Gilead Sciences (NASDAQ:GILD) is a well-known biotech that is regularly in the news both on television and written up in the Wall Street Journal and other financial publications. Briefly for those unfamiliar, GILD owns two drugs that cure hepatitis C, as well as drugs that help to treat patients who have or are at high risk for having HIV. GILD derived 93.59% of its revenues from these two sources in 2015. The company has a deep and well-funded research pipeline with 180 active clinical studies, 61 of which are in Phase 3 trials.
GILD PE Ratio (TTM) data by YCharts
My investment thesis for Gilead Sciences is based upon the stock market's current valuation of the business and its research pipeline. The stock trades at a P/E ratio of about 8.4 at the time of this writing. The stocks that trade at that sort of multiple typically have one or more issues that weigh on the business. GILD's "issues" could be summarized as its lack of diversification of revenue streams, with 93.59% of its revenue coming from two sources, hep C and HIV drugs. The other issue, which in a vacuum would be a real cause for concern, is the adversity of the various payors towards the pricing of the hep C drugs. The drugs are very expensive by any measure, but they remain dominant in terms of market share because they are the best hep C treatments available. They have been referred to by doctors as "miracle drugs." Sales growth of the hep C treatments, Harvoni and Sovaldi, has slowed in recent years and is expected to continue to slow in the years to come unless the prices are lowered. While these are headwinds, the nature of the company and its size are factors that contribute towards the relative efficiency of the stock's current pricing due to any known factors such as these. These are not new issues and are well publicized, so they are in large part already priced into the stock.
GILD Price to Free Cash Flow (TTM) data by YCharts
The previous paragraph describes GILD's headwinds, and what are in my opinion also the strongest reasons to invest in the company's shares. The fact that its revenue sources are so concentrated is in itself a reason for the stock to have a depressed multiple relative to the market. I believe personally that this is the same reason Apple (NASDAQ:AAPL) has a low multiple; because for the intents and purposes of the stock price, Apple is a one product company as the iPhone accounts for over 70% of its revenues. So goes iPhone sales, so goes Apple's share price. However, I make this comparison not to point out the similarities, but to point out the differences between the "investability" of the two companies.
Apple's strength is derived almost entirely from its brand's value in the minds of its customers, the hardware it produces is widely matched and replicated in terms of performance by its competitors, yet it remains dominant because of its superior branding and marketing efforts. In a luxury consumer marketplace, as the market for $500+ cell phones is, brand matters immensely. Compare with other luxury brands such as Coach, Bentley, and Armani. Customers buy these products not because they are necessary for survival, or even because they are a good value for the money. Customers buy such products because of the weight that the brand carries. Thus, for such a company which lives and dies by the perception of their brand, the greatest risk to their business is that their brand loses value in the minds of their customers. The quickest way to dilute such a potent idea of branding is to dilute the company's image with "cheapened" or products unrelated to the flagship business of the company. Their chief risk lies in their own innovation.
GILD Price to Free Cash Flow (TTM) data by YCharts
In contrast to the above-mentioned situation, a company which makes life-saving drugs is at the polar opposite of the spectrum of brand name weight and concerns about image. If I have a life-threatening illness, the last thing in the entire world I would care about is the brand name of the treatment's manufacturer. Drugs have a brand name too, but their brand name is FDA approval, not prestige or image-related ideals. Thus, Gilead can diversify its business immensely and suffer no damage to its brand name or marketing efforts because of it. This allows the company to shake off the low multiple currently awarded by the market with the only limitation being its ability to create and own new drugs and treatments. This is where the upside in the stock lies. Looking at a well-diversified drug maker such as a Pfizer (NYSE:PFE) or Johnson & Johnson (NYSE:JNJ) that has a multiple north of 20, Gilead is well on its way to entering the category of diversified drug makers with its enormous and growing pipeline. In addition to the current pipeline, GILD has a cash hoard of over $26.2B in cash and marketable securities, as per its latest 10-K filing, which will go to fund continuing and further R&D and possibly acquisitions.
In summary, GILD generated cash from operations of over $20B in 2015, and there is no reason to expect a major functional decrease, if not an increase. In addition to the cash generated by the business, the company sits on a cash hoard of over $26B and a pipeline of 180 clinical trials, 61 of which are in Phase 3. It has plenty of runway, room, and ability to diversify its revenue sources and thus earn a significantly higher multiple from the market in addition to increasing its revenue and earnings in the interim.
The simple but most important factor to consider in taking exposure to a stock, long or short, is the "room to change," meaning capacity for improvement or for deterioration. Buy/short for what the company will be, not what it is. More specifically, take exposure for what the probability indicates the likelihood of the business' future prospects may be, adjusted for the capacity for change and the probability of the necessary changes happening.
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.