Gilead: 'Negative Growth', No Problem

| About: Gilead Sciences, (GILD)


Often I’ll use a “no growth” scenario for companies as a downside or base case assumption.

Gilead has shown exceptional growth, but could perhaps be a bit more susceptible to unpredictable earnings.

As such, this article looks at what a “negative growth” scenario could look like for investors.

When I look around for growth expectations related to Foster City, California-based biotechnology giant Gilead (NASDAQ:GILD) I see a 6% expected growth rate there or a 10% intermediate-term consensus growth rate here. Basically a lot of people anticipate that the company can continue growing. Which makes a good deal of sense considering Gilead's exceptional growth over the last decade. Back in 2005 the company was earning less than $1 billion. Last year the company reported profits of over $18 billion.

Of course this is not to suggest that everything is "ho hum" and the growth expectations must materialize. First, no matter how great of a growth story, there is always the possibility of a hiccup and ultimate slow down. Moreover, with Gilead in particular you have some unique product dependency and potential pricing risks.

To give you some context, last year Gilead reported that total worldwide sales for Harvoni came in at $13.86 billion, while sales of Sovaldi were about $5.27 billion. That's a total of $19.1 billion for the two hepatitis C drugs or nearly 60% of the company's product sales. Naturally these drugs have been widely successful (with combined sales up over 50% since last year) but that doesn't mean that concentration risk is not present. No matter how effective or innovative a product might be, continued competition is always a factor.

From there you have a senate investigation and ongoing news in the industry that could lead to future pricing pressure. Lawmakers reported that Gilead was "fully aware" that the price of their drugs - $84,000 for a 12-week treatment for Sovaldi and $94,500 for Harvoni - put it out of reach for many. Moreover, they contended that the high pricing of Sovaldi was merely done so to set up an even higher priced second wave of treatment.

Now none of this is to suggest that the drugs are not effective; and billions of sales show the need and demand. Gilead has denied the allegations, suggesting that the price points were done with great review. And to be sure, the cost of developing and acquiring these types of treatments can be huge. Companies ought to be compensated for the upfront capital required.

Yet this sort of thing creates a unique headline risk nonetheless. It's the sort of risk that isn't present in a company like Coca-Cola (NYSE:KO), as an example. Both Coca-Cola and Gilead command a premium for a quality product. The difference is that if you don't want to pay the Coca-Cola premium you can switch to PepsiCo (NYSE:PEP), select a generic that's 20 cents cheaper or pick any number of alternative beverages. People are willing to time and again pay the premium (be it with sodas or numerous other options) but the idea is that the choice is theirs. With these drugs, the choice isn't always as clear-cut.

So at present Gilead has the majority of its sales under the shadow of potential pricing pressure. Granted nothing has to ever come of this, yet it ought to be a consideration nonetheless.

Naturally this sort of thing can be said for many companies, but the idea is that a cautious view can always be prudent: better for things to work out well if the business performs marginally, than to need exceptional growth to support your thesis.

Ordinarily I would "scale down" the growth expectations by seeing what a "no growth" situation might look like. For instance, with a company like Union Pacific (NYSE:UNP) a "no growth" scenario on a company-wide basis would mean zero overall profit growth and could still translate to 5% annualized returns on the shareholder level.

For a company like Gilead, I wanted to see what a "negative growth" situation might look like, trying to bake in a good deal of uncertainty as detailed above. This sort of "downside" can work to illustrate what a less than stellar set of circumstances might look like.

As indicated above, the company earned $18 billion or so in 2015. Let's suppose that this amount decreases by 5% annually, leading to a number closer to $11 billion in the next decade. You can debate the actual amount (it's going to be guesswork regardless) but the idea is to think about what a "negative growth" scenario could look like.

The company recently announced a $0.43 quarterly dividend to be paid at the end of March, and also called their second quarter dividend shot (a la PepsiCo or Wal-Mart (NYSE:WMT)) by indicating that the board already authorized a 4-cent increase to $0.47 per share in the second quarter. In addition, the company announced a further $12 billion share repurchase program to commence upon completion of the existing program.

Gilead has approximately 1.47 billion shares outstanding, so the $0.47 quarterly dividend (prior to thinking about retired shares) would cost about $2.8 billion. We'll use that number moving forward.

During the 2010 through 2014 period Gilead elected to allocate roughly 50% of its profits towards share repurchases. We could suppose that continues as well, leaving ample coverage in the beginning and perhaps assuming a bit of flexibility down the line. Here's what those assumptions might look like (in millions):

If this scenario were to hold, you'd see company-wide profits declining by a 5% annual rate, to go along with a steady dividend and a steadily decreasing amount of capital going toward share repurchases. Naturally there are an unlimited number of actual possibilities; the idea again is just to get a feel for a base or downside case.

If you were to find out that this is what actually occurred in the business, I'd imagine a good portion of investors would have shunned the security. Seeing nearly 40% lower company-wide profits after 10 years doesn't exactly get your growth story rocking. Yet I'd contend that it's important to remain cognizant of how a security can interact with the business performance.

Here's a look at what this type of business performance (and capital allocation decisions) could mean on a per share level:

For this illustration I had to come up with future share prices at which the company would retire shares, which can vary dramatically. I kept it simple: using the round 7 times earnings trailing earnings throughout. A lot of people might bemoan this input, but as you're see shortly it doesn't have as large of an impact as you might originally imagine.

This is the sort of thing that is not intuitively obvious when people talk about a stagnating or declining business. The company might not be as profitable, but that does not simultaneously indicate that a shareholder's underlying ownership clam cannot be increasing at the same time.

Here you would still anticipate earnings-per-share increasing by about 2.3% annually and dividends per share growing by about 7.7% per year. Moreover, the share count effectively halves and the future share price could be over $100.

If you add in $27 or so in collected dividends, your total value might be around $132 or thereabouts. Expressed differently, this represents a 4.5% annualized gain.

Think about that. You can have a business that is declining in profitability by 5% annually and yet still see positive (mid-single digit) returns. The gains aren't exceptional, but it's the sort of thing that could turn a $10,00 starting investment into $15,000 or $16,000.

Plus, a lot of this is dependent on the starting price, robust underlying earnings machine and commitment to allocating capital to shareholders, not on future valuation. Instead of 7 time earnings, if we instead used an average P/E ratio of say 4 (after all the business is getting "worse and worse") the total returns would be about 5%. The share price would be lower, but so too would the number of common shares outstanding. Thus increasing the EPS and dividend per share growth rates.

Moreover, this is not exclusive to the lower P/E's either. Should shares instead trade at an average of say 15 times earnings, you would retire fewer shares and the EPS growth rate would actually be negative. Yet you'd still end up with a higher ending share price along with an annualized gain in the 7% to 8% range. In short, given the "negative growth" assumptions described above, shareholders could still see 4%+ annual returns. The capital allocation strategy can mitigate against a declining business.

Of course if you suspect that the business will perform much better or worse, the results can very widely. For instance, if you suppose that earnings will decline by 10% annually, using the same assumptions above indicate a total annualized gain of about 0.8%; still positive, mind you, but not very impressive.

On the other hand, should profits stay where they are, a "no growth" scenario provides 8% to 9% annual returns. And that's prior to thinking about reinvesting dividends or seeing an earnings multiple higher than 7 with a company growing EPS by the mid-to-high single digits.

In sum, for a lot of companies a "no growth" scenario on the company level is a fairly conservative base case. With Gilead, I took this one step further and assumed that company-wide earnings would decline by 5% annually. Lesser results can obviously come about, but it gives you a starting point. What's interesting is that should this take place, investors could still see reasonable or better investing results. A solid starting valuation to go along with a robust capital allocation program can combat a good deal of business negativity.

Disclosure: I am/we are long KO, PEP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.