a similar number of approvals but are potentially much larger opportunities for the group. Absent that kind of step-up, I still think the group is capable of growing. And I think we're very close to that even in this quarter, which I think does have quite a composition of different headwinds coming from different places, which have just knocked us south of that level. That's something which I continue to think we'll be able to achieve. Why? Because I think Japan, Emerging Markets, in particular, continue to grow larger and larger. Emerging Markets is very close to being our second-biggest region, very close to being bigger than the European business, if you look at the quarter's turnover number this time. So you're seeing a growth in the overall size of that business. And while the growth rates are off a bit for the reasons I just mentioned in Tim's question, the actual growth rates remain extremely robust and very punchy compared to anywhere else in the world. Japan, similar story, and Consumer, a similar story. So I think those businesses continue to be very good. What we just have to recognize is in the U.S., we're just coming through that kind of turning point and stabilization in our American business. We still have about GBP 800 million of old products disappearing this year compared to last year. We decided at the end of last year, we would no longer talk about that. We'd no longer strip out, but I can't make it go away. It's still there. It is still a drag on that business. That gradually winds its way out over the next year or so. Of course, new products start to click into the portfolio. And that starts to shift before you think about big, new products being contributed. So I personally think the business is capable of growing in advance of major products from the pipeline coming along. But of course, the exciting future of the group is all about the pipeline delivering enhanced growth. So for me, it's around growth and then enhanced growth. And I think what our shareholders are looking for and what the value-creating opportunity of this group is, is to take that growth that all of those base investment businesses can deliver and then enhance it with the organic pipeline. If we can do that, then I think we'd really get to a place which delivers a sustainable sales growth, good margin leverage and really powerful redistribution of cash to shareholders. And that's exactly where we want to try and get to. As far as the margin in the mid-30s, I mean, I'll just reiterate what I've said before. I think, yes, I want to make it clear that while we strive to expand our operating margin, driven by pipeline in particular, driven by taking costs out where we can sensibly do it, there is a limit, I think, to what will be reasonable in terms of our external stakeholders partly, and also because I think it's very important that we are investing properly in the new assets. We've announced recently that we're redesigning our organization to focus on franchises, to bring together our organization to drive global marketing capabilities in a more sophisticated way than we've done before. All of that is a signal of our intent to invest. And again, I would reiterate, I wouldn't forecast us to go much above mid-30s over the next several years. I'm going to hand it to Simon in a minute for the one-off question on COGS. But as far as divestments, I think what -- I'm not going to give you a list of things. But clearly, tail businesses are potentially in scope. We've already demonstrated that, that has been something we're willing to look at. But beyond that, I think it's fair to say that we will continue to look for businesses which are outliers within the core strategic focus of the group. Now the strategic focus of the group is what drives our Consumer business, what drives our Vaccine business, what drives the EMAP, Japan, America, Europe Pharma businesses and what drives the synergies between them. So where businesses sit absolutely in that matrix, those are the businesses which are absolutely core to the future of the group. Where there might be businesses or partial businesses which sit somewhat on the periphery of that matrix, maybe their synergy play across the businesses aren't as strong, maybe they are lower-margin, maybe they require very different ways of working to the core business, those are going to be candidates for us to look at sensibly. And if we can get good returns and accrue significant value through divestment, which we can then repatriate to shareholders directly in the way we have done with the Consumer disposal, we're going to do that. Because I think as the business has the opportunity to be grown through pipeline, it would be irresponsible of us not to have an aggressive housekeeping approach to taking out those businesses, which by definition, we should spend less time worrying about because we should spend more time worrying about the pipeline opportunity, and therefore, we should get on to it in advance, clean those businesses out, accrue the value and release it back to shareholders. Simon, maybe you could touch on the COGS issue?

Simon Dingemans

So Graham, in terms of the one-offs, they're split broadly between cost of goods and SG&A. At the cost of goods level, actually the one-offs in this quarter are pretty comparable to the one-offs we had this time last year. And the manufacturing cost base tends to have a variety of one-offs quarter-to-quarter. So I think that's not a significant driver. Where it's making more of a difference in the quarter is at the SG&A level. And as I said in my comments, I think we see this as an investment opportunity to allow us to fund some of the positioning for the pipeline without building permanent expense, and so contributing to the overall objectives. Overall, for the margin for the year, cost of goods probably is the bigger drag, given the mix issues I've discussed. We're obviously working in terms of the manufacturing base to address that. But I think in terms of trend over the coming quarters, that's where there's upward pressure. And we'll be pushing as much back on that as we can. But you'll see more downward movement probably at the SG&A line.

Operator

The next question is from Andrew Baum from Citi.

Andrew S. Baum - Citigroup Inc, Research Division

I have 3 questions, if I may. First, I think you're due to complete your SAP upgrade program at the end of next year. What does that mean for the future scope of additional cost savings on top of what you've already announced? Second, you highlighted that the EMAP and the European businesses are going to be consolidated under Abbas. Could you outline what you hope to achieve here in terms of revenue opportunities, cost savings? I'm not looking for numbers but just the motivation here. And then finally, a question on the U.S. The only 2 products which performance you highlighted in the quarter did GBP 40 million in aggregate. You're the only company required by the U.S. government not to incentivize true individual sales targets. And you continue to lose market share in volume across multiple primary care categories. What confidence can you give us that this is a portfolio issue and not a structural issue for GSK, following the consequences of the DOJ investigation?

Andrew Philip Witty

Okay, great. Let me, first of all, ask Simon to touch on the SAP, and then I'll come to the other 2 questions.

Simon Dingemans

So Andrew, on the SAP upgrade, we're making good progress. We now have 5 or 6 markets up and running in the last 2 or 3 months across Europe. And we're on track with the first phase of that plan, which will complete at the end of next year. What we're looking at the moment is whether we can extend that program within the existing budget to prioritize more of our emerging market footprint relative to our developed market footprint, consistent with what we've been talking about today. So more to come on that, but we're very much on track. And already, the early signs of the impact are giving us the confidence to press on.

Andrew Philip Witty

And I think all of the experience we've got either from people in the company who've worked with SAP or from other companies who deployed, is that the opportunities -- it's always harder to forecast where the cost-saving opportunities from an SAP deployment before versus when you've actually got it, you suddenly discover ways of working, which are big drivers of cost efficiency. And I suspect that, that will absolutely be the case here. As far as the combination of the emerging market and Europe is concerned, it's really 2 or 3 different agendas that I'm really looking to try and achieve here. So first of all, Abbas has really established, I think, over the last 4 years a very strong capability to drive operational performance in the emerging market region. And one of the things we're looking to do, and in fact we're announcing today internally, the structure below Abbas is we're streamlining and really shortening some of the lines between the senior management and operations to try and bring to Europe a new operational emphasis, which we recognize Europe's a tough environment, but we want to really leverage what we know has worked in emerging markets in terms of motivating our organization. So part of it is about short-term operational delivery. And I think that's absolutely the right focus for us to have. A part of it is around streamlining the business as we move into the pipeline arena. So as we are moving toward global franchises as a way to think about developing our pipeline, essentially translating the assets from R&D into the businesses, we didn't want to have the R&D organization having to engage with multiple different regions, particularly recognizing that actually, the era where a single Europe had a single opinion has really gone in the last 2 or 3 years. So today, there might be for a new drug a few countries in Europe who are very pro and for who market access is straightforward. There might be 5 or 6 others for which market access is a real problem. And therefore, the notion of creating a European average opinion, which then required R&D to engage with, was really a challenge. By putting together EMAP and Europe, what we've also signaled to the business is it's no longer going to be about a regional opinion, it's going to be which 5 or 6 countries have the biggest opportunity for these drugs. They should be connected with R&D direct, regardless of which region they're in. So it could just as easily be Brazil and China as France or Germany. And we really wanted to liberate the connectivity across the organization so that as the pipeline emerges, we didn't work through some kind of construct of organization, which was really a throwback to 1999 or 2000. We wanted something much more in touch with where we see the opportunities evolving over the next decade. So that was the second part. The third part is our European region has a significant above-country organization. And that gives us a lot of flex resource now for us to essentially deploy behind -- to be deployed behind the pipeline. And one of the things I said in my earlier comments was that the pipeline looks good, looks exciting. One of the things that's good about it is it goes into fields where we're already established, and therefore, we don't need to incur a lot of costs to bring that pipeline to market. Similarly, as we go through the next year or 2 of preparing, we're looking to divert resources and skills and people from areas which we believe may not be generating the biggest return into supporting the pipeline. And Europe, there is a significant number of very good people in our European organization, who because of the changes of the European environment have found it harder and harder to drive performance, if you will, because of the changes. We think that, that resource is better deployed now to support the globalization of the pipeline rather than just European market access. As far as the U.S. is concerned, I mean, there's a couple of things I would say, Andrew. First of all, if we're the most conservative promotional company in the U.S., I couldn't be happier. I think that would be -- I'm completely cool with that, I'm completely fine with it. Secondly, all the evidence we've seen is that our change in the way we incentivize our sales force, so moving away from the physician prescription-dominated model that the industry has used, and moved to a customer value, customer-informed, so a customer-judged performance metric, alongside things like standard of training and standard of product knowledge. 2 or 3 things you should know. Number one, sales force, I have yet to meet an employee in the U.S. who does not think this is the right thing to do. Number two, the feedback from customers is overwhelmingly positive, including the opening up of customers who do not anymore see any reps from anybody in the industry because they so resent the old model of remuneration. Number three, I accept that we have some major established products, which are no longer growing in the way we would like. Look at the products we've launched recently. Now unfortunately, they're in small niches. But if you look at the performance of our products in the oncology field, in the specialty fields, you'll see they're extremely good performance. They have exactly the same compensation system as the people who are selling Advair. So there's no correlate in terms of the relative performance. What's different is in Advair, we had a product which for 5 years we had 100% market share, it's not shocking that we're going to lose market share as new competitors come into the marketplace. What's impressive is we've held more market share in America than we've held in Europe. So actually, our overall retention has been extremely strong. But I'm not surprised we're losing share because we started with 100% and new entrants keep coming into the marketplace. So I think for me, this is not an explanation of what's going on. What's much more the reality is we have established products. They're at the mature phase of their life. They've been remarkably successful. They still have growth in them, but clearly, the incremental growth opportunity is less than it was. And just for everybody else in the industry, just the same, what we need to drive the U.S. forward as always is new products. And that's why the pipeline opportunity we've described today is important not just for the group but also very important for the U.S. marketplace.

Operator

The next question is from Alexandra Hauber from JPMorgan.

Alexandra Hauber - JP Morgan Chase & Co, Research Division

3 questions, please. Firstly, I was wondering what is the strategic commitment to drive operating margins. Is it a commitment? Or is it not a commitment? And also how important is that as a strategic goal? I mean, last week, Novartis scrapped their 2012 margin target because they're investing $300 million into new products, which was probably the right thing to do. So does it make sense to target margin expansion next year when you should be investing into new products? Second question is you mentioned parallel trade as one of the factors that contributed to the 7% price pressure in Europe. Can you give us a little bit more color on that phenomenon? Which country is it coming from? Were there any products particularly affected? And also why you think that problem won't become any worse? And the last question is on dermatology. Why is that declining? Surely, that wasn't what you expected when you were acquiring Stiefel.

Andrew Philip Witty

So as far as operating margin is concerned, I mean, what we tried to lay out at the beginning of the year is that we believe that the business dynamic that we foresee going forward would give us the opportunity to drive leverage. We've made very clear that we expected this year the leverage to be very small. We're now signaling it's more likely to be in line than the very small. And I think through all of the smoke and mirrors of the way we communicate to you and you listen to us, I think we'd all broadly conclude that, that very small meant 20 basis points. So what we're really talking about here is the kind of pinhead of a needle or the head of a needle. So the reality, I think, is not so much about this year. The reality is around do you believe that the delivery of the pipeline on top of the business of the shape we have, absent the kind of drags that we've lived with for the last 5 years, is capable of spinning off leverage in the margin? And our view remains, yes, it will. It will be driven by the positive sales and mix contribution of pipeline, and then therefore, as the pipeline comes in, that will be what really drives it. And that will be either accelerated or nullified by headwinds or drags, I mean, to state the obvious. Now this year, in a year where it was never about pipeline this year, obviously, the increase in headwind, particularly in Europe, has been just enough to take away that very small opportunity that we'd originally thought might have begun to kick in this year. Now I've already suggested it, if we got to a point, if in the middle of next year, Moncef Slaoui comes to me and says, "Andrew, for another GBP 200 million of investment, we can turn drug X from a GBP 1 billion to GBP 2 billion product," I'm going to not even think twice about saying yes. And then we'll have to come and tell you we're not exactly where we thought we were. But given our current plans and expectations, we think we can deliver what we need to and begin -- and then to begin an accelerating rate, deliver margin. But you're absolutely right, Alexandra. I, more than anybody else, will not be made a slave to a percentage. And we will do what's right for the business. And what's right for the business is to invest behind the drivers of organic growth. At this point in time, we think that what we can see going forward allows us to do both. And I think that's a good tension to put into the organization. But if the tension comes under pressure, the decision will be very clear, we'll invest for the long-term value creation of the business and not economize our way to prosperity. As far as parallel trade is concerned, really, what we've seen is a number of -- there are a number of dynamics happening in Europe. But one is parallel trade, and parallel trade is the physical movement of goods and services across the European boundaries. There is, of course, a secondary version, much more difficult to see, which is reference pricing. Both of those are at work in a very extensive way at the moment. And if anything, it's probably one of the most damaging parts of the European system. What's driving it? So Greece is a major problem, very significant price cuts in Greece last year, be in reference price outside of Greece and product being exported. The same is true in countries like Romania, which has really surfaced in the last 6 months. I'd say, for us, the surprise has been the negative impact of Romania, exporting both its price reference and its physical product. You've got to remember, in these countries where perhaps austerity is really biting, then there's lots of macro incentive for the arbitrage players to just start exporting. Why sell locally if you can double your price by selling internationally? So there's a lot of movement of goods. There's a lot of reference pricing going on. We're trying very hard as an industry to get the European authorities to take particularly the reference pricing issues seriously. But so far, nothing has really changed on that. As far as dermatology is concerned, it's a mix. So EMAP, looking pretty good, although held back a bit by supply issues in the quarter. So I don't think anything to be concerned about in terms of EMAP, which has really been the big growth opportunity from the Stiefel acquisition but held back a little bit by some supply glitches during the quarter. I don't think that's going to be a long-term issue for us. You asked some genericizations. Europe actually just hit by the same general pricing pressures as we've seen across the board. So not one single thing. I think going forward, what you should expect, good EMAP performance. I think as we brought in the asset we just acquired from Basilea, that gives us a nice opportunity to add growth here. We're going to burn our way through some of the genericizations in the U.S. As you've seen, we've just had 1 or 2 new products approved in the U.S. So again, I think there's a bit of turbulence in the short run. It's nothing strategic as far as the business is concerned.

Operator

Next question is from Gbola Amusa from UBS.

Gbola Amusa - UBS Investment Bank, Research Division

I have 3 of them. First, on the European pricing pressure, the 7%, I'll ask it slightly differently. Can you give us a bit more on what that number looks like for your Vaccines business, for your Consumer business and how big the gap is between your mature and nonmature products? Secondly, on the new tax rate guidance, how much of that, if any, is driven by geographical mix and might, therefore, be a bit more durable into the future beyond 2013? And then lastly, on LABA/LAMA. How much of the Phase IIa/IIb dosing studies will be presented or discussed in the coming months?

Andrew Philip Witty

Okay. Let me ask Simon to talk about tax rate. And Moncef, can you do the LABA/LAMA? And then I'll come back to that pricing question.

Simon Dingemans

On the tax rate, the original objective of 25% was driven by a mix of factors in terms of bringing our files up-to-date with a whole series of authorities around the world. And we made good progress, and that's really why we've been able to accelerate our path towards that target. So yes, there is a global element to the objective. There is also part of the process of realigning our cash flows and our profit flows with the changing shape of the group. And that's certainly underpinning the fact that we believe the 25% target to be very durable. Once we get to 25%, the challenge is then to look for other efficiencies and thinking about opportunities such as the U.K. patent box, certainly, we believe will give us room beyond 25%. So I don't think there's anything in the mix to date that undermines that target or how we're going to make it persist for the future.

Moncef Slaoui

On the LABA/LAMA, first, we have almost the totality of the data, we think, is required for filing. What we still expect within the next literally handful of weeks is longer-term safety observations from our Phase III trials. We have the fullness of Phase II data. And we are of the view and we're very comfortable that we can demonstrate the once a day and the adequacy of the dose selected. The data will be presented in September and available for comments.

Andrew Philip Witty

Thanks, Moncef, Simon. So in terms of pricing, Gbola, I'm afraid there's no simple answer to that question, as you probably would expect. If you look at the Pharma business in Europe, you've got a mix. So Greece, pretty much across-the-board price cut for all assets, so no different, mature, not mature. If you look elsewhere, you will see big assets being targeted. So products like Seretide, and I'm sure in our competitors, similar large market-leading type products, get picked out and they get hit specifically. Parallel trade tends to touch the bigger, higher volume products, higher value, higher volume products more than others. So again, the parallel trade dynamic tends to be more relevant to a product like Seretide than perhaps some of the smaller or older or lower value unit cost products. Vaccines oftentimes isn't included in the direct pricing negotiation but can sometimes be picked out as a special case, as was the case in Germany last year. And a very big part of the European price impact we're seeing still is the phenomenon of the German vaccine price cuts, which kicked in, in Q3 of last year. And if nothing else new comes along, it's one of the reasons why we think this quarter may be the nadir of European price impact. As that German number starts to wind its way out, that all depends on whether new stuff comes along. Elsewhere, obviously, vaccine price pressure comes through tenders. And what we've seen particularly again in Europe is tenders being delayed as negotiations drag on in some cases, or in fact, they just decide to defer the tender completely as a way of deferring the costs. So it's a real mix. Consumer, of course, there's not so much direct pressure from government. But as you're all aware, there's a lot of retail competition. There's an awful lot of price pressure in the system. Certainly, in the more sophisticated markets, you're going to see a lot of buy one, get one free type of pressure. Actually, within that, the key way to defend your price point and the reason why our business actually is looking pretty good in that context is through innovation. So by having the new forms of Sensodyne, as an example, Repair & Protect has significantly strengthened our price position in the Sensodyne arena. Same is true with new forms of Lucozade in the Nutritionals business and new forms of Panadol, like Panadol Advance, in pain. So those -- the key in Consumer is being able to drive innovation to offset the retailer price negotiation pressure, which is always there but has definitely amped up in the last year or so as the general retail environment has gotten very hostile.

Operator

The next question comes from the line of Jo Walton from Credit Suisse.

Jo Walton - Crédit Suisse AG, Research Division

I have 2 questions, please. Firstly, and I'm sorry to go back to the European situation, just looking at your numbers, we can see that there was a very material price cut of 7% in the second quarter. You said you think that will be the nadir. Would you like to give us some sense as to what the underlying rates you think continuing might be just for us to think about? And the European margin, last year, that European margin was trucking along at about 55%. Now it's trucking along with about 53%. Is this a permanent diminution in margin until new products come through? And my second question is really referring to these newer products. I wonder when you think the leverage might come through because if there's one thing that's happened in the industry, we haven't had many new products. But I can count on the fingers of one hand the new products that have come through that have performed well very quickly. So are we -- when you look at all of our notes that are out there, are we being too optimistic about the timeframe that you can get these admittedly interesting assets through these additional hurdles that are out there in the various markets? And may this be a concern that we have that whilst your products are going to be great in 5 years time, they're still going to be pretty small in 3 years time?

Andrew Philip Witty

Okay, great. I'm going to take 2 of the questions, but ask Simon to talk to the margin point in a second. In terms of the pricing story for Europe, so if there were no new price cuts or initiatives and if parallel trade didn't get worse, sorry for the caveats, then I would expect the 7% that we've seen this quarter to start to go down through 6%, 5% during the rest of this year and the next 2 quarters. My anxiety, of course, is I don't know whether parallel trade is going to get worse or not. And I certainly don't know whether a government's going to announce another price cut. But if there were no new negatives, then that would be the kind of shape of what we know playing through the system and particularly driven by things like the German price impact dropping out. Maybe Simon, to margin, and then I'll come back to the product portfolio.

Simon Dingemans

Yes. Jo, I mean, the margin in the quarter for Europe really reflecting the top line pressure and the mix factors with a lot of generic and parallel trade taking the tail down. I think going forward, if the curve on the top line looks broadly as Andrew has described, I think we would hope the margin might move forward a little bit. But I think remember also, in Europe, we need to invest behind those launches that we have planned. And we're also in the process of looking at how we reallocate some of the resources we have around Europe, how do we best structure those to deal with these tougher environmental conditions. And so I think I wouldn't put a lot in your model in terms of forward progress at this point. But I'm certainly confident that we can make that balance if the sales line delivers as Andrew described. So around the same sort of level, maybe a little bit better, Jo.

Andrew Philip Witty

And then in terms of your concern around the contribution, listen, I think it's a completely reasonable concern. And the last thing I'm going to do here today is make very firm commitments on specific timing of delivery of leverage, given that we haven't finished the job yet of bringing these products successfully to market. So I don't want -- while I think we've got a very significant opportunity, I don't want to get ourselves too far ahead of it in terms of exactly what this is going to drive. Having said that, these assets are now at a stage where if we don't plan for success, we for sure will not get success. So we have to marshal the organization behind these assets because it's exactly what we're doing with the realignment of the organization, particularly under Moncef and under Abbas in the way I've touched on already. As we go forward, what's the likely timing? Well, the beauty of the pipeline, if it stays as it is, is the numbers. And I'll take you back to May 2008 when I first laid out this strategy and we talked about developing an R&D capable of delivering not just one drug but many drugs. That's exactly where we're at. What is the benefit of that? The benefit clearly is we are less vulnerable to one thing being stopped in the process or one slow launch delay. If you play forward over the next couple of years, there's a scenario where we have a building Benlysta product, which we already have. And I continue to be pleased with the quarter-by-quarter progression, not just of the sales but of physician intent to prescribe and all the other leading indicators of that particular drug. You see products like that already in the market building. Votrient already in the market, now been expanded building. All of that business rolling forward, the drag on the tail diminishing in the way we've been talking about. And then as you think about the pipeline, you have products like Promacta, hepatitis C thrombocytopenia indication, just given priority review. If all goes well, would be at the leading edge of an expansion opportunity. MEK, BRAF, a portfolio opportunity, which again could go relatively quickly. Dolutegravir in HIV, again, a field which tends to move quite quickly. And then you've got the bigger, more classic primary care opportunities, which some of which may take longer to get to market. Maybe they're in divisions which are 2-cycle divisions. Maybe they're going to have complexities, who knows, when we finally get to the negotiations to get to market. I think the beauty of this portfolio is you've got those layers of different opportunity clicking in. Now obviously, if they all click in at the same time, you have a much bigger impact and a much bigger opportunity to drive the top end of margin. And if they don't, we don't. And I think there's not much point speculating on what's going to happen until we get more facts and get a lot nearer to what the reality is going to be. But I firmly believe that we are in a very good position in terms of the stabilization of the base, which is very clear now in what this business is and the potential spectrum of opportunity that we have in the next 2 to 3 years. And increasingly, and what we've shown in the quarter within that spectrum, some very interesting assets, which speak to the market we now live in, i.e. unmet medical need and differentiated from what's already out there. If we can bring that to finality in the next couple of years, I think we should be optimistic about what it can do for the business. But there's still a lot to be done. And that's why we're going to focus on it and get it right.

Operator

Our last question comes from the line of Brian Bourdot from Barclays.

Brian Bourdot - Barclays Capital, Research Division

There's been a lot of discussion about margin operating leverage, and I think I get a lot of it. But I was just wondering if you could help us tie it all together and be clear about what you're saying about expectations for margin expansion going forward. So previously, you had said that you expect some small margin expansion at the operating level in 2012 and then more substantial margin expansion in 2013 and 2014. So I'd just like you to clarify for us, please, what you're saying now if anything about 2013 and 2014 and whether you are perhaps stepping away from that, either because uncertainty around investment requirements has increased. And these things are always -- I think we've always known that, and/or uncertainty around the world economy and in particular, Europe has increased. So could you just, please, sum up now what your expectations for margin expansion in those years, please?

Andrew Philip Witty

No. Listen, obviously, I'm not going to give you guidance for next year. And you know I'm -- to the extent we're going to give you signals for next year, we'll give it to you in February as we normally do. And so I'm going to be careful not to stray into that. But I think the sensible way to think about this is that 20 basis points of opportunity that we had originally hoped we might deliver this year looks not to be there, and we expect to be in line this year versus next. I think at least for the time being, a sensible way to think about this equation is just shift the curve to the left a year. So just think about that, and then we'll update you more specifically when we get to February because then we'll have a much clearer view, another 6, 8 months of pipeline progression, timing, where we are with files. We'll have a much clearer view of what we think the investment needs might be, if there are any that we need to address, and we'll have a much clearer view about exactly where the headwinds are going. And then I think that is the right moment for us to be very precise. But I think in the interim, I think you shouldn't take away from this conversation anything other than there's a shift to the left in terms of what we'd hoped for and recognizing that the first year, this year, was intended to be a very slow takeoff anyway. It's not that material in terms of the way we view the company. And we'll update you in February, once we have much more information to give you a much clearer view, and we'll give you a sense then.

Listen, with that, I want to thank everybody for joining the call today. We obviously appreciate your interest. The IR team are available to take your calls. And once again, thanks for your time this afternoon.

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