Gilead Sciences: Cause For Concern?

Jul.10.14 | About: Gilead Sciences, (GILD)

Summary

Gilead has launched the most successful drug in history and is undervalued by typical fundamental metrics.

GILD bears cite two main reasons why the stock is overpriced.

Is Sovaldi pricing a concern?

Is Gilead a "one trick pony"?

Gilead (NASDAQ:GILD) is a cheap stock by any sort of fundamental earnings evaluation. According to Yahoo Finance, analysts expect the company to earn $6.35 per share in 2014 and $7.92 per share in 2015. For the next five years, the average annual growth estimate is a whopping 28.2%.

So how can the stock be so cheap at a forward 2014 P/E of about 14? Bears point to two factors.

1. Cost of Sovaldi

The government and insurance company complaints about Sovaldi should be very well known at this point, but in case you've somehow missed it, here's the gist of the argument about the $84,000 price tag of Sovaldi:

The leading U.S. health insurance trade group on Tuesday hit out at the extremely high cost of new specialty medicines, accusing drugmakers of taking advantage of the insurance system by pricing products at unsustainable levels.

The latest salvo in the war on escalating U.S. healthcare costs came from AHIP - America's Health Insurance Plans - and targeted Sovaldi, the new $84,000 hepatitis C treatment from Gilead Sciences Inc.

"Sovaldi has shown tremendous results, and it's the kind of medical innovation we need to sustain. Unfortunately, the drug's maker has priced it at an astronomical level that is not sustainable for consumers, innovation, or society," AHIP said on its Coverage blog.

(Source: reuters.com)

I won't go into all of the details of who is right, who is wrong, and what drugs "should" be priced at. I do believe that the price is a bargain compared to the alternatives. However, I will focus on whether or not I think Sovaldi can sustain its price. As a shareholder, that is what matters to my investment.

Note that the price is expected to be $59,000 in the UK as Gilead realizes the need to price the drug lower in order to get it accepted there. And the company is giving enormous discounts to places such as India, Pakistan, Egypt and China.

From the point of view of those in the US that oppose Gilead's pricing, the problem with their contention with the high price of Sovaldi is more than whether or not Sovaldi is a rip-off or not. Their problem is that their argument has no legal teeth. As far as I know, there is no precedent or legal way to force a drug company to lower its pricing -- at least not in the United States.

In the US, it seems that Gilead is holding all the cards versus the politicians, regulators, and insurance companies. The following is a general statement about how drug patents operate:

Having received patent protection for a certain medication, the company has the ability to set its own price; without competition, there is no downward pressure on the price from other potential drug suppliers. The monopoly power gained from patent protection provides incentive for drug companies to invest the large amount of capital needed for R&D by allowing them to earn more than what would be the result from a more competitive market. Without patent protection, other companies would copy the drug formulation at a cost much less than the initial outlays of R&D by the original firm.

(source: medscape.com) (e-mail registration required)

The medscape article goes on to say how the US government has set up this monopolistic system with good intentions:

In review, the high costs of prescription medications derive from market forces as well as government intervention. Patented medications benefit from a government sanctioned monopoly and the producers of these medications are able to set prices where they believe profit potential will be greatest without facing lower prices from competitors. In this way, they have the opportunity to earn enough revenue to cover the fixed R&D costs as well as the costs of producing and marketing the medication.

So, in essence, the US government is fighting its own policies if it chooses to go to war against Gilead.

The following snippet has some insight about the amount of control drug companies have compared to the government:

Drugs designed to fight rare diseases routinely cost two or three hundred thousand dollars; cancer drugs often cost a hundred grand. And, whereas product prices in most industries drop over time, pharmaceuticals actually get more expensive. The price of the anti-leukemia drug Gleevec, for instance, has tripled since 2001. And, across the board, drug prices rise much faster than inflation. The reason for this is that prices for brand-name, patented drugs aren't really set in a free market. The people taking the drugs aren't paying most of the cost, which makes them less price-sensitive, and the bargaining power of those who do foot the bill is limited. Insurers have to cover drugs that work well; the economists Darius Lakdawalla and Wesley Yin recently found that even big insurers had "virtually zero" ability to drive a hard bargain when it comes to drugs with no real equivalents. And the biggest buyer in the drug market-the federal government-is prohibited from bargaining for lower prices for Medicare, and from refusing to pay for drugs on the basis of cost. In short, if you invent a drug that doctors think is necessary, you have enormous leeway to charge what you will.

[bold is mine]

(source: newyorker.com)

Essentially, the government has its hands tied. Policy may very well change in the future, but it is unlikely to affect Sovaldi in the present. The New Yorker article goes on to say:

You might think that this prospect [price regulation] would encourage companies to be more cautious. But, if you assume that price controls are coming, the rational play is to squeeze out all the profits you can now. The uproar over Sovaldi may, somewhere down the line, help contain drug prices. But in the short run it could well make drugs even more expensive. And that's what you call a serious side effect.

For good or bad, the price of Sovaldi is unlikely to be affected by those in Washington. Additionally, and fortunately for GILD shareholders, politicians often have the attention span of small children. Every day that goes by without regulation means a smaller chance of any regulation being passed that will affect Sovaldi. The US government rarely moves quickly and I believe the odds of intervention in this case to be extremely small.

Finally, all of the above political chatter may simply go away once competition for Sovaldi comes into the picture. At that point, natural economic forces will determine the price -- which is as it should be. And here is where Gilead might actually see some pricing pressure. The general consensus here on SA seems to be that the competitors to Sovaldi will be priced in the same ballpark and that Gilead will not need to lower the price. I agree with that sentiment for the most part, but there obviously is the chance of pricing pressure. No analyst or writer currently knows what the pricing will be of competitor's drugs, but it is possible that they will attempt to undercut Sovaldi.

The CEO of AbbVie noted that his company does not plan on competing on price regarding its upcoming competitive hep C regimen:

Analysts had many questions about the "3D" regimen for hepatitis C, particularly AbbVie's pricing strategy as it competes against Gilead Sciences' recently launched blockbuster Sovaldi. Pharmacy benefit manager Express Scripts (NASDAQ:ESRX) has been saying that it hopes to reduce Sovaldi's $84,000 price by playing competitors against each other. But when asked whether AbbVie planned to compete on price, CEO Richard Gonzalez said, "That's not our strategy going forward."

(source: investors.com)

In the past, blockbuster drugs have tended to increase prices over time. As per the New Yorker article above: "across the board, drug prices rise much faster than inflation." The following chart shows Lipitor pricing long before it lost patent protection (in June 2011):

Click to enlarge

(source: aarp.org)

2. One Trick Pony

The second bear argument is that Gilead is a "one trick pony." In Q1 2014, the company's revenue from Sovaldi represented 46.7% of total revenues. While that is certainly stunning, it does not mean that the company is devoid of other important products.

Stribild is four drugs in one pill used to treat HIV-1 in adults. It had sales of over $215 million in Q1 2014 compared to $92 million in Q1 2013. Projections for the future are bright:

Stribild has not only performed well financially but also has been dubbed an outperformer. First projected to generate $842 million a year by 2016, its early sales have been so hot that it is now expected to rocket to $2.38 billion that year.

(source: fiercepharma.com)

Idelalisib is a drug under investigation for the treatment of chronic lymphocytic leukemia. It is expected to begin sales in 2014.

Earlier this year, it became clear that idelalisib would pave the way for Gilead's foray into oncology when Phase I findings on the compound as a single agent in CLL were singled out among early abstracts at the American Society of Clinical Oncology (ASCO) meeting. At the time, Leerink Swann LLC analyst Howard Liang wrote that, "Idelalisib is among the most important new agents in the industry's pipeline for cancer, as indicated by the ASCO selection."

(source: BioWorld Today, May 20, 2013)

According to Thomson Reuters, sales of idelalisib are forecast to exceed $1 billion by 2017, with consensus sales forecasts of $1.218 billion that year.

Gilead has other blockbuster drugs besides Sovaldi currently in production and more are on the way. There is no doubt that Sovaldi, which very well might soon be the most profitable drug in history, will be the most important product for Gilead's bottom line for years to come. However, the company has other important products as well and will surely continue to develop and/or purchase others.

Conclusion

Every stock in the market has some sort of cause for concern. Do the causes in Gilead's case merit putting a forward P/E of 14 on the stock? I don't think so.

While pricing pressure could occur for Sovaldi, I feel that it is very unlikely to come from the government. Sovaldi could encounter pricing pressure in the future from competitors. I also feel that this sort of pressure is unlikely and if it does occur I think the pressure will be minimal.

Does Gilead have all of its eggs in one basket? Well, a lot of eggs are certainly in one place. That is simply unavoidable when a company with about $10 billion in yearly revenues suddenly puts out a new drug that changes the landscape of pharmacology.

Sovaldi is a huge hit; the drug has already shattered records. In the first full quarter of sales, Sovaldi had far more sales than any other drug has had in its first four quarters of sales. In fact, only 4 drugs have ever passed $1 billion in sales in their first four quarters. The past record holder was Vertex Pharmaceuticals when its hepatitis C treatment Incivek racked up $1.56 billion in sales during its first four quarters on sale. Sovaldi revenue was $2.27 billion in Q1 2014 and could be as much as $9 - $10 billion for the full year. In other words, sales are expected to be about 6x higher than the largest previous drug launch.

So yes, Sovaldi is a large component of Gilead's revenues. It will be for many years to come. That is a reason to assign a slight discount to the value of the stock. However, a forward P/E of 14 is ludicrous. The fact is that Gilead is making, and will continue to make for many years, incredible amounts of money from Sovaldi. The fact is also that it has other blockbuster drugs such as Stribild in production and others such as idelalisib in the pipeline.

Gilead has a heck of a pony in the race, but it has others in its stable as well.

Recommendation: STRONG BUY

Disclosure: The author is long GILD. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.