Bull Case On Gilead Sciences

| About: Gilead Sciences, (GILD)

Summary

Gilead Sciences is undervalued at the current market price.

It represents a combination of great upside potential and low risk.

Price war between Zepatier and Harvoni/Sovaldi should be closely monitored.

My target price for Gilead Science is $116, which implies 30% potential upside from the current market price. My 2016 NI estimate is $16.1B and my 2017 NI estimate is $14.1B.

In recent years, Gilead showed substantial growth in revenue and ability in cash generation. In addition, Gilead also showed strong ability in cost control. Both factors lead to a strong balance sheet, despite the recent debt issuance. In 2015, Gilead started the dividend program and continued the stock repurchase program, which, in my opinion, both should be rewarded by the capital market.

Valuation price: $116

My valuation price is based on my DCF analysis using a WACC of 10%, which I believe reflects the current cost of capital and risks. Factors that can substantially impact the valuation includes: revenue projection on key products- Sovaldi & Harvoni; future M&A activities; and interest rate risk.

Summary

I believe Gilead shares are currently undervalued and have very limited downside risk. Even under pessimistic assumptions, Gilead shares will still outperform the overall market and biotech sector. They represent a combination of high return and low risk.

Reason for recommending Gilead shares…

Extraordinary Revenue Growth

Gilead generated $32.6B on topline in 2015, which represented a 31% increase year-over-year. This success was largely contributed by its key products - Harvoni and Sovaldi. Harvoni and Sovaldi contributed $19.1B to topline, which represented a 54% increase year-over-year. Other products contributed to 13.5B to topline in 2015, which represented an 8% increase year-over-year.

However, I expect Harvoni and Sovaldi to experience negative growth from 2016 due to product life cycle and increasing competition. This will be discussed in details in risk and valuation.

Strict Cost Control & Great Profitability

Over last 6 quarters, GILD had demonstrated very strong ability in cost control. Gross profit margin was always above 85%; and net profit margin was above 45%.

COGS and Gross Margin

Gross margin for 2015 increased by another 3% compared to 2014.

According to the 2015 company 10K,

"Our product gross margin for 2015 increased compared to 2014 primarily due to changes in product mix, as Atripla sales, which include the efavirenz component at a gross margin of zero, declined and HCV sales increased as a percentage of product sales."

In my opinion, Atripla sales will continue to decrease in the future due to product life cycle and the emerge of the new treatment, like Complera/Eviplera & Stribild. This will have a positive impact on gross margin.

SG&A to Sales Ratio

SG&A expenses relate to sales and marketing, finance, human resources, legal and other administrative activities. In financial analysis, SG&A to Rev ratio has been used to illustrate the efficiency of the organization. For Gilead, the SG&A to Rev ratio was decreasing over last 3 years, which was another positive signal of rigorous cost control.

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Data source: 2015 company 10K and personal database

Effective Tax Rate

The effective tax rate of Gilead was decreasing over recent years, primarily due to different rates between domestic and foreign.

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Data source: 2015 company 10K

In my opinion, the effective tax rate will be significantly lower than the Federal statutory rate (35%) in the future due to increased revenue coming outside of US. In 2015Q1, revenue outside of US accounted for 31% of the total revenue. This ratio increased to 34% in 2015Q4.

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Data source: 2015 company 10K and personal database

Strong Liquidity & Solvency Position

With such strong cash generation ability, GILD is well positioned in term of liquidity and solvency. Over last 6 quarters, current ratio was above 2, and defensive interval was above 1 year. Both metrics indicated that GILD has sufficient cash to cover day to day operation for next 4 quarters even without any revenue or addition debt issuance.

What are the risks?

I think the two primary risks GILD faces are:

Harvoni and Sovaldi will hit the peak sales soon, if they have not already hit it Drug pricing pressure from both competitors side and politician side

My view on these two issues:

This is the primary reason why market is undervaluing GILD. It is absolute true that Harvoni and Sovaldi will hit the peak sales very soon, if they are not there already. Following two charts show the revenue of Sovaldi & Harvoni from last two years. I highlighted the product launch time in Japan for both Sovaldi & Harvoni.

For both products, they hit the peak sales after 2~3 quarters in US & UK. In Sovaldi's case, it experienced significant decrease in revenue after 2015Q2, until 2015Q1, when GILD launched the product in Japan. Interestingly, the sales remained stable for the next 4 quarters, even after 2015Q3, when GILD launched the next version of product Harvoni in Japan. I believe the market in Japan takes a longer time to hit the peak sales comparing to market in US or UK. For Harvoni, we can see a similar trend regards to US and UK market. It started to experience decreasing revenue after first 3 quarters after the product launch. But if we apply the same finding in Sovaldi, which is Japanese market will take longer time to hit the saturation level, the revenue outlook for both products should be fairly stable for 2016H1 at least.

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Data source: 2015 company 10K and personal database

This topic has raised a lot of attention recently, especially after company like VRX has been occupying the headlines. Harvoni & Sovaldi are expensive. Harvoni costs $94K for a single treatment regimen and Sovaldi costs $84K. In my opinion, the pressure from competitors should outweigh the pressure from other short term factors.

According to company 10K,

" Our HCV products, Harvoni and Sovaldi, compete with Viekira Pak (ombitasvir, paritaprevir and ritonavir tablets co-packaged with dasabuvir tablets) marketed by AbbVie, Zepatier (elbasvir and grazoprevir) marketed by Merck & Co. Inc. (Merck), Daklinza (daclastavir) marketed by Bristol-Myers Squibb Company (NYSE:BMS) and Olysio (simeprevir) marketed by Janssen Therapeutics."

Among all the competitors, Zepatier (Merck) should be the primary concern for GILD, given a single treatment regimen costs only $55K. Zepatier was launched in US in 2016Q1. A potential price war should be closely monitored between Zepatier vs Harvoni.

In my opinion, Zepatier will cause a negative impact for sure, but how much will be the impact is a more important question. A single treatment regimen for Harvoni lasts for 12 weeks. We have seen the product hitting the peak sales within US & UK. With more and more patients been treated, the market size is diminishing. For the patients who are currently on Harvoni, I don't believe they will switch from Harvoni to Zepatier during a treatment regimen because of the cost. So the real impact will kick in after 2016H1, which is 8 quarters after Harvoni's launch in US. Now if you recall that it takes 2-3 quarters in the US & UK to reach the peak sales, I think it is reasonable to conclude that after 8 quarters, the market size will be significantly reduced because most patients have been treated already. In other words, I believe the product cycle in US & UK is very short, so first-mover advantage means almost everything. This is not necessary the case in Japan. So the launch date of Zepatier in Japan will have a bigger impact than in US & UK.

Valuation

My discounted cash flow (DCF) analysis results in a valuation price of $116, which is approximately a 30% potential upside from the current market price. I am using a weight average cost of capital of 10%, which factors in the capital structure of the Gilead. I am also using a perpetuity growth rate of 3% after 2022. Finally, I assume Harvoni and Sovaldi will experience substantial negative growth rate from 2016.

Revenue projection 2016 - 2022

Data source: personal database

Unlevered FCF projection

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Data source: company filings and personal database

DCF - Sensitivity analysis on WACC and perpetuity growth rate

Data source: personal database

In my opinion, all assumptions used in this model are relatively conservative, which could result in a lower valuation price. But even under all these conservative assumptions, GILD still shows a 30% upside from current market price. That, in my opinion, is really a good investment.

Disclosure: I am/we are long GILD.

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.