GSK trades at a discount to the pharmaceutical sector for good reason, not least because the company is beginning to look rather accident prone.

Yesterday’s surprise was a £145 million provision to cover legal costs. The costs are presumably connected to patent disputes and class action lawsuits although GSK was reluctant to provide details.

GSK’s exposure to patent expiries was highlighted by the precipitous 40 per cent fall in Augmentin sales in the US in the three months to end-September following the launch of a generic competitor. GSK is fighting the case, which no doubt accounts for some of the increased legal costs, but the outcome is far from clear. The company is seeking to recover some of its antibiotic franchise with the imminent launch of Augmentin XR, a controlled release version of the drug. Such versions can grow quickly. Paxil CR, a controlled release version of Paxil which was launched in April, already accounts for 24 per cent of Paxil prescriptions in the US.

But weighing heavily on GSK’s shares is the potential loss of US patent protection of Paxil next year. GSK believes its Paxil patents are sound and is forecasting group earnings growth in the high single digits. However, the company was taken completely by surprise when its Augmentin patents were ruled invalid earlier this year. Analysts are forecasting the launch of generic Paxil in September next year, which would dramatically undermine group earnings. Other drugs, such as Wellbutrin, are also at risk from generic competition, leaving GSK particularly vulnerable to loss of earnings.

The merger of GlaxoWellcome and SmithKline Beecham was driven in part for defensive reasons as both companies realised they could benefit from the huge costs savings that could come from such a merger. These savings will amount to £1.8 billion by 2003 though neither company probably realised how vital the savings would be to bolster earnings.

GSK, though, is a group of huge financial strength, underlined by its ability to launch another £4 billion share buyback, which should help to support the share price. The main problem is the drug pipeline, which has insufficient late stage products to reassure the market that the company had handle the loss of Paxil. That said, GSK has 123 drugs in clinical trials and is energetically licensing new products so long term prospects are promising. The outlook is rocky but these shares are a hold.

Stagecoach

YESTERDAY’s 40 per cent slump in the price of shares in Stagecoach suggests that investors fear for the survival of the bus and train operator. The market capitalisation of the company is now £175 million; four years ago the firm was worth more than £3 billion. The £175 million equity market value also compares with a debt burden of £780 million.

Coach USA, acquired in 1999 for £1.2 billion, is at the root of the worries about Stagecoach. Investors have long wondered whether the business was biting off more than it could chew by entering the US market. Yesterday’s update showed that trading on the other side of the Atlantic is going from bad to worse. But some fear that the worst is still to come.

Stagecoach is conducting a review of its options on Coach USA. It is likely to have to write down the value of Coach USA and if the writedown is as severe as some fear the firm may breach its lending covenants. Stagecoach could try to reduce its debts by selling off part of Coach, but in the present market conditions it may be unable to find a buyer even at a knockdown price.

Meanwhile there is also a concern that South West Trains, one of Stagecoach’s key UK rail operations, will lose its franchise or see its economic value much reduced.

On present form the company will generate enough cash to cover its interest bill. Profits from Coach are falling but lower interest rates are also reducing the firm’s costs of borrowing. If there is no further deterioration in trading it could cover its interest bill one and a half times over.

The chances are that Stagecoach will survive in some shape or form. But the debt burden is likely to drag on the company’s fortunes and eclipse the opportunities to generate shareholder returns. The risk that the firm will pass on its dividend is already high. Bonds trade at about 25 per cent below par, but they look no more a bargain than the shares. Avoid both.

Matalan

THE growth in profits at Matalan, the discount clothes retailer, may be a good deal more modest than was once hoped for. But under guidance from Paul Mason, the newish chief executive, the firm is capable of advancing quite respectably.

In common with many young, fast-growing firms, Matalan overstretched itself. But Mr Mason and his cohort of directors recruited from Asda are putting Matalan on a more stable footing. None of the measures being introduced amounts to rocket science but by increasing investment in staff, information technology, supply chain and shop formats the firm is putting itself in a much better position.

It is particularly intriguing to note that the Matalan of the future will seek to sell more higher value items. It will still hope to offer goods at discounted prices but thinks that a dinner suit at £50 is as much of a bargain as a pair of 99p socks. At the same time it will broaden its appeal to a wider constituency of shoppers.

Mr Mason sought to play down the significance of its 8.9 per cent rise in like-for-like sales in the seven weeks to October 19. This is a strong performance and one which will put most retail rivals to shame. Investors, meanwhile, may assume that Mr Mason’s caution is born of a desire not to inflate expectations. Besides, Matalan is aiming to double its selling space and that ought to drive actual annual sales growth at double digit rates.

Much of the attraction of the shares comes because the stock has fallen back so far. But at 189p, compared with 800p two years ago, the shares trade on a forward p/e ratio of 9. That is cheap for a stock with growth potential. Buy.

tempus@thetimes.co.uk

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