Buy Gilead: 4 Reasons Why

| About: Gilead Sciences, (GILD)

Summary

GILD is trading at an absurdly low valuation, even considering slowing earnings growth.

GILD has a well-managed balance sheet, high cash position, and decent dividend yield (2.16%).

GILD is likely to be involved in a highly beneficial acquisition.

There are some indications that GILD may positively surprise on earnings.

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Valuation

GILD Stock Price over the Past Year

Gilead (NASDAQ:GILD) shares are down 26% over the past year as a result of declining revenue from Gilead's two Hepatitis C Virus (HCV) drugs: Harvoni and Sovaldi. These HCV drugs are the main reason GILD earnings have increased almost 110% annually over the past three years, but they are now facing new competition from Bristol-Myers Squibb (NYSE:BMY), AbbVie Inc. (NYSE:ABBV), and Merck & Co. (NYSE:MRK). This newfound competition has caused a 5.6% first-quarter decline in revenue for Harvoni and Sovaldi. Even without the increased competition though, there is little additional room to grow as Gilead already controls north of 90% of the market share in HCV drugs. While two products may not be a big deal for many large biotech companies, in this instance, GILD's HCV drugs make up about 65% of its revenue. The remainder revenue mostly comes from Gilead's HIV treatment drugs, which do not appear to be as threatened.

Now as a positive for the core business, GILD did get two drugs approved by the FDA this year: Descovy (HIV treatment) and Epclusa (HCV treatment). There are also several drugs in the pipeline, nine of which are in Phase 3. I am not a drug expert so I can't really speak to the potential of these drugs. What I can say, though, is drug launches are always highly speculative. Most drugs will miss, but every once in a while you will have a winner. That is what I count on long-term.

Source: NASDAQ GILD Analyst Earnings Projections - Source: NASDAQ

Given what I have read about Gilead, I think NASDAQ's composite of analyst earnings projections is reasonable. GILD has a diluted TTM EPS of $11.69. Plugging in the EPS and 5-year growth rate of 2.72% into the discounted EPS valuation model previously outlined at KnightInvestor.com, I come up with a valuation of $130.83 per share. That represents a 51% upside from the current price of $86.66. Given Gilead's solid cash flow generation and the fact that the FCF ($11.84 per share) is actually quite close to the EPS, I think this is a pretty reliable valuation. If you're still unconvinced by the theoretical intrinsic valuation, check out the valuation ratios:

Click to enlargeSource: Fool.com

As you can see, Gilead is significantly cheaper than the industry in almost every valuation ratio metric. In addition, it is actually currently trading at its own five-year low P/E ratio. GILD's valuation statistics should immediately pique the interest of any value investor.

Cash Management

Gilead is currently sitting on about $6 billion of cash. At the end of December 2015, that cash balance was at $12.5 billion, but the decrease is not due to anything operational. Instead, GILD bought back about $7.8 billion of its own stock and paid out about $500 million in dividends in the first quarter. In addition, Gilead already has an approved plan to buy back approximately $12 billion more of its own stock. GILD can afford it too; it still generated a positive operational cash flow over the past quarter of about $4 billion. As a result, it can build up that cash balance quickly again with a moment's notice.

In short, that large quarterly decrease in GILD's cash balance is nothing to worry about. Instead, it is a sign of confidence from management that they too know the company is undervalued. Gilead's strength of balance sheet, operational cash flow, stock buybacks, and 2.16% dividend yield represent just another handful of feathers in its ten-gallon cowboy cap.

Acquisition Potential

Whenever a company has such a large cash balance, but is lacking earnings growth potential, the easy answer is always acquisitions. GILD is no exception; analysts and shareholders alike have been impatiently expecting Gilead to make an acquisition. I agree that an acquisition would be a phenomenal idea. After all, Gilead can easily afford it and a new source of earnings could push the stock far past even the $130 target I think it is worth today. It may be just the catalyst the market needs to send GILD on a long bull run. In addition, it would be highly beneficial for Gilead to diversify its drug lines away from its HCV products. I don't know what GILD management has planned, but I am sure they have well-considered their options. I would rather Gilead find the right company at the right price than to rush into anything. Returning value to shareholders while they decide is something I can tolerate as an investor.

There is also another interesting possibility for Gilead and that is actually being acquired. Now because of Gilead's size (market cap around $115 billion), there are not very many potential suitors. Forbes has an excellent article discussing potential mergers in the biotech space and the article floats the idea of an acquisition by Merck . A merger there could result in substantially reduced costs for Gilead which is another play to increase earnings. Additionally, Merck may be able to utilize GILD's HCV cash flow to invest in potentially more promising drugs that they are already working on. If Gilead is hoping to be acquired, I wonder if the stock buybacks are part of that strategy. The stock buybacks could actually provide more value than simply holding cash when it comes to negotiating a price.

While I am not sure which route is best for Gilead, I completely agree that the company should be involved in some sort of acquisition. Given all the pressure, I would be surprised if we do not hear a development on this front in the next year. Although I said I am patient, I believe an acquisition will be the catalyst that brings GILD's stock to new heights.

Earnings Surprise

Gilead will report second quarter earnings on July 25, 2016 after market close. With the important exception of last quarter, GILD has a good history of beating analyst expected earnings by around 9% on average. Zack's Equity Research also has an interesting article pointing out how analysts have very recently bumped up GILD's earnings expectations by almost 7% (from $3.04 per share to $3.25 per share). The author says that this fact, in addition to its positive rating by Zack's, is a historic indication that the company will positively surprise on earnings about 70% of the time. I view this type of speculation much as I do technical trading: it's a sort of horoscope voodoo to me. That said, it is an interesting observation and perhaps the last reason you need to buy this stock now without waiting for earnings.

In Conclusion

Flat out, this is one of my favorite long-term value investment ideas. Although in a perfect world I would like to see a little more positive growth potential, that is easily remedied when you consider the likelihood of an acquisition. Judging almost every other metric, especially the crazy cheap valuation, I think Gilead is a strong buy. If you are young, I also think biotechs are a great component of your portfolio as they can have great long-term growth potential.

The most major risk factor I see to Gilead's future is politics, with Hillary Clinton making high drug prices a major component of her campaign. Should she win and get a drug bill passed, it could result in a significant negative effect to GILD's earnings. This fear is what brought the biotechs down earlier this year and it's still a threat that should be in the back of everyone's head. That said, if there's one thing I have learned from following politics, little usually ever happens. So I'll take that bet and stay a strong bull on Gilead.

Leave a comment, send me a message, or contact me at KnightInvestor.com if you have a stock you would like me to analyze.

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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I intend on increasing my long position in Gilead Sciences in the short-term. I am not a financial advisor. Do not make any investing decision solely based upon what you read here. It’s your money, invest it wisely.