Challenges Surround GlaxoSmithKline - TheStreet

As Big Pharma companies have stumbled in recent years,

GlaxoSmithKline

(GSK) - Get Report

has been a virtual fortress for drug industry investors.

Look at stock activity at various intervals -- two years, one year, six months and three months -- and you'll see that GlaxoSmithKline has outperformed the Amex Pharmaceutical Index of Big Pharma stocks at every turn except the three-month period. In all but the two-year time frame, the company has also outpaced the

S&P 500

index.

Now, however, a few cracks are appearing: A suspension of testing on a multiple sclerosis drug, a long-running dispute with the Internal Revenue Service and a U.S. investigation into Medicaid pricing are viewed by analysts as probably small chips in the fortress. But the recent seizure by the U.S. government of two products because of manufacturing problems could represent a full-fledged fissure.

Suddenly, GlaxoSmithKline -- the second-largest seller of drugs in the U.S. -- looks a bit less solid: Two investment-banking firms downgraded the stock recently.

"We believe that the story of manufacturing deficiencies ... is far from over," says Kevin Wilson of Citigroup Smith Barney in a March 21 report to clients, as he cut his rating to hold from buy. "We believe FDA will be very tough, given the company's apparent failure to deal with four warning letters."

Although the products accounted for about 3% of corporate sales last year, manufacturing quality disputes with the Food and Drug Administration can be expensive beyond the cost of lost sales. Just ask

Schering-Plough

(SGP)

: Its constant failure to improve manufacturing practices at two plants metastasized into a $500 million fine in 2002.

Some Good Signs

The unsettling news comes at a time when GlaxoSmithKline is outshining giant U.S. rivals such as

Merck

(MRK) - Get Report

and

Pfizer

(PFE) - Get Report

by offsetting patent expirations on big-revenue drugs with new products and promising experimental products.

Moody's Investors Service says GlaxoSmithKline faces a generic risk through 2007 of only 11% of revenue based on 2003's sales. Merck's risk is 28%; Pfizer's risk is 33%. These calculations reflect drugs whose patents will expire but exclude drugs whose longer-term patents are being challenged.

Moody's also likes GlaxoSmithKline's balanced portfolio. Its top three products accounted for 24% of revenue in 2003, while its top five drugs accounted for 32% in that year. Contrast those figures with

Eli Lilly

(LLY) - Get Report

, whose top three drugs produced 46% of revenue and whose top five drugs accounted for 57%. At Merck, the top three compounds accounted for 46%, and the top five drugs accounted for 66%.

Analysts who favor GlaxoSmithKline -- its ratings are divided almost evenly among buy, sell and hold, according to Thomson First Call -- believe the company has considerable potential. In late February, Sanford C. Bernstein & Co. told clients that 2005 could be quite promising, depending on what data the company release on 15 experimental products in midstage clinical testing.

"Some of those products will move to phase III trials shortly thereafter," says the firm, referring to the final stage of human trials before a drug is submitted to regulators.

Bernstein, which still has an outperform rating, said at the time that recent stock price gains "reflect the market's increasing belief in the visibility and viability of GlaxoSmithKline's pipeline." (The firm has provided non-investment-banking services; its analysts don't own shares in GlaxoSmithKline.)

In addition, the company should hear from the FDA in a few days about its application for a once-a-month pill for treating osteoporosis.

A Sudden Change

Like Merck learned dramatically, GlaxoSmithKline is learning, in a more modest fashion, that bad things can happen quickly in the pharmaceutical business.

In early March, the FDA and the Justice Department seized batches of Paxil CR, a controlled-release antidepressant, and Avandamet, a treatment for diabetes. Although the FDA says it wasn't aware of any patient injuries, it adds that the company failed to ensure the safety, strength, qualify and purity of these products at its Puerto Rico plant.

The government "will not allow drug manufacturers to ignore our high public health standards for drug manufacturing," said John M. Taylor, a top FDA official, on March 4. "Once we discover a company is not following the standards ... we expect it to correct the deficiencies in an expedited manner."

Citigroup Smith Barney's Kevin Wilson says the FDA began investigating the plant in October 2003 and later issued two warning letters. It reinspected the plant in November 2004 and issued two more letters.

He predicts that Paxil CR and Avandamet won't return to the U.S. market until the third quarter of 2006. He adds that a "highly likely outcome" would be for the plant to operate under a consent decree, meaning GlaxoSmithKline must fix all problems before resuming production.

The plant also could be subject to periodic reviews by the FDA, and the company could be hit with big fines.

Wilson adds that it's possible the entire plant -- not just the two products -- could be ensnared in the consent decree. If so, that would affect products with an estimated $3.65 billion, or 9.5%, of corporate revenue for 2005, he says. The plant also makes a standard version of Paxil, a cousin of Avandamet called Avandia and a congestive heart failure drug called Coreg.

As a result, Wilson cut his 2005 earnings per share estimate by 8% to $2.71 and his 2006 EPS estimate by 7% to $3.11. (He owns shares; his firm has an investment-banking relationship.)

Prudential Equity Group analyst Tim Anderson cut his rating to underweight from neutral weight on March 4, just as the U.S. marshals were seizing GlaxoSmithKline's products. He told clients the company's shares had outrun his price target. He is less enthusiastic about experimental drugs, saying he is "not able to give GlaxoSmithKline credit" for these products, "mostly because we have yet to see concrete clinical data to help us assess these compounds."

Two weeks later, Anderson issued another report and reduced EPS estimates for 2005 and 2006 to $2.64 and $2.67, respectively. The consensus views, according to Thomson First Call, are $2.98 and $3.22, figures which Anderson says "are at risk." (He doesn't own shares; his firm doesn't have an investment-banking relationship.)