Source: Gilead Sciences Corporate Fact Sheet (pdf)
By Brian Nelson, CFA
There’s nothing quite like market instincts. They can’t be taught from reading textbooks, in the classroom, in a valuation model, or even with years and years of experience. It’s the intangibles that sometimes count the most.
When we removed Gilead (GILD) from the portfolio of the Best Ideas Newsletter, “Alerts: High-grading! GILD–>JNJ… (Jan 2016),” we just knew something wasn’t right. Sure the introduction of Merck’s (MRK) once-daily single-tablet combination therapy, Zepatier, a significantly less expensive therapy to Gilead’s prized hepatitis C franchise was one major concern at the time, but the market is often not this inefficient when valuing equities. Almost counterintuitively, it became worrisome to us that for a company that was generating so much free cash flow and had just initiated a dividend that the market wasn’t even coming close to assigning it a mere market multiple. We had been holders of Gilead for some time, and the recent stock-price performance just wasn’t adding up.
One could have written off the weak share price action to “political badgering” from the ongoing election coverage or from capital-flight to safer assets amid concerns of global growth, but there had to be more. The information contained in the market price was telling us something that couldn’t be pulled from the recent quarterly report or management’s latest outlook, or anything you might find in the backward-looking GAAP financials. Of course Gilead has tremendous product concentration with its hepatitis C franchise, but that alone couldn’t be responsible for its significantly below-market multiple, something that could be remedied in part as the company puts its outsize cash balance to work via diversified growth through acquisitions.
There wasn’t even anything wrong with Gilead’s fourth-quarter results, “Gilead Guides Revenue to Decline in 2016, Below Consensus (Feb 2),” announcing a new share buyback program and upping its dividend 10% in the press release. Sure we were a bit concerned about management’s gross-margin guidance for 2016 in that it didn’t, in our view, logically capture the pricing pressure from Zepatier, which is set at $54,600 for a 12-week regimen, a fraction of Gilead’s Harvoni at $94,500, but there was nothing that told us to run for cover. In many ways, it was the pricing action that told us something was wrong. We lost the stomach to hold a company with a very product-concentrated business, one that generates 60% of total sales from Harvoni/Solvadi alone. How could we possibly forget what happened to AbbVie (ABBV), “If It Happened to AbbVie, Could It Also Happen to Gilead?”
Then the story arc continued.
On February 5, the FDA cleared the expanded use of Bristol-Myers’ (BMY) hepatitis C offering Daklinza for “additional challenging-to-treat patients with genotype 1 or genotype 3 chronic hepatitis C,” revealing even more competition in the hepatitis C space. Bristol Myers HCV combinations revealed cure rates as high as 99% in certain patient demographics. Then, on February 27, Regulus Therapeutics (RGLS) announced that a phase II trial of a key hepatitis C offering received positive interim results, implying even more choices for patients with chronic hepatitis C virus infection. Regulus’ HCV candidate showed a respectable 97% cure rate after eight weeks in the mid-stage study. Certainly the hepatitis C “cure” space was becoming more and more crowded by the day. It seems that even if Gilead is able to retain its dominance in the HCV space, pricing pressure and share loss can only be expected in coming years, and that’s without the prospect of politicians exerting even more weight on drug pricing practices.
Then on March 18, we got word that one of Gilead’s top cancer executives would step down after just a 15-month stint, coming shortly after noting it would halt half-dozen clinical trials, exposing a significant roadblock in Gilead’s efforts to expand beyond its anti-viral offerings. Then the beginnings of the outcome of the courtroom brawl with Merck’s sofosbuvir patents began to surface. Sofosbuvir is a critical nucleotide used in Gilead’s Harvoni/Solvadi franchise, and Merck has been claiming for some time that Gilead has been infringing on its intellectual property, pointing to a patent that Merck published in 2002. The jury concluded that Merck’s patents were valid, and an award to Merck could be in the billions, not including a royalty of 10% that may be applied to Gilead’s sofosbuvir sales going forward, inevitably pressuring margins.
Gilead is a fine company, with a fortress balance sheet, and throws off a tremendous amount of free cash flow. Cash and cash equivalents stood at ~$26.2 billion at the end of 2015, and the drug maker generated a whopping $20.3 billion in operating cash flow during the year. It’s possible the jury may award Merck more than it wants, but the impact to Gilead will still be marginal, in our view, taking a few billion of cash off the books and squeezing its margins by a few percentage points going forward. The big question, however, is how the future of the hepatitis C “cure” market shapes out, and whether the judgment paves the way for future growth in Zepatier. Gilead’s revenue is already expected to fall, its margins are being squeezed, and the company is resorting to buybacks and dividend increases to appease shareholders. Overpaying for an acquisition won’t solve its ills, and the company’s pipeline, while promising, took a big blow in oncology recently.
Gilead’s market capitalization is nothing to scoff at near $130 billion, and while a forward earnings multiple of ~8 times may look enticing on the surface, there’s still a lot to be cautious about. We’re sleeping better at night not including shares in the Best Ideas Newsletter portfolio, and we’re pleased that shares of its high-grade replacement, Johnson & Johnson (JNJ), continue to rally nicely.