The merger of Glaxo and Smithkline Pharma in India will undoubtedly create a market leader in the domestic formulations business. The merger ratio announced on Friday implies that Glaxo (the merged entity) is now available at a cheaper price and with better growth prospects. Before explaining how, let us have a glimpse of the combined earnings for the year ending 31 Dec ’00.

As you can see, the EPS of the combined entity (assuming a swap ratio of 1 Glaxo share for every 2 SKB shares) is 15% higher than that of Glaxo, which implies that Glaxo is trading at a lower PE ratio than before the merger. How did this happen? Because, the ratio is more in tune with the prevailing stock price than with EPS numbers. To put it another way, the two companies have similar EPS but very different stock prices. Glaxo is trading at a PER of 37x FY 12/2000 EPS while SKB Pharma is trading at 19x FY 12/2000 EPS. Why this gap is a different issue altogether?

Given this situation, you have a stock (Glaxo) which is now trading at a PER of 32x FY 12/2000 EPS (merged) as against 37x three days back, while the fundamentals have actually improved. The merged Glaxo Smithkline will be a leader with more than 150 brands- many of them market leaders, a sales force of around 2,400, a portfolio of new products (from the SKB vaccine stable), a management with an impeccable track record, a parent which is amongst the largest pharma companies in the world, and so on. Such a stock should be rerated, not derated!

So, where’s the hitch? The integration process can face some problems, especially with the difference in wage structure of the two sales forces. The Glaxo Burroughs attempt at integration is a case in point. But this time around, the management seems to be more firm. The speed with which the merger and swap ratio was announced took most people by surprise. On the plus side, integration of functions would save cost and improve profitability ratios.

The next question- is it better to buy Glaxo or Smithkline? Going by the ratio, Smithkline is trading at a 7% discount to its fair value. The discount might narrow, but will still remain, probably at around 3-4%. So, there is no great arbitrage possibility. Buy anyone- both are good investments.

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