That De-Escalated Quickly! Is Gilead A Busted Growth Stock?

| About: Gilead Sciences, (GILD)

Summary

Gilead reported disappointing financial results in Q1 yesterday after the close.

These were led by a surprisingly sharp fall-off in Harvoni revenues in the US.

The article discusses Q1 results and puts them in the context of the long term.

Gilead Sciences (NASDAQ:GILD) surprised the Street with EPS of $2.53 per share. This was down from $2.76 per share in Q1 last year. These numbers are reported in GILD's less favored metric, namely using the accounting principles that are accepted in the US. That's as opposed to the "fantasy" numbers that are higher that exclude real costs such as those related to acquisitions.

The EPS decline was in spite of modestly higher sales and a massive stock buyback in the quarter.

GILD booked a $0.12 per share loss from the loss to Merck (NYSE:MRK) on the sofosbuvir (Sovaldi) patent case in March. There were also significant rebates to "true up" from the prior two quarters, ongoing forex losses, and early price adjustments in Japan within the supply chain in advance of mandated price cuts that took effect April 1 for Sovaldi and Harvoni.

No one could have guessed at some of the strangeness of the quarterly results. A neglected product, Zydelig for cancer, was GILD's fastest growing product on a percentage basis (88%, but only to $49 MM). The killer product, Harvoni, saw sales collapse in the US, from $3.0 B in Q1 last year to $1.4 B this year.

What saved the quarter, in addition to the share buybacks, were nearly $1.1 B in HCV product sales in Japan, compared to no sales there one year earlier.

Interestingly, the company maintained the same full-year guidance for 2016 that it presented in its January report three months ago:

(In millions, except percentages and per share amounts) Provided

February 2, 2016

Net Product Sales $30,000-$31,000
Non-GAAP*
Product Gross Margin 88%-90%
R&D expenses $3,200-$3,500
SG&A expenses $3,300-$3,600
Effective Tax Rate 18.0%-20.0%
Diluted EPS Impact Related to Acquisition, Up-front Collaboration, Stock-based Compensation and Other Expenses $1.10-$1.16
Click to enlarge

* Non-GAAP Product Gross Margin, R&D and SG&A expenses and effective tax rate exclude acquisition-related, up-front collaboration, stock-based compensation and other expense

I am guessing at shares outstanding, but I came up with about $10.50 per share in EPS as a new working estimate for this year using GAAP.

But GAAP may overstate earnings available to shareholders:

However, I always think about this tax rate, which reflects very low tax rates in Ireland for the intellectual property that is domiciled there, plus lower corporate tax rates globally than in the US. As happened to GE (NYSE:GE) when it finally sold off its ex-US financial operations in part of its big recent restructuring, and as occurred with Yahoo! (NASDAQ:YHOO) when it sold off a large part of its stake in Alibaba.com (NYSE:BABA), eventually the US government gets its cut when money comes back in distributable form.

So, another way I think about multinationals such as GILD is to assume a higher tax rate than the stated rate. Doing so - my own adjustment - gives a projected EPS below $10/share.

In other words, while GILD's insiders and their friends on the Street promote non-GAAP projections and sadly do not even provide GAAP projections, leaving me to do it on my own, the reality is the opposite. If one wants to think like an owner of a company rather than just a stock flipper, one should close the loop and ask if, at the end of the day, one wants a trading sardine or a real return on investment. If the latter, one has to be realistic about taxes. Even in tax holidays, which the US is "due" to have under the next President, some additional tax is often paid.

When I make an adjustment to a 30% tax rate (YHOO's was 40% on the BABA sale), GILD's P/E on 2016 projected EPS are not much less than 10X.

So, whatever numbers one uses, there's this stock that's been churning after a huge multi-year run on the expectations for Sovaldi and Harvoni. What are its investment merits and demerits?

Ways to think about GILD

Most readers are well acquainted with this company and the stock. I've gone through the slide presentation that accompanied the earnings report; if you have not and are seriously interested in understanding the quarterly results, it's almost a "must read."

In any case, with GILD around $92.50 pre-open, therefore back to a level it first reached in August 2014, the question is whether the pressures on the HCV line are so great that the stock is a value trap, or a busted growth stock where sales and earnings have peaked and may head downward.

I'm focusing on the following topics as reasons to A) stay the course and B) join the company in buying shares in the $80s:

  • HIV/AIDS franchise
  • Market share dominance in HCV
  • Market size of HCV in the US and elsewhere
  • China and rest of world opportunity
  • Pipeline maturing

I'll take these in order.

HIV/AIDS becomes a growth engine again

It's gratifying to see that the GILD story with TAF is meeting my high expectations for it. The TAF version of Stribild, called Genvoya, is off to a strong start both in the US and in the EU. I look at HIV/AIDS druf treatment as the gift that keeps on giving both to patients as well as to GILD shareholders. As GILD's EVP of Commercial Operations, Paul Carter said in his prepared remarks on the conference call:

We're pleased with the launch of Genvoya both in the U.S. and in the European markets where we've achieved reimbursement. Starting with the U.S., through five months post the launch of Genvoya, cumulative prescriptions were twofold more than any HIV product from any company since Atripla, which was the first single-tablet regimen to come to market back in 2006. As expected, most of Genvoya's initial prescriptions came from switches. Qualitative feedback from HIV prescribers is very encouraging and indicating a clear intent to switch patients at the earliest opportunity...

In addition to switches, preliminary quarter one 2016 data indicate to us that Genvoya may soon be among the most prescribed products of patients new to treatment...

Genvoya was launched in Germany during quarter one. And at the end of the quarter, preliminary data indicate that it had the leading market share for both naive and switch patients...

This is exciting. Combined sales data for Genvoya and Stribild in the US were very strong.

In addition, confirming that TAF-based regimens are well positioned to gain market share back from ViiV's offerings, Mr. Carter also said of the new product Descovy, the TAF version of Truvada:

Finally on HIV, we launched Descovy this month in the U.S. and the EU. We see this launch as a milestone in HIV treatment... we're confident that Descovy will quickly replace Truvada and become the leading HIV regimen backbone in all our markets.

It appears that GILD was developing TAF with a clear knowledge of what the HIV/AIDS treating community felt was important. This is in contrast to some naysayers who minimized the benefits of TAF versus the older TDF found in Truvada, Stribild, etc.

Unfortunately, from a societal point of view, HIV/AIDS remains a growth field for GILD. This is in spite of growing use of Truvada for PrEP (pre-exposure prophylaxis).

With several new TAF-based products in development, GILD's HIV/ADIS line looks to me to be poised for renewed real growth.

Patent cliff averted for now!

HCV, pricing and market share

Harvoni and Sovaldi, which is soon to become nearly obsolete wherever the SOF/VEL combo comes to market (July in the US), are overwhelmingly the choice of doctors who treat HCV - where they have a choice.

Yet price pressures are everywhere in this field now. Mr. Carter made clear that the company is going to do what it takes to keep market share, which means to be flexible on price.

Price is such an issue that GILD has walked away from some contracts in northern Europe.

The mix of payors is changing to GILD's financial detriment. There is an ongoing trend toward governmental, mostly Medicaid, payors in the US, which means lower prices. In the EU, the highest prevalence of HCV is in Italy and Spain, where reimbursements are lower than in, say, Germany. GILD is seeing a greater share of its EU business come from "Club Med," also to its detriment; this is probably a permanent shift.

In further addition, a positive selling point for GILD with doctors and payors is the 8-week treatment option with Harvoni for patients with milder disease burdens. This also leads to lower reimbursements, and the company believes this trend toward more 8 week treatments probably has a little further to go.

With SOF/VEL coming soon in the US and probably next year in the EU after pricing is worked out, I expect the company to maintain a high market share in the US and globally in HCV, but at the expense of a downward trend in reimbursements.

In this sense, the GILD bears had it right.

In a public policy sense, the critics had it mostly wrong. The sickest patients who were being warehoused, waiting, often desperately, for Sovaldi and Harvoni, were most needy and were treated at higher cost. Now, less sick patients are being treated, and competition between drug companies means that the costs are dropping, often sharply.

GILD was not price gouging, and it is not going to end up having made unreasonable profits on its HCV products.

One reason it's going to "work out OK" in my view comes from the growing market size.

GILD again points to higher HCV numbers

In some emergency rooms, researchers are finding 10% HCV infection rates.

GILD is saying that over 3 million Americans have HCV. That's after the better part of a million have already been treated and cured. Yet when Sovaldi was introduced, many estimates were that the total patient pool was 3 million.

Going back to 2014, I used more like 4 million as a realistic number, taking new cases into account. New cases occur from IV drug use, sex, and immigration.

Given falling prices of treatment and the infectious nature of HCV, public health requires an attempt to virtually eliminate all US cases. This would be a principle in the EU as well.

This would lead to many years of treatment opportunities for GILD, and would be, in my opinion, an offset to the expectations for price erosion of the drugs.

China finally enters the equation

GILD estimated 15 million Chinese HCV patients, give or take 5 million. Meaning, no one knows. In response to a question, GILD CEO and President John Milligan said this:

So in terms of timing for China, there is a fairly fixed process. And according to the recent processes, we could possibly have sofosbuvir on the market in 2017. As you may have seen, there are new - the Chinese government is working hard to try to accelerate review and approval of HCV drugs because currently none are on the market of the direct-acting antivirals, and that could help us accelerate the timelines into China, and we are working on that. Particularly of interest to us would be accelerating the timeline for sof/velpatasvir because there are so many different genotypes in China. Genotyping is not common in China, and this could provide a very good option for the people of China. So there's hope, but we can't guarantee of course that we can accelerate that approval beyond its current timeline, which is 2019.

The Chinese market is fairly large. Between 10 million and 20 million people are thought to have HCV. I don't want to get into public discussions of pricing, but I do think there's a price/volume relationship that would work for us and for the Chinese health system that could be very, very good for us both. And so that's what we're working towards is access in China.

It's not clear how to model GILD's profits out of China. If it sells its products to a local marketer, then it will not earn distribution profits, only manufacturing profits.

In any case, it's been my guess that analysts have not been modeling HCV profits for GILD from the large Chinese market, and that full-year 2018 profits from that market could be meaningful and continue for many years.

In addition to China, it's really a proxy for the rest of the world that was not covered by the generic deal in India. Other countries that offer profit opportunities include South Korea, Taiwan, Mexico and Brazil.

Pipeline - more hopeful

A year ago, I began emphasizing the importance of the company delivering on the pipeline, as HCV profits were going to be discounted unpredictably by Mr. Market (who was also not a true believer in the TAF story). The year ended on a down note for the pipeline, with disappointing news about Zydelig and other aspects of the oncology program.

In addition to the impressive progress in HIV/AIDS and HCV, the pipeline is looking fuller than it has in some time.

I would direct readers to slides 9-11 for a list that's too long to discuss in this article of timelines for 2016-7.

In addition, there are a number of preclinical programs that the company does not talk about that could move into public view over the next 12 months.

Two pipeline details seem worthy of discussion.

One is that NASH is a growing focus at GILD. It has 3 compounds in clinicals and is about to close on a deal to acquire a fourth one. Let's hope that either alone or, better, in combination, the company can make something happen here. This is enough of a focus now to justify its own article later on.

The other is that GILD must like something it sees about a kinase (SYK) inhibitor called entospletinib, which initially was focused on treating lymphoma. It has now entered two Phase 2 studies, one for acute myeloid leukemia and the other for chronic graft versus host disease. The rule in drug development is to take chances in Phase 2, so as with the candidates in NASH, the return on investment is uncertain, but it is encouraging to see that the company sees something in this compound that makes it worth testing in other diseases.

As far as more acquisitions, GILD partly is holding off until it sees which of its current products succeed and which do not.

Risks

The company discloses them in its 10-K and other communications.

I'd focus on weakening sales trends in HCV, where Harvoni's problems in the US could be a model for worse problems in other markets.

Technically, GILD is not looking too hot. It's now making a series of lower highs, but as of now is 10 or so points above its February low that short-sellers may think about as a first target price.

Then there are the pipeline uncertainties. There is not a lot going on in Phase 3 outside of HIV/AIDS and HCV, and Phase 2 projects are performed to try to prove a concept. Lots of Phase 2 projects may not mean all that much, especially if one is bearish about HCV sales and profit trends.

Also to be considered are the possibility of ongoing royalties to MRK on sofosbuvir, in a case that is ongoing and then will go to appeal.

Conclusion - GILD as secular growth stock versus value trap

GILD is a leading biotech/biopharma stock, so it's worth discussing the sector (NASDAQ:IBB) for a moment.

In 2014, looking at how easily GILD was clobbered by some boastful projections out of AbbVie (NYSE:ABBV) on its Q3 conference call, I began thinking that since GILD had gained over $100 B in market cap since acquiring Pharmasset to gain sofosbuvir, and as I disclosed in a 2014 year-end interview with Seeking Alpha (published in early 2015), I cut back my exposure to biotech substantially. I then began providing my very cautious views on biotech stocks last June through August before the meltdown.

With those factors in mind and the worsening technical picture for GILD, two weeks ago, I reported on GILD and the recent ILC (liver; EASL) meeting in Spain and said this in my conclusion:

If I had to guess, the stock will be capped near $100 for a time...

That was without guessing at the poor results for Harvoni this past quarter.

However, stocks do this. P/Es drop as growth challenges emerge. Then they increase, and we see very high P/Es with numerous Big Pharma stocks that remain ponderous, unlike dynamos such as GILD and Celgene (NASDAQ:CELG).

I look at SOF/VEL as a very important product for GILD, especially in China and the "rest of world/ROW" but also in developed countries where Sovaldi can be forgotten. GILD is the one-stop shop for HCV treatment; everyone else is playing catch-up.

As I've tried to emphasize for a long time, the HIV/AIDS segment of the company is of great importance. With a cure seemingly a long way off and new HIV infections occurring much more rapidly in developed countries than desired, HIV/AIDS led by TAF-based combination products has in my view a high present value.

With a market cap around $120 B, I look at GILD as providing good value in an expensive market. In fact, I think that the entire large cap biotech/biopharma sector provides good relative value in my opinion relative to "safe havens" such as utilities or consumer staples at 25-30X TTM EPS. How strange it is that one of the great growth stocks of our era, CELG, is trading at a similar P/E on GAAP 2016 EPS as some electric utilities.

GILD is already at a P/E where I think some of its peers might trade down to. I'm encouraged that it maintained guidance for the whole year, and consider the stock a strong hold or an interesting new money buy for investors to consider. Its field is a secular growth field, which provides a tailwind that compounds over time as I see it.

I continue to be overweight GILD within a portfolio that is underweight equities and increasingly overweighting cash.

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.