A Re-Analysis Of Gilead After Q2 Results And The Early Idelalisib Approval

Jul.24.14 | About: Gilead Sciences, (GILD)

Summary

Gilead Sciences announced Wednesday that it had another great quarter.

Sovaldi sales met all but the very most optimistic projections.

The rest of the company is also in gear.

A large short position and strong business prospects make Gilead a stock that I find to be very attractive, especially in a high-P/E market.

Gilead Sciences (NASDAQ:GILD) reported yet another record quarter Wednesday after the bell, of $2.36 per share, which compares with $1.48 in Q1 and much lower in Q2 2013 (all data non-GAAP). Sales of Sovaldi for hepatitis C reached $3.5 B, up by about half from Q1, and is already, in half a year, one of the most successful drug products in history. All records for a first-year launch have been shattered into little pieces. Presumably in 2015, Sovaldi (sofosbuvir) plus the likely sofosbuvir-ledipasvir combination product for genotype 1 hepatitis C will become the most successful drug "team" in history by sales.

Guidance now includes Sovaldi. From Gilead's press release:

Gilead updated its full-year 2014 guidance, which it initially provided on February 4, 2014 and reiterated on April 22, 2014, to include the impact of Sovaldi product sales:

(In millions, except percentages and per share amounts)

Initially Provided
February 4, 2014;
Reiterated April 22, 2014

Updated

July 23, 2014

Net Product Sales $11,300 - $11,500 $21,000 - $23,000
Non-GAAP*
Product Gross Margin 75% - 77% 85% - 88%
R&D $2,200 - $2,300 $2,300 - $2,400
SG&A $2,100 - $2,200 $2,300 - $2,400
Effective Tax Rate 28% - 29% 17.5% - 20.5%
Diluted EPS Impact of Acquisition-Related, Restructuring and Stock-Based Compensation Expenses $0.63 - $0.66 $0.63 - $0.66
Click to enlarge

Most of the non-GAAP costs that are excluded are from amortization of intangibles and goodwill.

This was a great sales and earnings report. The HIV franchise was strong, as well, and the cardiovascular division showed good growth.

Also on Wednesday, the FDA gave Gilead's shareholders unexpected good news. A few years ago, Gilead acquired Calistoga and its oral anti-lymphoma/leukemia candidate, idelalisib. Wednesday, a few weeks ahead of schedule, the FDA approved idelalisib, now named Zydelig, for chronic lymphocytic leukemia, as was expected. What happened about six weeks ahead of schedule, and which was not certain, is that the FDA also provided Zydelig an accelerated approval for two of the more common non-Hodgkin's lymphomas. Accelerated approval allows marketing, but requires the company to obtain permanent approval based on submission of more clinical trial data. The approval is, therefore, conditional.

Caveats that the FDA required a "black box" warning for Zydelig but not for its close competitor Imbruvica damped the enthusiasm for this approval.

Thus, the stock closed basically unchanged after-hours, but up a dollar on the day. It is trading at new highs Thursday, however.

GILD shareholders face the buy-sell-hold question now, and non-GILD shareholders face the question of whether the stock is buyable here. There are several reasons to stay aggressively bullish here, as I see it. We can all look at the low P/E, so there's nothing I have to add about that. Great and large companies can deserve a low P/E if earnings are peaking for a sustained period. So I would like to review Gilead from a stock market and sum-of-the-parts approach, though with the understanding that it is not about to break itself up, and I do not own it with any thought that it will receive a lucrative buyout offer.

Here's an updated analysis. The first point relates to the stock; the rest relate to the current and prospective business of the company.

1. There is a large short position, while the stock is in a confirmed uptrend:

The latest Nasdaq data on the short position in GILD is as follows:

Settlement Date Short Interest Avg. Daily Share Volume Days To Cover
6/30/2014 93,715,153 9,625,018 9.736621
Click to enlarge

Before Sovaldi was approved, there were "only" 70 million shares sold short and 6.8 days to cover. Assuming there are still about 90 million shares sold short, there may well be some continuing upward pressure on the price as the shorts realize that Gilead is truly a strong company with sustainable earnings power with earnings that could continue to grow, rather than peak and head south as they hope.

Meanwhile, the stock chart is a thing of beauty. GILD is about 20% above its EMA. This could be a warning sign, but given the incredible earnings breakout, I take the chart as consistent with a steady breakout that could continue for years if the fundamentals cooperate.

I think that the shorts are misguided, and that growth and value players both have reasons to buy GILD at and above current price levels. Which other stocks have the overall attractiveness of GILD?

The rest of the points address the fundamentals.

2. The hepatitis C franchise looks powerful for the long term:

There is great worry about the competition to Sovaldi and the combo from AbbVie's (NYSE:ABBV) pending anti-hep C products, which may be approved by the FDA in December. On May 12, I discussed this and came to the conclusion that to the extent we know the story, AbbVie's entries are not all that competitive with Gilead's. Subsequently, in a follow-up article, I undertook an ambitious, though admittedly speculative analysis and concluded that Gilead's hep C franchise could have an after-tax value equal to the entire market value of the stock.

The Q2 Sovaldi sales breakout strengthens my valuation argument, which has a wide error range. Regarding competition, management took the time in the conference call to lay out its extensive knowledge of how to bring the time to treatment down below 8 weeks. It talked about not only two-drug combos for hep C, but three-drug combos. I think that Gilead is probably doing in hepatitis C what it did in HIV treatment - dominating.

I'm reminded of a story about the first NBA All-Star game to feature a 3-point shooting contest. The story was that Larry Bird came into the locker room a little late pre-game and announced to the other players something like, "OK, who's playing for second?" And he went on to win the contest.

Larry Bird was #1 and knew it. Gilead is #1 in hepatitis C. Gilead's competitors know it. There's no need to recoil in fright from the fact that - gasp - there will be competition. Gilead has achieved a commanding market share in anti-HIV treatment, starting as a weak company. Now it's a major company. Should it do much worse in hep C than it did in HIV? Why?

Some questions on the conference call related to pricing of the sofosbuvir-ledipasvir combination product. Gilead declined to comment other than to say the obvious, namely that most of its value came from sofosbuvir (Sovaldi). This combo, when approved, can treat about 2/3rds of hepatitis C patients. I expect it to cost more than Sovaldi, perhaps a good deal more. Eventually, we all expect pricing pressures to become significant, but the good news is that this is "in" all the analytic models. Less pricing pressure than expected is, in my view, a realistic possibility, and if that occurs, GILD will have been correspondingly undervalued today.

3. HIV treatments: Gilead is hitting on all cylinders:

Its HIV treatments are now at about a $9 B annual run rate. In addition, Viread for hepatitis B adds roughly another billion in sales.

Gilead's Truvada, a two-drug combo, has now been shown to be wonderfully protective against HIV infection in high-risk sexually active individuals, most importantly MSM (men who have sex with men). Truvada sales may be set to explode upward. Truvada's patent protection is until 2018 in Europe and 2021 in the U.S. Whether additional protection can be gained is unknown; I would not invest based on that hope.

Gilead updated its plans to replace the current active ingredient in Viread, called TDF or tenofovir DF in some of the references in the conference call, with TAF. TAF is a different version of TDF with the same active, but it is much more potent and thus uses much less drug to be produced and swallowed. There is correspondingly much less systemic exposure. For the first time I am aware of, Gilead downplayed the clinical benefits of TAF over TDF. I think that TAF may be a niche drug initially, but will take over for Gilead's charity program due to lower costs of production. Over time, the much lower dose of TAF could, however, allow different combo products to come to market that could replace the current ones that use TDF.

Gilead's HIV franchise is extremely valuable. The combination of its (evolving) hepatitis C and (established) HIV franchises - which is what they are - is an amazing business (and scientific) feat. From a valuation perspective, even allowing for conservative judgments, I think that these two dominant product lines are worth well north of $100/share.

4. Zydelig (idelalisib) was approved early:

The approval for several B-cell malignancies puts it (probably only temporarily) well ahead of Imbruvica in treating terminal lymphoma patients, given that Imbruvica's lymphoma approval was, unlike Zydelig's approval, only for a rare type.

The underlying growth story here is the migration of treatment of CLL and non-Hodgkin's lymphomas with oral medications. Imbruvica is the breakthrough product from Pharmacyclics (NASDAQ:PCYC), which it is promoting with Johnson & Johnson (NYSE:JNJ). This new paradigm should allow for robust sales both of Zydelig and Imbruvica.

If we want a quick and dirty estimate of Zydelig's market value, we can look at PCYC, which is basically a one-product company. PCYC currently has an enterprise value of about $7 B. Its deal with JNJ involves a 60-40 profit split. I would estimate that since PCYC's pipeline adds little to its share price, Imbruvica may be currently valued around $13 B in value. Zydelig has a black box warning that Imbruvica lacks. However, its indication is for terminal diseases, so a black box warning may not hurt its sales much. Gilead has five ongoing late-stage clinical trials for Zydelig, which will better define its safety and efficacy. Might Zydelig have a market value in the $10 B range? I think so, and think that this might be low, given that peak sales could easily exceed $2 B with sky-high profit margins. Thus, perhaps Zydelig is worth $7 per GILD share.

It is, however, important to be aware that Zydelig's side effects could be worse than Gilead believes. If so, sales would suffer.

5. Cardiovascular is strong:

Letairis for pulmonary hypertension and Ranexa for angina are both growing and comprise an important product line. Patent expirations for both this decade limit the value of these to Gilead; we will have to see if the CV pipeline proves valuable. At the least, Gilead has a trained CV sales force that presumably could, if necessary, co-promote another company's product. Gilead's (non-dominant) CV franchise is worth billions.

6. The pipeline has great potential:

Gilead has an adventurous pipeline in cancer (simtuzumab), CV, respiratory syncytial virus, and a potential breakthrough cure for hepatitis B. This is in addition to its pipeline for hepatitis C, which is robust, and two pending approvals for single-agent drug products for its HIV line. I do not believe that this pipeline is being given much, if any, value in GILD's valuation.

7. Gilead's intangibles are valuable:

Any well-functioning, integrated pharmaceutical company has made large investments in a sales force, regulatory expertise, and other intangibles, such as industry contacts. We know from takeover activity that these alone are of surprisingly significant value.

Looking at all the above, my view is that there is a meaningful margin of safety in GILD stock here. Whether one looks at P/E, P/E/G, or sum-of-the-parts, there appears to me to be the likelihood that in a richly valued stock market, GILD is underpriced.

Risks: Some of the risks to investing in GILD shares include general market conditions. It would be reasonable to expect a bear market at some point, and GILD has moved in more or less a straight line from $20 to above $90. Even if it moves much higher, a sell-off could take it below $90. Most of us are aware what P/E Microsoft (NASDAQ:MSFT) and Apple (NASDAQ:AAPL) have hit in the past few years, not only during the 2008-9 panic but after that. The market does not owe investors a P/E ratio.

There are numerous company-specific risk factors. The sofosbuvir-ledipasvir combination could experience delays in approval. Research can go poorly, and patents can be invalidated or worked around. Competition can lead to greater pricing pressures on the hepatitis C and HIV drugs than expected, as well as eroding Gilead's market share. There is no dividend support and no asset value such as Yahoo (NASDAQ:YHOO) has with its Asian shareholdings.

Gilead's SEC filings detail its risks in great detail.

Conclusion: The power of Gilead's earnings explosion driven by Sovaldi, with the potential of even higher hepatitis C sales and earnings than Q2's astounding $14 B run rate, is, in my view, so unique that analysts and institutions alike have had trouble getting their arms around this story. When added to a still-growing HIV treatment franchise, the evolving cancer treatment product line, and a promising pipeline, the case for higher GILD share prices over time, perhaps much higher, looks strong to me.

In contrast, many stocks look much closer to fully priced to me.

In a market that has come a long way, GILD strikes me both as attractive on absolute terms and very attractive relative to the investment alternatives. I think that if one more major pipeline product hits with multi-billion dollar sales potential, GILD could be the most highly valued public pharmaceutical company on earth.

I remain quite overweighted in GILD.

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.

Additional disclosure: Not investment advice. I am not an investment adviser.