Sell-Off in Gilead Sciences a Classic Overreaction

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Includes: AMGN, GILD, MRK
by: Stephen Castellano

Gilead Sciences (NASDAQ:GILD) sold off in what we think was a classic overreaction to negatively revised guidance, a potential near-term peak in operating momentum and general future uncertainty. With the stock now trading at 11.8x an ultra-worst case estimate of $3.45 there is very little risk embedded in the current stock price. The stock is now a screaming buy.

Solid results for the March 31, 2010 quarter
GILD reported good results for its quarter ended March 31, 2010. Revenue came in slightly above consensus and operating profit and margin improved significantly. Normalized EPS were $0.99 versus consensus at $0.94 and a high of $1.03. A back-of-the envelope calculation for ROIC improved slightly and ROE declined slightly.

Sell-off driven by potentially sharp reversal in operating momentum
Results were strong for Gilead, but the stock, which is in our "high-quality" model portfolio, sold off 9.56% to $40.76. The sharp decline is probably the result of significant reversal in sentiment following lower revenue guidance, purportedly the result of recent health care legislation. In the same way momentum often begets more momentum, a sudden cap to that momentum may have the opposite effect, deserved or not.

The reduced revenue guidance caps previously strong analyst revision trends and could point to a reversal. Moreover, the reduced guidance essentially guarantees the stock will move off of our "high quality" screens -- and probably many others. In addition, uncertainty regarding its product pipeline together with a big pile-up in its significant net cash position, may presage an acquisition. Companies usually make acquisitions when operating momentum stalls, and big cash positions make it easy for companies to overpay and negatively impact ROIC. (Press release, slide show,Seeking Alpha transcript)

Details and implications of guidance: Ultra worst case 2011 EPS estimate could reset $0.50 lower
In more detail, revenue guidance was cut for 2010 by $200m to $7.4-7.5b from $7.6-7.7b as the result of health care reform legislation. Any investor targeting the high-end of the range will now be probably targeting the low end, so perhaps revenue estimates could decline by $300m.

This potentially negative $300m+ swing in revenue estimates might be able to impact EPS by about $0.14 for the year. This assumption could drive the existing worst case estimate of $3.49 to $3.35. A more reasonable guess would be that EPS forecasts for 2010 decline to $3.50 from $3.61.

Management would not comment on revenue for 2011, but given the back-end loaded nature of the 2010 guidance cut related to health care legislation, it seems like a reasonable guess to assume a $300m negative impact to revenue next year.

In addition, there is a pending industry excise tax and pending Medicare discount, which may further impact revenue for that year. Perhaps a reasonable pessimistic revenue forecast for 2011 could be $500m less than the existing low-end revenue estimate of $8.5b; in any case, the high-end 2011 revenue forecast of $10.4b now seems absurd.

Further, it seems reasonable to assume that 2011 EPS estimates could be lowered by about $0.10-$0.25. Consensus EPS may decline to about $3.84 from $3.94, and a worst case estimate could now be about $3.45. The most pessimistic investor might interpret this as ~$0.50 reset from current consensus of $3.94 to an ultra worst case estimate of $3.45.

Investors often like flexibility of large cash positions in the face of uncertainty, but in this case perhaps it is a cause of concern
The company ended the quarter with $4.6b cash, up from $3.9b in the previous quarter. The company provided no statement on its debt levels, but there is no reason to assume it's materially different from the total debt of $1.2b reported last quarter.

Normally, excess cash is a good thing. But the number of shares GILD purchased were down in the quarter. This may indicate the company is planning to use the cash for a potential acquisition, or that management thinks the shares are overvalued. An acquisition would reduce ROIC in the short-term, would probably be much expensive now than a few months ago, and as always carries the risk to become a major distraction. Companies with too much cash also carry the risk of overpaying or rushing into an acquisition that is not a perfect strategic fit.

What is there to like about Gilead? Plenty.
Despite a likely reversal in analyst revisions, uncertainty regarding its pipeline, and the potential for a ROIC-diluting acquisition, investors need to focus on what matters most: ROIC, cash flow potential and value relative to other potential investments in the Healthcare Sector.

Normally we would prefer to conduct a free cash flow scenario analysis, but due to time constraints and for the sake of actionability, we are just going to use multiple-based analysis for now.

Gilead is trading at an absurdly low P/E multiple of 11.8x our "arbitrary" worst-case 2011 EPS estimate of $3.45 compared to its long-term average of 25x. Even removing outlier P/Es in the 30xs seven or 8 years ago, a 25x multiple seems reasonable. GILD first experienced multiple compression during the summer sell off of 2007, and again as the market deteriorated, moving down to 11.8x our worst case estimate today.

Perhaps a 25x P/E is too high given all the uncertainty - but how about 14x an ultra worst case EPS of $3.45?
Even assuming a negative hit to revenue of $500m relative to current consensus estimates for 2010 and 2011, which might negatively impact EBITDA by about $75m per quarter for the next seven quarters, this would only negatively impact ROIC by about 3 percentage points to 34%, according to our models.

Compared to ROIC forecasts for companies like pharmaceutical company Merck & Co. Inc. (NYSE:MRK) (our ROIC forecast is 12% today and could move up to 16% next year) or biotech company Amgen (NASDAQ:AMGN) (ROIC 16% today moving up to 17.5% next year) we can cut our arbitrary "worst case" ROIC forecast for Gilead of 34% to 17% (perhaps due to an acquisition) and it would be in line with either of these companies. Even assuming a significant acquisition, a 17% cut to ROIC seems too onerous. That means GILD deserves to trade at least inline if not at a higher multiple than either MRK or AMGN.

AMGN is currently trading at 10.7x the calendar year 2011 consensus EPS estimate of $5.48 and at a forecast PEG ratio of 1.2x. MRK is now trading at 8.8x calendar 2011 EPS of $3.93 at a PEG ratio of 1.4x. In contrast, GILD is currently trading at 11.8x our worst-case EPS estimate of $3.45 for 2011, and assuming its forecast earnings growth rate declines to an extreme 7.5% from 15% currently, the associated PEG is 1.4x.

Forget for a moment that MRK and AMGN also look undervalued given their prospects for improving ROIC. At 10.7x $3.45, GILD would be valued at $37; at 8.8x GILD would be valued at $30. $30 seems to be an absurdly worst case scenario for GILD, and $37 seems to be a extremely pessimistic case. With the stock at $40.76, the risk seems extremely low for whatever future value you want to assign it.

We would prefer to assign a 14x multiple to the company, a multiple that seems below average for a number of companies with mid-teens ROIC prospects in a variety of industries, and is what MRK has averaged over the last 3 years and is well below AMGN's average 3-year PE of 19x. That gets us to a $48 target, assuming worst case EPS of $3.45.

Any way you look at it, the sell off Wednesday was too extreme - the stock is now a screaming buy
In summary, applying extreme EPS estimate cuts and low multiples, we still get a favorable risk/reward ratio. If there is even a slight improvement in the company's outlook, the multiple could once again surge. A better approach to valuation would be through detailed scenario analysis of cash flow streams, but the huge discrepancy between various benchmark multiples and company-specific prospects compels us to quickly issue what we can only describe as a screaming buy recommendation for a long-term investor. Regarding cash flow, there is still forecast improvement even assuming a heavy $75m per quarter hit to unrevised EBIT estimates over the next several quarters.

A pdf of this report is available here.

Risks and Disclaimers
Investing in stocks include a high degree of risk, including the risk of total loss. We are not soliciting the sale of any security. We do our best to provide relatively and accurate data and analysis, but make no guarantee.

Trailing 12-month free cash flow forecast for GILD, implied by consensus forecasts less $75m EBIT per quarter:

GILD-Free-Cash-Flow-Model-Ascendere-Associates-LLC-2010-04-21

Implied by consensus, less $75m EBIT per quarter

GILD-Economic-Profit-Model-Ascendere-Associates-LLC-2010-04-21

Disclosure: None