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Sunday, September 09, 2007

The drugs don't work for GlaxoSmithKline

Source: The Business - London's first global business magazine

Jean-Pierre Garnier has no idea what his shares closed at last night but the chief executive of GlaxoSmithKline, Europe's largest drugs company, could be forgiven for not keeping up with what the market thinks.

GSK's shares have remained firmly stuck in the doldrums in recent months - in fact, they have gone south since the merger seven years ago of Glaxo Wellcome and SmithKline Beecham in 2000. Over that time, GSK's market value has dropped by a massive £54bn to £74bn.

In an interview with The Sunday Telegraph, Garnier admits the share price could be better but insists critics are wrong to focus on just that. "You need to be careful that you don't look at the tree - you've got to look at the forest," he says.

Garnier's argument is that over the longer term - since 1985 - the industry has created more value than any other. The year 2000 was "an abnormal peak" when share prices hit a high, he says, since when there has been a huge derating of the sector.

"The pharma industry has the potential to create enormous value for shareholders and has done so consistently until the recent past. That is not indicative of the future," he adds.

But it is the recent past that has been occupying Garnier's shareholders of late, many of whom bought into the story that bigger was better seven years ago. A number have even begun to wonder if there is not a more radical solution that could cure GSK's ills, such as spinning off the company's consumer business.

GSK insists no such radical surgery is necessary but has responded by hiking its dividend and increasing its share buyback. The move has been welcomed by investors but the company's share price and those of its peers remain sluggish. The dismal performances have led to some serious soul-searching within the industry and even prompted some to think the unthinkable: has Big Pharma become too big?

Unfortunately for Garnier, who is retiring at the company's annual meeting in May, it is difficult to think of a miracle cure that could allow him to depart on a high - at least when it comes to the share price.

Industry experts argue the traditional business model - where companies placed expensive bets on a few molecules and used their huge sales forces to market them to doctors in the hope they would turn into best sellers - is broken.

The Holy Grail of the industry is to develop new medicines. But despite billions of pounds put into research and development (R&D), most companies' laboratories are failing to come up with the goods. "Even allowing for inflation, the industry is investing twice as much in R&D as it was a decade ago to produce two-fifths of the new medicines it then produced," says a recent report from PricewaterhouseCoopers.

Last year, a record $55.2bn (£22.5bn) was spent on R&D in North America, but "the US Food and Drug Administration (FDA) approved only 22 new molecular entities (NMEs) and biologics (drugs from natural sources), a far cry from the 53 it approved in 1996," continues the report.

Moreover, only nine of the new treatments launched in the US last year came from the labs of the world's top 13 drugs companies.

More worrying, Big Pharma is relying for the bulk of its revenues - some 90 per cent - on medicines that have been on the market for more than five years. "Yet the patents on many of these products are due to expire quite shortly, exposing an estimated $157bn worth of sales (in 2005 terms) to generic erosion"," says the report.

Garnier is the first to admit that the average performance across the industry is not good enough.

"The opportunity to create significant value for our shareholders is right in front of us", he says. "The number-one mission of society is health. They want better health, people want to live forever and be fit and well".

The caveat, however, is productivity. "We have to be productive in terms of R&D, we have to come up with the drugs? If you crack this one, you will create enormous value for your shareholders."

GSK, he believes, is doing better than its rivals. The company is on the right path "to improve its fundamentals". But seven years after the merger is that really good enough? The question hits a nerve.

"When I took over as CEO I had two drugs in the late-stage pipeline. We have 33 today. Think about that," he hits back. "That is remarkable progress because the cycle of R&D is 15 years."

The company expects to launch 25 new products over the next five years, including at least two potential blockbusters, Cervarix, its cervical cancer vaccine, and Tykerb, a treatment for breast cancer.

One of the reasons GSK's pipeline is looking more healthy than that of many of its peers is because it has already changed the way its scientists work. As part of the merger in 2000, the company decided to split its research activities into a number of smaller units focused on different therapeutic areas. These so-called Cedds - Centres of Excellence for Drug Discovery - are run autonomously. The aim was to inject the entrepreneurial spirit of a biotechnology company into an organisation that employs more than 100,000 people in 117 countries.

The experiment has undoubtedly worked, but there is a difference between the number of medicines in a pipeline and the quality of these medicines; not all will be blockbusters.

"Why is our stock price not double what it is?" asks Garnier. "It has nothing to do with our pipeline, nobody has made the change in their structures in R&D that we have. The reason may be because some of the older drugs of GSK are being threatened by generics."

He knows what he is talking about. Since taking over at GSK, the company has lost three products - Paxil, for depression, the antibiotic Augmentin for infections and Wellbutrin, also for depression - with combined annual sales of £4bn to generic competition.

Garnier believes the market has misunderstood the extent of the company's exposure to generics. Advair, the company's best-selling asthma drug which generates sales of £3bn each year is due to come off patent in the US in 2010 and in Europe in 2013. Prescription medicines typically lose 90 per cent of their sales as soon as they come off patent, but Garnier argues that because Advair is an inhaled drug and not a pill, it is an exception. The delivery system is protected until 2018 so generics shouldn't have the automatic impact they would normally have.

"Nobody is unhappy about the derating of an industry," he says, "but we have improved our cost ratios every single year since the merger so this has been a very successful effort to strengthen the fundamentals of the company."

But even though GSK's laboratories appear to be delivering, there are many more that are not. Some long-term industry watchers argue that the poor stock prices across the sector are evidence that investors are unable to differentiate between those companies doing well and those that are not. The share prices of the top 12 companies are trading on a huge range of earnings multiples - between 11 and 22 times for 2008. This range narrows to just 9.5 to 11 times for 2010.

"That is telling you investors don't believe in the sustainability of the model any more," says one industry expert. Scenarios being mooted include companies reducing the time and costs involved in research by trying to gain a more holistic understanding of diseases early on. Others argue that companies need to change the way they market their products or even consider splitting off their sales activities from the research business. The trick is to provide more transparency for investors.

"There is so much subsumed within the pharma monolith," is how one analyst puts it.

Garnier believes the Big Pharma model still works "as long as you evolve it". "It is part of what we are doing and firmly part of what my successor will have to do. Some of the big pharma companies have not moved on their productivity problems and they will pay the price and some of them will not be around in the future," he says.

Would he back the merger that created GSK today? Yes, he says, adding that without a merger neither Glaxo nor SmithKline would have survived.

And given the challenges that are facing the industry, does a company such as GSK need a scientist or a marketer to lead it? Garnier is too circumspect to be drawn on this point but says: "They should be led by leaders with character and integrity."

Whoever ends up succeeding Garnier had better be ready to lead. Times will only get tougher.

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