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A Response to the Barron's Article: "Biogen & Gilead: Time To Ring the Cash Register?"

With equity markets posting strong gains in 2013, it is time for portfolio rebalancing and assessing which assets to buy, sell, or hold. As a scientist in drug development, I have focused my trading efforts in the biotechnology sector as a reliable source of alpha. One of the crucial determinants of successful investing in this sector is an understanding of the current market environment and what undercurrents will impact the sector outlook. The present conditions are due to a prolonged period of an accommodative monetary policy, primarily from the European Central Bank, the Federal Reserve, and the Bank of Japan. These policies have led to a reduction in the credit-default risks in the periphery of the Eurozone and a general improvement in global financial conditions. Collectively, these developments resulted in a sharp reduction in the equity risk premium and a normalization of intra-equity correlations to pre-crisis levels. We are likely to see these market dynamics continue to normalize next year, which will be supportive of strategies focused on individual stock selection over sector selection.

The iShares Nasdaq Biotechnology Index (IBB) returned 63.43%, outpacing the S&P 500's respectable 29% gain. But given the large relative outperformance and P/E multiple expansion, it is time to be selective in the biotechnology sector. Johanna Bennett's recent article in Barron's, entitled "Biogen and Gilead: Time to Ring the Cash Register," highlighted some of these points, but improperly focused its attention on two stocks that remain undervalued and poised for substantial gains in 2014. The author offers her readers the following pearl of wisdom: "take some profits while you have them" and "valuations may be stretched " in Gilead (GILD) and Biogen (BIIB). She contends, "Gilead's fortunes, are tied largely to sofosbuvir, an oral medication for hepatitis C, as well as efforts to develop an all-oral drug regimen." She goes on to say "Analysts, meanwhile, are at odds over how much strength the hep C market will have down the road as patients are cured of the infection and demand for the drugs diminishes."

But these statements reflect an uninformed viewpoint of the current hepatitis C market opportunity, and what factors drive biotechnology stocks in the present market conditions. Share prices of high-quality companies with strong, long-term growth rates can continue to appreciate for many years. Absent a change in the underlying company's future growth prospects, it is misguided to sell on price appreciation alone.

She may be correct in the short-term that these stocks will eventually present a better entry point. However, will investors be savvy enough to time their reentry? Recall that Gilead's prospects today do not resemble what they were only 12-months ago, and that valuing a stock on a trailing 12-month earnings basis is unwise. This year's gains are due to the recognition by investors of lower regulatory risk and their anticipation of some of its late stage pipeline sales potential.

This article will present a conservative Sovaldi sales model demonstrating how low consensus estimates of $2.4 billion represents. The evidence used to derive this sales model support the argument that the primary risk in Gilead is leaving substantial profits on the table. But first it is important to have a discussion on the factors that support higher biotechnology equity valuations.

The essential factors that translate into higher equity valuations in the biotechnology sector are new product cycles, acquisitions of new pipeline assets, improving innovation, and a more predictable regulatory environment. From 2006-2012, the biotechnology sector endured a prolonged contraction of its price-to-earnings (P/E) and price-to-sales (P/S) multiples based on fears of reduced government spending, large patent cliffs, and an unfavorable regulatory environment. In a bull market environment, which we all affirm describes the current market, growth stocks undergo P/E and P/S multiple expansion. No sector exemplifies this phenomenon better than biotechnology (Chart 1). These phenomena emerge as a result of the reduced equity risk premium (ERP) demanded by investors from a less turbulent global macroeconomic background experienced during 2008-2012. Additionally, intra-equity correlations are normalizing to pre-crisis levels from the volatile risk-on/risk-off period experienced during 2009-2012 (Chart 2). This combination of developments has altered investor sentiment and resulted in a sector wide re-rate by investors.

(click to enlarge)

(click to enlarge)

This article's sales model is derived from the evidence in the medical literature, and clearly supports the argument that the primary risk in Gilead is leaving substantial profits on the table. The most difficult and controversial aspect in biotech investing is valuation. To successfully invest in this sector, one must accept the nuanced differences essential to assessing these stocks. Recognizing that it is a very dynamic process, one should not solely rely upon backward-looking financial ratios as in other sectors. It is an evolving process, where valuations are continuously changing based on the performance of drug candidates during each phase of clinical trials. Because valuations are swiftly impacted by clinical trial outcomes, it is essential to become proficient with data analysis of clinical trials.

The ability to identify the nuanced differences between the experimental drug and its potential competitors is particularly helpful in elucidating its competitive advantages. The primary factor of a new drug's commercial success is dependent on the improvement in clinical outcomes compared to the current standard of care in Phase III trials. It is then possible to extrapolate prescribing habits and potential demand. From these analyses, a financial model (full description of sales model at bottom of article) can be developed to deduce future sales and earnings estimates. Finally, using both historical and relative valuations for the stock and the sector, we can then determine if the stock is trading at a historical premium or at a discount to future sales and earnings estimates.

When considering Gilead's current valuation and valuing its future prospects, it is important to recognize that there are several catalysts that put upward pressure on consensus estimates. Gilead is entering a new product cycle with the recent approval of sofosbuvir (Sovaldi) and recently announced an earlier than anticipated NDA filing for sofosbuvir/ledipasvir fixed-dose combination in Q1 2014. Moreover, many of their late-stage assets have been granted a Breakthrough Therapy designation by the FDA, which is granted to investigational medicines that may offer major advances in treatment over existing options. This enables an expedient clinical development pathway with higher probability of approval.

As Bennett noted in her Barron's article, Gilead is transforming HCV treatment to an "all oral regimen." However, this is only one component of the overall story. Next year offers multiple HCV and oncology related catalysts that could drive Gilead's stock price considerably higher. On December 6, 2013, the FDA approved sofosbuvir under the trade name Sovaldi, and gave it broad indications for treatment across Hepatitis C subpopulations. On December 16, 2013, Health Canada approved sofosbuvir (Sovaldi) with similar labeling. The Sovaldi labeling covers Genotypes 1-4, including patients with hepatocellular carcinoma meeting Milan criteria (awaiting liver transplantation), and those with HCV/HIV-1 co-infection. On December 18, 2013, Gilead announced the results from three Phase III trials in 1,952 genotype 1 patients with its fixed-dose combination regimen containing sofosbuvir/ledipasvir. The study participants were treated for 8 to 24 weeks and exhibited cure rates in the range of 93-98% without ribavirin or interferon. It is essential to acknowledge that Gilead's strongest competitor, Abbvie (ABBV), requires the addition of ribavirin to its HCV regimen. Gilead said it anticipates filing for FDA approval during the first quarter of 2014, and it should have an FDA decision 6-9 months thereafter.

At the 64th AASLD Liver Meeting, Gilead presented findings from the LONESTAR study and the ELECTRON trial. The LONESTAR study evaluated sofosbuvir/ledipasvir taken with or without ribavirin for 8 or 12 weeks in cirrhotic patients, who were either treatment experienced or treatment naïve patients-a historically difficult-to-treat population. Additionally, 87% were carriers of the HCV subtype 1a and only 15% had the favorable IL28B CC gene variant associated with interferon responsiveness. In both arms of the trial, sofosbuvir plus ledipasvir achieved SVR8 and SVR12 rates (equivalent of cure) in 95% - 100% of patients. Remarkably, similar HCV trials with other treatments achieved only 44% - 70% cure rates despite durations of therapy exceeding 24-weeks.

From a safety standpoint, the ribavirin free arm of the trial had no associated anemia toxicities (0% vs. 19%). This is an essential competitive advantage because many HCV patients suffer from multiple comorbidities, such as heart failure, HIV, and cancer. Ribavirin's inherent hemolytic anemia toxicity can greatly complicate a patient's clinical stability and survivability, as well as interfere with the treatment of their comorbidities. In the HIV/HCV co-infected population (approximately 200,000-300,000 in the U.S.), patients must take complex drug regimens with high overall pill burdens (including treatments to prevent opportunistic infections). These complex drug regimens have the worst drug-drug interaction profile of all disease states. Sofosbuvir's unmatched safety, efficacy, and clean drug-drug interaction profile firmly secures it as the treatment-of-choice for patient with comorbidities. The safety profile and cure rates observed with sofosbuvir and ledipasvir exemplify the proverbial "holy grail" of rational drug design: "one pill, safe and effective for all patients."

Gilead's approach to the HCV market is analogous to its successful business strategy in the HIV market, where Gilead has already developed the top two selling drugs. Gilead's strategy to control the HCV market is aimed at accomplishing four main objectives:

  1. Improve safety by eliminating both ribavirin and interferon.
  2. Enhance efficacy by delivering superior cure rates.
  3. Decreasing treatment durations at least 50% from 24 - 48 weeks down to 8 - 12 weeks.
  4. Reducing overall pill burden to just one pill per day.

Critics will argue that reducing the overall pill burden does not automatically imply a monopoly in the HCV market. But these same critics are disregarding the evidence in the HIV market that it does significantly influence physicians prescribing habits. Collectively, there is ample supporting evidence that Gilead will not only secure the majority of the HCV market, but will have preference over all other competitive oral agents still in development from Abbvie, Merck (MRK), or Bristol-Myers Squibb (BMY).

From a valuation perspective, Gilead is trading at 41x 2012 and 2013 earnings, but only 23x 2014 consensus estimated earnings per share (EPS) of $3.27, and 14.6x 2015 estimates of $5.09 per share. When normalizing Gilead's earnings to its forward earnings growth rate, it is only trading at a forward PEG ratio of 1.1. Regeneron (REGN) by comparison currently trades at a forward P/E ratio of 55, and has an expected 5-year annual growth rate of 32% corresponding with a PEG ratio of 2.24. Gilead's is expected to have a similar 5-year annual growth rate of 34%, but still trades at nearly a 50% discount to Regeneron. In 3Q13, Gilead reported 20% (yoy) sales growth, but with sofosbuvir approved, total sales will grow from $10.9 billion in 2013 to an estimated $19.82 billion in 2015. Evaluating these growth metrics compared to the S&P 500 or any other large biotechnology company, it is apparent that Gilead's growth and valuation metrics are extraordinary. Remarkably, these estimates assign no value to any pipeline assets outside of its HCV and HIV programs.

Consequently, from an investor's point of view, the overall opportunity set of large healthcare stocks that possess the holy trinity of strong growth, cheap forward valuations, and low execution risk is limited to Gilead and Biogen. Gilead is the only pharmaceutical company with a market capitalization greater than $100 billion with double to triple-digit growth prospects in sales and earnings. Old Pharma, such as Pfizer (PFE), Roche (OTCQX:RHHBY), GlaxoSmithKline (GSK), and Astra Zeneca (AZN) are stuck in stagnation, with moderate or declining single-digit earnings and sales growth. Only a few rivals, such as Bristol-Myers and Amgen (AMGN), currently have double-digit quarterly revenue growth of 8.8% and 10% (yoy), respectively. However, Bristol-Myers trades at a PEG ratio of 3.13 and Amgen at 1.66, both of which trade at a premium to Gilead's 1.11 PEG ratio. When you normalize the data to their relative growth rates, Gilead remains not only the most undervalued amongst the large biotechnology stocks, but also has the highest 5-year expected growth rate.

Gilead is already working toward sustaining its revenue base beyond the latter years of its HIV and HCV pipeline. Gilead is well positioned to offset future patent cliffs with at least 15 Phase II and 5 Phase III programs across HIV, Liver Diseases, Cardiovascular, Respiratory, Oncology, and Inflammation. This deep pipeline provides a sustainable source for future growth beyond 2016. Most notably, Gilead's two leading oncology drug candidates, idealasib for iNHL and GS-9973 for CLL, generated palpable excitement from doctors and researchers at this year's American Society of Hematology (ASH) annual meeting. Additional oncology assets include simtuzumab and GS-5745 with potential indications across several solid tumor types and myelofibrosis. New data will be released for all four of these oncology assets during next year's American Society of Clinical Oncology (ASCO) annual meeting. Gilead is also applying its expertise in virology to the development of a Hepatitis B (HBV) vaccine, estimated to be at least a $1 billion market opportunity, but it's at least a few years out. Each of these programs can contribute an additional 2-5% increase in future earnings estimates. Conversely, if any of these programs fail, it will only marginally affect its long-term growth rate and will not impact shares disproportionately. Based on these prospects, Gilead's shares represent a favorable risk-reward opportunity for investors with the risks skewed to the upside. Analysts will begin assigning value to these programs over the next 12 months and start raising their price objectives, providing a free call option to shareholders in 2014.

Investors should remain bullish on Gilead over the next 3 years despite its recent gains. There is growing evidence that there is substantial upside to the $2.4 billion 2014 consensus sales estimates for sofosbuvir . Early signs of the Sovaldi sales launch are already dwarfing consensus expectations. For instance, according to Michael Yee, an analyst with RBC Capital Markets (account required) stated "Sovaldi is seeing more than 200 new prescriptions per day, making it the fastest new drug launch in history." Yee's research further establishes that the "combined total prescriptions and new prescriptions for Sovaldi for Wed (12/25) through Fri (12/27) were in the 700 - 800 range. For week 3 of launch, scripts were in the 1200 - 1300 range, up 33% (week/week) despite its being a holiday week. For historical context, Vertex (VRTX) and Merck combined showed new prescriptions in the 400 range in week 3 of launch, so the launch of Sovaldi is currently running at 4x the run-rate at a comparable point in launch versus VRTX/MRK combined in 2011."

Current consensus sales estimates for sofosbuvir would make it an instant blockbuster, but still do not reflect the reality that only 8-15% of the total HCV population have been treated. By conducting an extensive literature review on current treatment trends of HCV sub-populations, we can conservatively forecast which cohorts of patients are likely to receive sofosbuvir in 2014. Subsequently, we can incorporate this information with the FDA approved labeling to project treatment durations that will more accurately forecast sofosbuvir sales.

The most important aspect of this sales model (full model at end of report) is determining which type of HCV patients will need sofosbuvir now, and who can wait for Gilead's new sofosbuvir/ledipasvir fixed-dose combination regimen in 2015. The largest bolus of patients who will need to take sofosbuvir next year will likely be the HIV/HCV co-infected population with cirrhosis. There is strong supporting evidence for this assumption. In the developed world, the "introduction of highly active antiretroviral treatment (HAART) since 1996 led to a dramatic reduction in deaths due to acquired immune deficiency syndrome (AIDS)." As a result, cirrhosis and hepatocellular carcinoma (HCC) are now the leading causes of death due to co-infection with HCV.

The Veterans Affairs (VA) health care system is comprised of 154 medical centers and 875 ambulatory care and community-based outpatient clinics throughout the United States. The VA carried out a large study with 24,040 HIV-infected patients and found that 66% of HIV patients with cirrhosis also had HCV. Furthermore, these patients were 6x more likely to develop cirrhosis and 10x more likely to develop hepatocellular carcinoma requiring transplant. "Among HIV/HCV-co-infected patients, the increase in the proportion of patients with cirrhosis (3.5%-13.2%), decompensated cirrhosis (1.9%-5.8%), and HCC (0.07%-1.6%) during 1996-2009 was even more pronounced than among all HIV-infected patients." There are at least 200,000-300,000 co-infected HIV/HCV patients. Based on this study, we can safely assume that there are approximately 3-5% with cirrhosis and 0.5% to 1% with HCC translating into 6,000-15,000 patients with cirrhosis (needing treatment) and 2,000-3,000 requiring liver transplant each year. The majority of the HIV/HCV co-infected population is expected to delay treatment until FDA approval of Gilead's sofosbuvir/ledipasvir fixed-dose combination in late 2014 or early 2015. However, disease progression will force a portion of these patients into treatment now. Because this is unpredictable, we will conservatively assume only 5% (~10,000 patients) of this population will be treated in 2014. Despite the fact that only a small percentage of these patients will be treated in 2014, a higher proportion of them are carriers of the genotype 3 infection requiring 24-weeks of therapy.

The World Health Organization estimates at least 160-170 million people worldwide have HCV, and that at least 3 million of those are in the United States. But the number of diagnosed cases each year is likely to accelerate from recent policy initiatives at the CDC. Based on findings by the U.S. Preventive Services Task Force, "it is now advised that doctors conduct a one time nationwide HCV screen for all baby boomers, which is the demographic with the highest undiagnosed prevalence of 3.25%, 5x higher than other birth cohorts."

Consensus expectations underestimate the "warehoused" patients awaiting interferon-free regimens. Based on several proprietary HCV prescription sales data sources, HCV physician surveys and expert conference calls conducted by Bank of America Merrill Lynch (account required), there has been a significant deterioration in HCV prescriptions for interferon in the U.S., which are 55% lower today vs. 3-months prior to the first protease inhibitor approval for HCV. Experts believe there is "no debate that sofosbuvir has the entire GT 2/3 population locked up and expect all their patients to be treated in 2014," and have already begun scheduling patient visits with fibrosis or cirrhosis. The implications of this evidence are unambiguous and indicate a substantial bolus of HCV patients in 2014. These surveys project that current patients under care by a HCV physician in the U.S. are:

  • GT-1: ~2.1 million patients 70% of total HCV patients,
    • ~11,000 new cases per year
  • GT-2: 120,000
  • GT-3: 90,000
  • Liver Transplant candidates: 15,000
  • HIV/HCV: 200,000-300,000
  • Interferon Ineligible: 40% of GT-1 patients
  • Implied "Warehoused" Patients: ~22,000

It is common knowledge amongst liver disease experts that many HCV patients of all types have deferred treatment the last couple of years awaiting sofosbuvir. Based on the these proprietary surveys, it is reasonable to conclude that over the last two years only 50% of the newly diagnosed HCV patients were treated. Thus, we can assume that there may be as many as 23,800 GT1 patients awaiting treatment, producing a 2-year accumulation (warehousing) of ~16,660 GT1 patients alone. The FDA labeling specifically states "Sovaldi in combination with ribavirin for 24 weeks can be considered for CHC patients with genotype 1 infection who are interferon ineligible." It is estimated that 70% of the patient population are carriers of the GT1 variant and have treatment failure rates of 50-60% with interferon-based regimens. Given this fact, it is safe to assume that at least 15% of the "warehoused" GT1 patients will be treated with sofosbuvir. Sovaldi labeling continues saying that it is "indicated for the treatment of chronic hepatitis C (CHC) infection as a component of a combination antiviral treatment regimen." The FDA was purposefully vague, because they want treatment providers to have flexibility in prescribing sofosbuvir regimens. Furthermore, the FDA is addressing the public health risk by sanctioning broad use by physicians and obligating health plans to cover broad usage of sofosbuvir.

According to a Gilead press release, on November 22, 2013, the Committee for Medicinal Products for Human Use (CHMP) of the European Medicines Agency (EMA) issued a positive opinion on Gilead's application for marketing authorization for Sovaldi, indicating that Gilead is likely to receive European approval and reimbursement in early 2014. Due to high demand for sofosbuvir, Gilead has already established early access programs in France and other European markets. The expected pricing across the E.U. will fluctuate, but we will assume a 30% discount to the U.S. This is a larger discount than the 20% discount seen with the protease inhibitors. Importantly, the EU has approved compassionate use of sofosbuvir for patients on the liver transplant list and post-transplant patients at risk of decompensation.

The FDA labeling states that Sovaldi "should be used in combination with ribavirin for treatment of CHC in patients with hepatocellular carcinoma awaiting liver transplantation for up to 48 weeks or until liver transplantation, whichever occurs first." A recent report from the U.S. Organ Procurement and Transplantation Network (OPTN) confirm that there are between 6,000-6,500 liver transplants annually. According to the national registry, 60% of these patients have HCV, and there are at least 15,000 patients on the Liver Transplant wait list. This implies approximately 9,000 HCV patients are on the waiting list. Importantly, the median time to transplant for more than 80% of patients exceeds 400 days. For our model, we will assume only 35% (5,250) of patients on the wait list have HCV, and that median wait times for 80% of patients is at least 400 days until transplant (sofosbuvir treatment in this population is 48 weeks or 336 days). Collectively, these are the primary influences driving my model 40% above consensus sales estimates.

In conclusion, this model is extremely conservative to assume a 20-40% discounted price, and ignores that this is an undertreated population with higher mortality rates than HIV. The upside to this conservative model of $2.84 billion could be in excess of $2 billion, implying $4.7-$4.9 billion in 2014 Sales, which would make it the most successful new drug launch in history. The "good news" reflected in today's stock price of $75.02 is likely only to get better in 2014. With multiple catalysts provided by multiple Phase II/III trials throughout 2014 across HCV, HBV, HIV, plus three separate oncology programs.

Sovaldi Treatment Model Flow Chart

(click to enlarge)Sovaldi Patient Model

Sovaldi Sales Model

(click to enlarge)Sovaldi Sales Model

Source: The Gilead Rebuttal

Additional disclosure: I am long Gilead (GILD), Biogen (BIIB), Roche (OTCQX:RHHBY), and Abbvie (ABBV) through equity and options.