By Damion Rallis, Senior Research Associate
While the share price of Gilead Sciences, Inc. (GILD) continues its steady and impressive climb-up more than 80% since the start of 2012 -- a closer look at the company's governance profile reveals several troubling indications that there could be trouble ahead for the biopharmaceutical company. Despite the drug maker's announcements last week of its upcoming two-for-one stock split and its acquisition of YM Biosciences, we have identified red flags in all of our assessment areas for Gilead, including an ESG Rating of "D," a "Very Aggressive" AGR® Rating, and a Litigation Risk Model assessment of "High Risk." In our view, while Gilead's recent trading history shows a clear potential for short-term gains, the company's governance profile and accounting practices could pose material roadblocks to long-term prosperity.
Governance concerns at Gilead Sciences are highlighted by pay practices formulated by an entrenched board that appears to heavily favor CEO and Chairman John C. Martin. Including the CEO, five Gilead Sciences board members are long-tenured with over a decade of service, and six directors are at least 70 years old, which may signal succession-planning concerns. Long-tenured directors include Lead Director James M. Denny, and Corporate Governance & Nominating Committee chair Gayle E. Wilson. While we see the value in experience, it is increasingly difficult to consider board members independent after so many years of service; long-tenured directors can often form relationships that may hinder their ability to provide effective oversight. Not only does the board's leadership call into question its ability to act as an effective counterbalance to management, but there are concerns with many of the other people who attend Gilead Sciences board meetings.
According to an article from Fortune magazine, Gilead Sciences board is "politically well-connected." Notable well-connected board members include former U.S. Secretary of Defense Donald Rumsfeld, who served as the company's chairman before leaving to join Bush II's cabinet. Former U.S. Secretary of State George Shultz served on the board for a decade and is currently an emeritus director. Corporate Governance & Nominating Committee chair Gayle E. Wilson is the wife of former California Governor Pete Wilson. While it may be interesting to note that all three board members are directly tied to the Republican Party, it is Mr. Rumsfeld's role that causes the most concern.
In 1996, Gilead Sciences sold the licensing rights of Tamiflu, an antiviral drug, to Swiss biopharmaceutical giant Hoffmann-La Roche but maintained the right to collect royalties based on a percentage of net sales. Then, nearly 10 years later, when the globe was in the midst of a bird flu scare, President Bush unveiled a $7.1 billion plan to prepare for the looming pandemic. To make his case, Mr. Bush frighteningly described the impending crisis as "a lot like a forest fire … if caught early, it might be extinguished with limited damage; if allowed to smolder undetected, it can grow to an inferno that spreads quickly beyond our ability to control it." (Except, of course, that the pandemic never occurred). The plan included $1.2 billion to purchase vaccines; $1 billion to stockpile additional antiviral medications (including Tamiflu); and $2.8 billion for a "crash program" to accelerate the development of new technology to speed vaccine production. Mr. Rumsfeld, as it turns out, was not only the former chairman at Gilead Sciences, but he was also one of its major shareholders.
Gilead's board composition may contribute to policies which can further damage shareholder interests. The company's executive compensation practices already reflect this risk. Mr. Martin's 2011 total summary compensation ($15,615,645) is more than three times the median ($4,744,541) of the other named executive officers, raising concerns about internal pay equity. His total amount includes a bases salary that continues its annual ascent well above the limit for deductibility under Section 162(m). Additionally, the CEO's long-term incentives once again consist largely of market-priced stock options that simply vest over time without performance-contingent criteria. The CEO received about $6 million in stock options as part of his 2011 equity grant and realized over $36 million more from the exercise of 1,107,840 options. Over the years, the CEO has received copious options awards, nearly five million since 2000. While executives do receive performance share awards based on revenue and TSR results, the awards pay out for sub-median performance. Lastly, the CEO is entitled to a potential payment of over $36 million in the event of termination following a change in control.
Not only are there several governance-related red flags at Gilead Sciences, but its AGR Rating-a measure of the integrity of reported financial results-continues to suffer as well. In September 2011, its AGR rating stood at 16 ("Aggressive") but it has since fallen to its current score of 7 ("Very Aggressive"), placing it in the 7th percentile among all companies in North America, indicating higher accounting and governance risk than 93% of companies.
One area of concern is the company's aggressive acquisition strategy. Last week, Gilead Sciences bought YM BioSciences for $510 million in cash. According to an article on Seeking Alpha, "Gilead making an acquisition is nothing new, but for the company to spend such a large amount of cash outside its virology specialty is a bit odd. Perhaps the company is just looking to expand its horizon and become a more well-rounded biotechnology company, or maybe it saw something special in this company. Either way, the purpose behind the acquisition remains a mystery." A relatively large number of mergers and acquisitions is a red flag for corporate governance issues. Aggressively acquisitive companies sometimes buy non-viable companies in order to boost short-term revenues.
Similarly, GMI Ratings' Litigation Risk model-a projection of the probability of shareholder class action litigation-shows that Gilead Sciences' litigation risk assessment continues to be at "High Risk," placing them in the 2nd percentile of all companies in North America, indicating higher shareholder class action litigation risk than 98% of all rated companies in this region.
In the end, while we acknowledge Gilead Sciences' contributions to the fight against HIV and hepatitis, as well as the company's surging share prices and increasing yearly revenues, there are simply too many warning signs to ignore. The company's late 2011 acquisition of Pharmasset for $11 billion to "win in hepatitis" may prove, in fact, to be one acquisition too many as analysts have recently begun to wonder if "the hepatitis C market is far smaller than current estimates suggest." Consider this too: insiders sold less than 1.5 million shares in 2011 for about $59 million, while insiders in 2012 have already sold over 3.5 million shares for more than $212 million, according to InsiderTrading.org. Is there something they know that we don't know?
GMI Ratings is an independent provider of research and ratings on environmental, social, governance (ESG) and accounting-related risks affecting the performance of public companies. GMI Ratings is a registered investment adviser and is therefore subject to certain reporting requirements. Specifically, per our ethics policy, our analysts are precluded from engaging in any transactions involving any companies we follow. Our ratings and supporting research are intended to provide investors with an effective summary of ESG and forensic accounting factors that can and do impact issuer risk. They are not, however, intended for stand-alone use and should not be considered as simple Buy, Sell or Hold recommendations. We encourage investment professionals to regard these ratings as a specialized, proprietary input to be used in combination with existing fundamental analysis or other approaches and to help comply with the UN-PRI (United Nations Principles of Responsible Investing) and similar standards.