Which long-term road for GlaxoSmithKline

GlaxoSmithKline (GSK), the British pharmaceutical company with U.S. operations in the Philadelphia area, reported 2015 first quarter earnings this morning. The numbers tell a dismal story.

Sales were flat compared to the same period last year, even as revenue from prescription medicines declined 7% on a constant currency basis. As an example, sales for its leading brand, Advair, fell 14% percent when holding currency constant.

Net profit soared as a one-time basis, but this was due to a huge asset swap with Novartis. For the rest of this year, management projects that earnings per share will decline by a high teens percentage.

Looking back beyond the first quarter, the longer trend line has also been downhill.

GSK lags behind eleven Big Pharma rivals in annual revenue growth. During 2014 its stock fell by 7%, contrasted to a 30% gain for companies in the Bloomberg Europe Pharmaceuticals Index.

But an assessment of GSK's sustainability as a profitable pharma does not emerge from a quarterly earnings call. Even the last several earnings reports do not necessarily tell the story. It's the broader view beyond the numbers that raises concern by revealing a pattern of scandal and inept research management.

The company paid a $3 billion fine in 2012 for numerous marketing violations in the U.S. and, last year, it paid nearly a half-billion dollars to China for systematic bribery in that country.

R&D at GlaxoSmithKline, the lifeblood of a branded pharma company, has suffered ever since the 2000 merger that created the existing company.  After one downsizing and reorganization several years ago, several ex-GSK researchers moved onto academia and took the occasion to blast the company's helter-skelter R&D management. They claimed that one reason the company couldn't develop effective new drugs was that management wasted the time of its top scientists by making them fly back and forth across the Atlantic between Philadelphia, London and Research Triangle.

Then in 2011 GSK reworked its entire approach to drug research. Instead of allocating annual budgets to its various departments and programs, the company gave each of them three-year grants with specified milestones they would have to meet during that period to get their grants renewed.

R&D still didn't turn the corner.  GSK's research seemed incapable of successfully developing new compounds to significantly advance the standards of care in the various therapeutic classes.

During the past decade, as other Big Pharmas focused on developing specialty products to outmaneuver multi-tier formularies and other cost-control strategies, GSK's research productivity in those areas languished. Although Glaxo had been a leader in developing antiviral medications before the 2000 merger, by 2008 research productivity in those therapies declined and the company slashed headcounts by 40% at its sites dedicated to that work in Italy, the UK, the Philly area and Research Triangle Park. The next year GSK moved its HIV efforts into a partnership with Pfizer and the two companies reduced their stakes by acquiring a third partner, Shionogi, three years later.

Last year GSK gave up on its existing oncology product line and sold it to Novartis. Now, instead of pursuing specialty drugs that offer pharmas more immunity from price competition, CEO Andrew Witty has focused GSK on primary care, over-the-counter consumer products and vaccines.

This current strategy is not necessarily bad, but it places a burden on Witty and new chairman Philip Hampton to specify their objectives and to clarify how and when such goals might be achieved.

The OTC business, for example, frees the company from large R&D expenditures and provides steady revenue without the peaks and troughs inherent in the patent-protected, branded prescription business. On the other hand, OTC pharmas generate smaller operating margins than their branded-prescription counterparts, so Witty and Hampton need to explain if their goal lies in making GSK a smaller company with a slow-but-steady growth trend.

Witty told investors that while most Big Pharmas are trying to provide exorbitantly priced, specialty medications for the 600 million consumers in the advanced countries of the U.S. and Europe, GSK will target the world's other 6 billion people. Fair enough, but that strategy immediately raises the question of how many of those 6 billion can afford even modestly priced medications. Most of them live in countries with nationalized health systems that limit drug prices to levels far beneath the $1,000 a pill range permitted by America's every-man-for-himself market.

Compared to OTC pharmaceuticals, the vaccine business operates with robust net margins but it displays a cyclical pattern that includes more political and legal hazards, together with what amounts to an ever-diminishing base of potential end-users. Once someone is vaccinated for pneumonia, human papilloma virus or most other conditions, that person is no longer a potential customer.

From a social benefit standpoint, a successfully applied conception of the vaccine business that expands it beyond infectious childhood diseases and influenza to include chronic conditions such as cancer, autoimmune conditions and heart disease can potentially represent pharma's most important contribution to public health in this century. Does Witty's plan for GSK's vaccine business include this ambitious vision?

So the direction of GlaxoSmithKline, a business with longstanding ties to the Delaware Valley, isn't to be seen in a quarterly earnings report or even in the last several. Earnings calls address the objectives of short-term, institutional investors that cite "shareholder value" as their primary or exclusive justification. GSK's chief executive and/or its chairman can realign the company to accord with the better aspects of its history by articulating a higher mission than groveling to vulture capitalists. The question is whether Witty and Hampton have this wiser, long-term vision, as well as the guts to sell it to investors.

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