Image Source: Gilead
By Brian Nelson, CFA
“They” say nobody saw this coming, but then again not everybody follows Valuentum’s research and analysis. That’s a good thing.
We were starting to doubt our de-risking maneuver in the Best Ideas Newsletter portfolio that we made in January, “Alerts: High-grading! GILD–>JNJ; EBAY–>FB (January 2016),” in light of Gilead’s shares recovering nicely along with the market advance. However, the hep-C giant’s first-quarter report, released April 28, looks like it will be the catalyst to bring shares back down to earth, fair or not. Given some of the comments/questions we’ve received in recent months, we think it is worth noting that since the January 29 transaction alert, shares of Johnson & Johnson (JNJ) have rallied at a high-single-digit pace, while Gilead’s shares have rallied by a similar margin (1). The “alpha” of the de-risking trade looks mostly like a wash thus far for those keeping score. Johnson & Johnson breached an all-time high last week, “Domestic Pharma Drives JNJ’s 1Q; Stock Hits All-time High (April 2016).”
In its first quarter report, Gilead missed both the top-line and bottom-line consensus forecasts, but the company’s revenue and earnings performance wasn’t terrible as both measures on a non-GAAP basis advanced modestly during the period. We had outlined how the company’s growth spurt was over, “Gilead Guides Revenue to Decline in 2016, Below Consensus (February 2016),” and how we’re sleeping better at night no longer having the product-concentration risk and political pricing risks that have become almost too great for even a risk-seeking investor to bear, “What Gilead’s Patent Miscue Means for Shareholders (March 2016).” Harvoni sales dropped to $3.02 billion from $3.58 billion in the year-ago period, a fall of ~16% as contributions from Japan failed to offset more than a halving of revenue in the US ($1.41 billion from $3.02 billion). We think Gilead’s pain is a positive read-through for Merck (MRK), which has priced rival drug Zepatier aggressively. As we had mentioned in prior research, Gilead is a great company – it’s just too risky to garner a position in the coveted Best Ideas Newsletter portfolio any longer, even as we say that shares still look cheap.
We found out what was driving Gilead’s stock higher the past few months, and it wasn’t the incremental investor or fund manager – it was the company itself. During the first quarter, Gilead spent $8 billion on share buybacks, a breakneck pace of repurchases that surely and “artificially” helped to propel some of its strong equity price performance the past few weeks. As of March 31, 2016, the company’s cash balance stood at $21.3 billion, down from $26.2 billion just three months prior, and long-term liabilities held relatively steady from the sequential quarter at ~$23 billion, so not much brewing from a net cash standpoint. Though generally we’re in favor of companies buying back stock when their shares are undervalued, given the decline in Harvoni sales, particularly in the US, the announcement that the board has approved the repurchase of another $12 billion of the company’s stock wasn’t all that welcome news. Even Gilead’s ~9% dividend hike, to $0.47 per quarter, was overshadowed by the fundamental weakness.
We know a lot of readers like to question us in the near term, but let’s keep watching the Gilead story. It looks like pricing pressure, particularly in the US, will be difficult to overcome, and share buybacks are absorbing a cash arsenal that could be used to make savvy acquisitions. We’ve outlined our many concerns about Gilead in the past, and we invite readers to continue reading our recent commentary on the company’s stock landing page on our website here. Our $130 per share fair value estimate for Gilead remains unchanged, but no longer is it a coveted best idea. The risks of it becoming a value trap are far too great. We continue to prefer Johnson & Johnson, which coincidentally raised its dividend April 28 as well.
(1)
Returns calculated as of 9:32am, April 29, 2016
Removed Gilead: ($90.30 + 0.43 dividend)/$83.37 = 8.8%
Added Johnson & Johnson: ($111.95 + $0.75 dividend)/$104.18 = 8.2%