LONDON -- With its strong pharmaceutical business and clutch of consumer health care and nutrition brands, GlaxoSmithKline (LSE: GSK.L) (NYSE: GSK) is a business with very definite attractions. A 65 billion pound FTSE 100 constituent, the company is expected this year to deliver revenues of 27 billion pounds, and pre-tax profits of 5.5 billion pounds.
And with margins like that, no wonder this defensively-positioned business is popular with many investors. Better still, with its shares changing hands today at 1,325 pence, the company is rated on a relatively modest prospective P/E of 11 and offers a tempting forecast dividend yield of 5.4%.
But how safe is that share price? And -- critically-important for income investors -- how safe is that dividend? In short, how could an investment in GlaxoSmithKline adversely impact investors' wealth?
In this series, I set out to answer just these questions. My starting point: GlaxoSmithKline's latest annual report, where the company's directors are obliged to address the issue of risk.
Risk management
One immediate thing that I'm looking for is an acknowledgement that risks do exist, and that they need managing.
The good news? As you'd expect from a business of GlaxoSmithKline's size and caliber, the company has in place a risk management policy, a system of regular reviews, and a number of high-level committees tasked with monitoring the risks that the business has identified.
But what, precisely, are those risks that the company faces?
Read the small print, and GlaxoSmithKline identifies no fewer than 22 risks as having a significant prospective impact on the company's financial performance. They range from environmental liabilities to product liability legislation, and from failure to protect intellectual property to bribery.
So, let's take a look at three of the biggest.
Expiry of intellectual property protection
Glaxo invests heavily in R&D, in order to bring to market new drugs and treatments that it can sell to health care providers and patients around the world. In 2011, for instance, R&D investment totaled 4 billion pounds. But as drugs go off patent, generic manufacturers can launch copycat products, stealing Glaxo's market share, and forcing it to offer steep price discounts in order to compete. As the company says:
Pharmaceutical and vaccine products are usually only protected from being copied by generic manufacturers during the period of exclusivity provided by an issued patent or related intellectual property rights such as Regulatory Data Protection or Orphan Drug status. Following expiry of intellectual property rights protection, a generic manufacturer may produce a generic version of the product.
The risk is certainly significant: As Glaxo points out, no fewer than eleven pharmaceutical and vaccine products delivered over 500 million pounds in annual global sales in 2011.
What is it doing about it? Well, keeping the pipeline full of new patentable drugs is an important protection, as are various "brand extensions" -- taking an existing drug and improving it in some way, or developing alternative delivery and treatment mechanisms. That said, the company also robustly defends itself against generic manufacturers' attempted patent-breaking actions. Finally, some 20% of sales come from its clutch of consumer health care and nutrition brands -- such as Panadol, Sensodyne, Macleans, Lucozade, and Horlicks -- which don't go off patent.
Product liability litigation
Sometimes, drugs and new treatments have unexpected and unwanted side effects -- and sometimes, these are serious enough to warrant litigation, and subsequent fines and compensation. Just last year, for instance, Glaxo settled a U.S. lawsuit over its diabetes drug Avandia, at a cost of 1.6 billion pounds. As the company puts it:
Pre clinical and clinical trials are conducted during the development of potential pharmaceutical, vaccine and consumer healthcare products to determine the safety and efficacy of the products for use by humans following approval by regulatory authorities. Notwithstanding the efforts the Group makes to determine the safety of its products through regulated clinical trials, unanticipated side effects may become evident only when drugs and vaccines are widely introduced into the marketplace.
The risk is significant. Glaxo is currently a defendant in a number of product liability lawsuits, including class actions, which involve claims for damages that the company describes as "significant."
How does the company address the risk? A robust legal defense, to be sure. Thorough testing, too, is also important. But the tensions are obvious -- the longer the testing process takes, the greater the period of patent protection that expires as testing takes place.
Pricing
As noted, Glaxo earns decent crust, with margins of around 20%. And in part, that is due to its ability charge sick patients what it likes for drugs that will provide a cure or alleviate symptoms. But increasingly, governments are stepping in, to keep a lid of prices and keep voters happy. As Glaxo puts it:
Pharmaceutical and vaccine products are subject to price controls or pressures and other restrictions in many markets, including but not limited to France, Germany, Italy, Japan and Spain. Difficult economic conditions, particularly in the major markets in Europe, could increase the pricing pressures on the Group's pharmaceutical and vaccine products.
And such risks are growing. In the United States, where Glaxo has its highest margins and the most sales for any country, there are no direct government price controls over private sector purchases, but federal law requires pharmaceutical manufacturers to pay prescribed rebates on certain drugs to be eligible for reimbursement under healthcare programmes such as Medicare and Medicaid.
What's more, due to the passage of comprehensive health care reform in 2010 in the United States ("Obamacare"), the government's role in providing or subsidizing health insurance is expected to significantly expand in 2014 -- giving it growing leverage, and a greater interest in keeping prices low.
Risk vs. reward
Two superstar investors who are well-used to weighing risks are Neil Woodford and Warren Buffett.
On a dividend-reinvested basis over the 15 years to Dec. 31, 2011, Neil Woodford delivered a return of 347%, versus the FTSE All Share's distinctly more modest 42% performance. Warren Buffett, for his part, has delivered returns of over 20% per annum since 1965, transforming himself into the world's third-wealthiest person.
Each, as it happens, are the subject of two special reports prepared by Motley Fool analysts. And they're yours to freely download, without any obligation.
So click here to download this free special report profiling the investment logic behind eight of Woodford's largest and most successful current picks.
And click here to discover which beaten-down British share Warren Buffett has been buying of late -- and why he bought it, and the price he paid.
