Never mind the performance targets - can GSK and Garnier deliver the performance?

As time runs out for patents that are his company's lifeblood, the 'big pharma' boss needs new drugs to satisfy shareholders' cravings. Tim Webb reports

Jean-Pierre Garnier, the chief executive of GlaxoSmithKline, will probably not sleep well tonight. Tomorrow, the drugs company will hold its annual general meeting. Mr Garnier suffered an embarrassing defeat last year when shareholders voted against his pay deal in a revolt that has become synonymous with shareholder power. He was vilified as a fat cat because he stood to receive an estimated £22m even if he were sacked. This time round, though, the outcome is likely to be different.

Jean-Pierre Garnier, the chief executive of GlaxoSmithKline, will probably not sleep well tonight. Tomorrow, the drugs company will hold its annual general meeting. Mr Garnier suffered an embarrassing defeat last year when shareholders voted against his pay deal in a revolt that has become synonymous with shareholder power. He was vilified as a fat cat because he stood to receive an estimated £22m even if he were sacked. This time round, though, the outcome is likely to be different.

Rumblings of discontent surround the amended package, which could still see him earn up to £18m. The Association of British Insurers has issued an "amber top" report to its members, highlighting breaches of best practice. In particular, the ABI warned, by benchmarking his long-term incentives to a comparator group instead of capping them, GSK risks "ratcheting up rewards". The performance-related targets may have been set too low, making it too easy for Mr Garnier to be paid in full. Yet shareholders contacted by The Independent on Sunday said they were happy to see Mr Garnier being well paid for doing a good job.

But there's the rub. Mr Garnier's problem is not the level of his performance targets, but his performance and that of the company. He is the first - and only - chief executive of GSK, which was formed in 2000 from the merger of Glaxo Wellcome and SmithKline Beecham. It has not been performing well under his leadership.

One of GSK's founding fathers, Thomas Beecham, launched his laxative Beecham's Pills in 1842 after studying the eating patterns of sheep. Today, the company is the fourth largest in the UK, with a stock market value of £69bn, but its share price is trading at a 20 per cent discount to its peers. Scope for further cost-cutting from the merger is limited. GSK has been underperforming the sector during the past five years; its profits are falling, and last month Mr Garnier warned that the next two quarters would be "challenging". Analysts at investment bank JP Morgan forecast earnings per share for 2004 will be down 4 per cent on last year, and that earnings over the next five years would be below average. So whose fault is it?

Analysts blame a number of factors for the slowdown in earnings. The biggest culprits are generic drugs, cheaper versions of drugs whose patents have expired. Patents for some of GSK's most successful blockbusters - defined as drugs that bring in more than $1bn (£570m) a year in sales - have recently expired. Among them is the patent for Paxil (or Seroxat as the anti-depressant is more commonly known in the UK), which ran out last year. Paxil was the biggest-selling single drug in 2002, bringing in over £2bn of sales out of £18bn of group sales in total. In the first quarter this year, Paxil made £291m of sales, compared with £490m for the first three months last year.

GSK is heavily dependent on blockbusters but it is not alone. Consultants at Arthur D Little estimate that GSK, the world's second biggest selling drugs company, relies on nine of these mega-selling drugs for half of its total sales. But the market leader, Pfizer, makes an estimated 80 per cent of its sales from just eight drugs.

Blockbusters only last as long as the patents, which protect the intellectual property. Typically, patents last for 20 years, beginning when a drug is first being developed. Because it might take a company 10 years to commercially launch a drug and to carry out all the clinical trials needed to get regulatory approval, most patented drugs on the market have less than 10 years to run before their patent runs out.

Generic producers do not waste any time once a drug's patent has expired. It is not uncommon for them to fly out lawyers overnight to a country where a patent is about to expire so they can be the first to patent a generic version.

The expiry of the patent for Prozac, made by Lilly, is the best example of the devastating effect of generics on sales of the original drug. On 2 August 2001, the patent expired. The following day, a generic version was launched and within one month, mail order companies in the US were reporting that 81 per cent of Prozac users had switched to the new, cheaper version. Lilly's chief executive, Sidney Taurel, said at the time that the slump was "the most severe for a blockbuster product in our industry".

The prescription written out by your GP is, in all likelihood, for a generic drug. New figures from the Department of Health show that 77.8 per cent of drugs prescribed last year were generics, compared with less than half 10 years ago. Richard Lay of the Association of the British Pharmaceutical Industry, the UK drugs companies' trade association, says that generics are used too much in Britain. "No one in their right mind would deny the role of generics," he says. "They are very cost effective. But we are becoming over-dependent on them in the UK. A lot of people would benefit from a more modern drug."

GSK has been particularly badly hit by generics, says Howard Miller, an analyst from Teather & Greenwood. "The timing of the launch of generics is difficult to predict for anyone, so GSK can't be blamed." Finding new drugs that will bring in enough sales to replace the huge revenues generated by blockbusters is no easy task, he says.

The prospects for GSK coming up with new blockbusters in the near future are not good. Analysts at JP Morgan bemoan the "lack of any meaningfully large new product launches", warning that the benefits will not be felt until 2010 at the earliest. The company aims to launch 15 new drugs over the next four years, but JP Morgan warns that only three of these have what it calls "blockbuster potential" and all are high risk, which means that - in a worst case scenario - none may ever make it to market.

Mr Miller says that results from advanced clinical trials due later this year will be crucial. "The market has higher expectations for some of the products which are in phase two of clinical trials, but we need answers on how the trials are going. If the products in phase two don't come off, GSK will find itself in difficulties."

GSK's record in developing new drugs has not been impressive. Despite an annual $4.3bn research budget, it has received regulatory approval for only five brand-new drugs since the merger. Only one, Avodart, which treats enlarged prostate glands, was developed in its own labs; the rest came about through alliances with other companies.

Generics aren't the only threat. Companies including GSK are also suffering from "parallel trading", where customers - mostly in the US - import drugs from countries such as Canada, where prices can be up to 50 per cent lower. A US court ordered GSK to co-operate last week in an investigation into whether it colluded with other companies to restrict sales to Canada to limit drug exports to the US.

There are several ways to respond to these challenges, say analysts. More of the drugs companies' resources can be poured into R&D, but this does not guarantee success. Consolidation in the sector will increase, as demonstrated by Sanofi's recent £32bn acquisition of its French rival, Aventis, as a way of cutting costs. The groups that make up the so-called "big pharma" will become more aggressive at defending their patents from legal challenges from generic producers and will try to reduce the "time to market" development phase of a drug to maximise sales before a patent expires.

But the old adage "if you can't beat 'em, join 'em" may be true in this case, according to Robert Kane, the healthcare practice leader at Arthur D Little. Swiss group Novartis is expanding its generics division, Sandoz, which brought in almost $3bn of sales last year, up 40 per cent from the previous year. "Big pharma's lawyers can hold off legal challenges from generics companies, but can only buy so much time. Novartis's approach is interesting and could be a model for other big pharmaceutical companies to follow," he says.

It would be wrong to single out GSK for overly harsh criticism for its lean R&D pipeline and flat earnings. The number of new drugs emerging each year has halved across the industry, despite global research funding having doubled since 1991. The US Food and Drug Administration approved only 21 last year, down from 53 in 1996.

Geoff McMillan, the chief executive of drug discovery company BioFocus, says it is tougher than ever to develop new drugs. "It is harder compared with a decade ago. The industry has already plucked the low-hanging fruit by developing treatments for high blood pressure, for example. But treatments for diabetes, one of the real growth areas, are harder to develop." Because trials are becoming more stringent, and the biggest customers - governments and insurers - are becoming more demanding on cost and efficacy, the end result, he says, is: "Companies are spending more money on developing fewer drugs."

Mr Garnier should take heart from the fact that GSK isn't the only big pharma company feeling the pain. But if it continues to underperform - and he continues to pick up fat pay cheques - he can expect more headaches from shareholders in future.

WHERE WILL THE FUR BE FLYING NEXT? TAKE YOUR SEATS FOR A SUMMER OF CORPORATE CONFRONTATION

The humiliating dressing down Jean-Pierre Garnier received from shareholders last year was not a one-off. In terms of investor activism, 2003 was a watershed year. The Higgs review forced companies to publish remuneration reports for the first time, and shareholders used annual general meetings to make their often unflattering views known. Investments had taken a battering but "fat cat" executives dominated the headlines.

This year, however, the mood is less aggressive. Shares are on the up, putting investors in a more forgiving frame of mind, and many companies have acquiesced to shareholder demands: contracts are shorter, rewards harder to attain and pay-offs scaled back. Only recently, for example, Tesco announced that its boss, Sir Terry Leahy, was switching to a one-year contract, while WPP has modified a controversial incentive plan for Sir Martin Sorrell and a handful of other executives.

Earlier this year, senior executives also met with heavyweight institutional investors to ensure there was more dialogue and fewer "surprises" at annual general meetings. The Association of British Insurers, in particular, is taking a more "softly softly" approach, preferring to negotiate away from the front pages.

Yet that does not mean, as the summer months develop, that there will not be a few flash points along the way.

Shell: The oil giant will be bracing itself for a truly rough ride at its 28 June AGM. The focus, with disgraced former chairman Sir Philip Watts now gone, will fall on the non-executives. Investor ire may have diminished a little following news of planned share buyback, but shareholders will want to know how the cover-up of a 4.9 billion barrel shortfall in reserves was allowed. In addition, Shell has long been criticised for its cumbersome three-pronged board.

J Sainsbury: The beleaguered supermarket chain, which holds its AGM on 12 July, has already fallen victim to shareholder pressure this year after it named deputy chairman Sir Ian Prosser successor to Sir Peter Davis - who himself broke best corporate governance rules by moving from the chief executive to the chairman's role. Sir Ian turned down the job, and no new candidate has been put forward, although it is hoped that this week's results will address the issue.

Wm Morrison: Sainsbury's rival had no non-executive directors until last week when Sir Ken Morrison honoured a pledge to find some after bagging Safeway. Most, however, believe the group - now a dominant player with a £6.2bn market value - needs more than the two named so far.

Other AGMs include Marks & Spencer, where the pressure is on to find a chairman by 16 July, and BSkyB. The broadcaster enraged shareholders last year by appointing Rupert Murdoch's son as its chief executive. After recently revealing a slowdown in subscriber growth, it should play host to another vocal event in the autumn.

David Somerlinck, the corporate governance policy manager at Pirc, Pensions Investment Research Consultants, also highlights mmO ₂ - over the pay package lined up for its chairman designate, David Arculus - and HSBC. The bank was criticised last year for its pay deals, and Pirc, one of the more outspoken shareholder groups, remains sceptical. "We have opposed its remuneration report again," says Mr Somerlinck. This is due to the package awarded to William Aldinger, who joined HSBC last year when it bought US lender Household, and to expectations that executive salaries will rise.

While the relationship between shareholders and those who run the companies they invest in may have mellowed, there is no room for complacency. Higgs has bought corporate governance to the fore, as well as empowering shareholders by allowing them to vote on remuneration reports. And with recent tales of overpaid executives and corporate scandals, it would appear investors have no intention of giving up their new-found voice any time soon.

Abigail Townsend