This article was adapted from our sister site across the pond, Fool U.K.
If big really is beautiful, then you don't get much more attractive than pharmaceutical giant GlaxoSmithKline
Glaxo the global giant
By any measure, GSK is a powerhouse. The world's fourth-largest drug-maker recorded annual sales of over 28 billion pounds in 2009 and posted a post-tax profit of 5.7 billion pounds. GSK employs nearly 100,000 people and paid more than 2.2 billion pounds in corporate taxes last year, so it's one of the biggest corporate contributors to HM Treasury's coffers.
Furthermore, with a market capitalization north of 61 billion pounds, the blue-chip firm's shares are very widely held, featuring at the heart of many U.K.-focused portfolios, both private and institutional. So, when GSK stumbles, it has an impact on millions of investors.
A 2 billion pound setback
One such stumble happened earlier this week, after it was announced that GSK is to record a charge of 2.2 billion pounds (or 1.8 billion pounds after tax) due to additional legal costs incurred in 2010.
This legal charge relates largely to an ongoing U.S. investigation into the sale and promotion of diabetes drug Avandia. Following concerns about raised cardiovascular risk among Avandia patients, the drug has been largely withdrawn from prescription in America and Europe. As you'd expect, this partial withdrawal has triggered a flurry of product-liability lawsuits, especially in the famously litigious U.S.
Legal side effects
Of course, this isn't the first time that GSK has had to dig deep to meet big bills arising from legal disputes and regulatory fines. In the world of Big Pharma, multi-billion-dollar settlements for product-liability cases are almost as common as the side-effects these drugs sometimes cause.
In common with other regulators, the U.S. Food and Drug Administration (FDA) and the European Medicines Agency have become far more hands-on when enforcing pharmaceutical safety. Hence, recent years have seen a notable increase in the number of enforced product withdrawals, "black box" safety warnings, and huge fines for regulatory breaches.
Indeed, in its last set of annual results, GSK had already set aside nearly 1.6 billion pounds for legal charges covering Avandia and antidepressant Paxil. This sum also included 500 million pounds stemming from manufacturing problems at a former GSK plant in Puerto Rico that was closed in 2009.
A bitter pill to swallow
In some pharmaceutical circles, such legal charges are seen as an almost inevitable price of launching blockbuster drugs into the lucrative U.S. and European markets.
Obviously, GSK shareholders will welcome the company's attempts to make proper reserves for new Avandia claims in the U.S. Then again, 2.2 billion pounds before tax is a bitter pill to swallow, as this record-breaking charge will wipe out Glaxo's fourth-quarter profit. What's more, this charge is only a "reasonable estimate," so it could rise or fall in future.
Nevertheless, GSK's shares closed down from where they were before this surprise announcement.
Has Mr. Market overreacted?
Given that the drop in GSK's value exceeds the expected loss by a wide margin, some investors will take the view that the market has overreacted. On the other hand, critics will argue that announcing such a large loss provision out of the blue suggests that, at best, GSK needs to improve its communication. At worst, investors will fear reputational damage to the company from yet another run-in with the FDA.
Even so, on a price-to-earnings ratio of around 10 and a dividend yield above 5% (covered twice), GSK displays some well-worn value characteristics. In addition, the company has a rock-solid balance sheet and throws off cash in the billions.
However, this charge -- approaching a quarter of 2010's total profits -- could spell an end to GSK's aggressive share-buyback scheme, during which the company has retired hundreds of millions of shares. Likewise, lower cash reserves could lead GSK to trim its dividends, although I don't expect this to happen. After all, GSK's annual dividend climbed by 36% between 2001 and 2009 and rose in each of these years.
In my view, this legal setback, while non-trivial, is only a small part of the big picture. Far more important is GSK's cost-cutting and its stated goal to move away from "white pills and Western markets." If these initiatives succeed by growing earnings, then we should see an upward re-rating of GSK shares.
More from Fool U.K.'s Cliff D'Arcy:
Cliff owns shares in Glaxo, which is a Motley Fool Global Gains choice. The Fool owns shares of and has written covered calls on GlaxoSmithKline. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
