Gilead’s (GILD) fourth-quarter report came and went, and it was just fine. Strong revenue and earnings growth and phenomenal free cash flow generation were all the rage in the quarterly press release. It even announced a new $12 billion share buyback program and upped its dividend 10% starting in the second quarter. We love the company that cured hepatitis C (“hep C”), but we no longer include it in the Best Ideas Newsletter portfolio. No quarterly report could ever cure our biggest concerns.
To put it straight, Gilead’s outlook for 2016 is nothing to write home about, and the probability of intense pricing competition in its blockbuster hep-C franchise taking its toll in 2017 and beyond is something even management may not have a great handle on. There’s very little reason, in our view, to believe that shares are poised to rocket higher, even as the stock trades at nearly half the “market” multiple. Please note that this is a change of opinion following the release January 29 of Merck’s (MRK) new HCV medicine Zepatier (elbasvir/grazoprevir), which we have been expecting to take a bite out of Gilead’s existing share and incremental growth across its hep-C franchise, “Alerts: High-grading! GILD–>JNJ; EBAY–>FB.” What was new to us (and to the market) in late January was Zepatier’s price tag, however.
The list price of Zepatier is set at $54,600 for a 12-week regimen, which is but a fraction of Gilead’s Harvoni $94,500, and while competition is nothing new for Gilead, we’ve simply grown uncomfortable in light of every new offering for hep-C that the FDA gives the “thumbs-up,” Merck’s only being the latest in a line-up that now includes AbbVie’s (ABBV) Viekira Pak, Merck’s Victrelis, J&J’s Olysio, and Vertex’s (VRTX) Incivek, “HCV Competition Not New “News” for Gilead.” Even modest pricing pressure on Gilead’s Harvoni/Solvadi franchise will be destructive to core net income growth; we weren’t expecting the hefty discounting by Merck. Perhaps something that we previously underestimated as well, the abnormal risks of having a very product-concentrated business, as in the case of Gilead’s Harvoni/Solvadi, which generated 60% of total sales in 2015, was best illustrated in Abbvie’s recent hep-C disaster, “If It Happened to AbbVie, Could It Also Happen to Gilead?”
We’ve lost the stomach to hold shares.
With all of that said, Gilead expects net product sales in 2016 to be in the range of $30-$31 billion (below the consensus estimate of $31.5 billion), a range that may turn out to be optimistic in light of increased pricing competition and yet another new rival to its prized Harvoni/Solvadi offering. The target top-line range of $30-$31 billion compares to net product sales of $32.2 billion in the recently-reported 2015, implying a forecasted decline in revenue for the year. Peculiarly, Gilead guided product gross margin to the range of 88%-90% for the year, better than then ~87.6% mark achieved for the full-year 2015, perhaps overlooking the increased likelihood of pricing pressure that may ensue. Even if Harvoni/Solvaldi only witnesses modest pricing pressure in 2016, however, surely more punitive damage may be ahead 2017; and if not then, what about 2018? The narrative surrounding Gilead’s outlook has become less and less attractive.
Frankly, we’re done making excuses for the underperformance of Gilead’s shares, and we’ll revisit them once the company resolves its revenue trajectory in a decidedly upward fashion, preferably from its budding pipeline. Until then, any and all earnings-per-share growth will come from lower-quality sources: lower taxes, cost cuts or buybacks, even if the latter may be value-creating relative to our fair value estimate. We’re starting to think Gilead may never get the multiple we’ve modeled unless it does something with its top-line “problem,” and deal-making at the top of this cycle only comes with selection, integration, and overpayment risk. From our experience, equities that have declining revenue and earnings coupled with the potential for a “price war” in an area that represents more than half of its business could end up being “disasters.” Throw in political risk related to drug pricing from those in the 2016 election, and the long-term outlook for Gilead just falls short.
You may not want to hear us change our opinion, but we can sleep better at night knowing that we no longer include Gilead in the Best Ideas Newsletter portfolio. Remember, we’re after risk-adjusted outperformance, and the risk-reward at Gilead has faded, “.” Don’t be surprised if you see us add Gilead back at a lower price in coming years, however.