No Balm In Gilead? Can Self-Inflicted Wounds Heal?

| About: Gilead Sciences, (GILD)

Summary

GILD has again disappointed the Street, and the stock has reversed Monday's strength, moving near the low of the past 12 months.

A critique of some of the negatives is discussed, along with the alternative, more bullish view.

I do feel as though management could have been speaking more realistically about the HCV product line's sales prospects for some time.

Perhaps we may see further C-suite change to show investors the company is going to change in that key aspect of running a public company.

Longer term, GILD remains a free cash flow champion, with a number of growth opportunities in the setting of a stock market that's at or near peak 1929 valuations.

Introduction

Gilead (NASDAQ:GILD) has now begun to fundamentally perform more like a busted growth stock than many of us expected, but my bigger disappointment actually lies elsewhere, in two directions. One, which is out there for all to see, is the embarrassing decline in financial guidance for the rest of this year and the lack of visibility beyond this year. That, everyone has seen, and it's not a big deal - though it never should have occurred so late in the year.

More importantly, the company is now putting close to its worst foot forward in terms of projecting an attractive image for the equity. For a stock that everyone remembers as a glamour stock not long ago, that's a big failing.

Without some pizzazz, you're just another wannabe when you're small, and you're dull when as big as GILD is. You can't count on the media (analysts, CNBC, etc.) to be your P.R. agents. You have to set the tone, and right now GILD is drumming off the beat, not setting the promotional pace.

Probably just about everyone reading this article is familiar with the Q2 press release, but for the record and for convenience, I'll spend a little time on it before trying to get to my conclusions.

GILD reports a not-pretty quarter and guides lower

The basic array is this:

Three Months Ended

Six Months Ended

June 30,

June 30,

(In millions, except per share amounts)

2016

2015

2016

2015

Product sales $ 7,651 $ 8,126 $ 15,332 $ 15,531
Royalty, contract and other revenues 125 118 238 307
Total revenues $ 7,776 $ 8,244 $ 15,570 $ 15,838
Net income attributable to Gilead $ 3,497 $ 4,492 $ 7,063 $ 8,825
Non-GAAP net income* $ 4,177 $ 4,845 $ 8,451 $ 9,449
Diluted earnings per share $ 2.58 $ 2.92 $ 5.11 $ 5.68
Non-GAAP diluted earnings per share* $ 3.08 $ 3.15 $ 6.11 $ 6.08
Click to enlarge

EPS (all data are GAAP in this article unless otherwise stated) dropped from $2.92 to $2.58. Harvoni sales cratered in the US, from $2.83 B to $1.47 B yoy. Patient starts were stable in the US, meaning that pricing was down. Also, 45% of Harvoni patients took it for 8 weeks rather than the more standard 12 weeks. Patient starts in Japan were down qoq. In the EU, pricing on Sovaldi and Harvoni was down, as a greater proportion of patients came from Italy and Spain rather than Germany and France.

International, ex-US/ex-EU sales of HCV products were relatively stable, annualizing near $1.1 B.

Guidance was poor. The midpoint of sales was lowered from $30.5 B to $30 B, and SG&A was revised up due to international expansion. Since GILD shareholders received guidance after the Q1 report that reaffirmed the previous guidance, any changes "should" have been to the upside; that's been the GILD way.

Here are those numbers from the press release:

(In millions, except percentages and per share amounts)

Initially Provided
February 2, 2016
Reiterated
April 28, 2016

Updated
July 25, 2016

Net Product Sales

Non-GAAP*

$30,000 - $31,000

$29,500 - $30,500

Product Gross Margin 88% - 90% 88% - 90%
R&D Expenses $3,200 - $3,500 $3,600 - $3,800
SG&A Expenses $3,300 - $3,600 $3,100 - $3,300
Effective Tax Rate 18.0% - 20.0% 18.0% - 20.0%

Diluted EPS Impact of Acquisition-related, Up-front Collaboration, Stock-based Compensation and Other Expenses

$1.10 - $1.16 $1.47 - $1.53
Click to enlarge

The big jump in GAAP to non-GAAP EPS is not my cup of tea. I have gone easy on GILD in the past because the incremental difference between GAAP and non-GAAP was fairly small, and the P/E was low either way.

Anyway, I computed full year EPS based on the above guidance using $29.5 B in sales, a 20% tax rate and the midpoints of the other ranges. This brought me to estimate right around a $10 EPS.

I also re-estimated using a 30% tax rate, which I consider ultimately much more realistic than 20%. This gave an EPS of $8.50.

Free cash flow was copious in H1 this year, but will drop off in H2. The company is building up lots of cash and marketable securities, probably almost all offshore and therefore overstated from the standpoint of returning cash to shareholders. Bringing cash back might mean not a 30% tax rate but a 40% rate.

But the numbers and how they can be sliced and diced are not my precise focus in this article. The focus is the stock, how it may trade, and what values may actually reside within the company.

Why GILD does not look too attractive to new money right now

If you read the press release, or the detailed slides that accompanied the conference call, you pretty much get a dry document that might just as well be the 10-Q that the SEC receives (which is not out yet).

So you see, from the press release, some disappointing numbers both in Q2 and going forward; that there was some management shake-up to go along with the recent change of CEO; and that by the way, some new HIV/AIDS products were introduced.

Based on this presentation, who wants to buy pre-owned GILD stock who does not already own it?

Few.

Whether one is an EPS or chart-based trend-follower, either way there's nothing positive here to bring you in. There's lots of cash and marketable securities, but there's almost as much long-term debt; so GILD is not an asset play. And FCF is going to decline for at least the next two quarters.

To compound the weak set-up, both the new COO, Kevin Young, and the CFO, Robin Washington, collectively admitted several times that they have no good idea about how to model HCV sales going forward. Yikes!

The team also sounded the wrong theme when emphasizing not to be too upset about current sales weakness, that it was the unsuspected brilliant start to the launches that was the surprise.

Going back to Dr. Martin's tenure as CEO when Sovaldi and Harvoni were launched roughly two years ago, shareholders now have to suspect that insiders have been selling heavily the whole time for a reason. Did the insiders think that the amazing profits surge was unsustainable, and that's why none bought the stock and all sold during this prolonged period?

There were other areas where the company has not been focused on selling the growth story that may still exist. For example, on Slide 32, patients beginning anti-HIV treatment for the first time have now been receiving Triumeq ("Other STR") more than any other brand. However, Genvoya is #2 and Stribild #3. Since Genvoya is Stribild, just the TAF version of it, why not combine them into one line? I don't know the raw data, but maybe together they received more scripts than Triumeq.

Not to go on a jeremiad, but just one more example of poor communications will suffice. The final question in the conference call Q&A related to the possibility of broadening the HCV prescriber base. I took this question to refer to adding general GI doctors to liver and ID specialists as Harvoni and Epclusa prescribers. However, Kevin Young interpreted the question differently and provided information about international launches. In this response, he unnecessarily stepped on a key part of the growth message, volunteering:

We are thinking carefully about China and how we launch there probably in a very modest, very focused way, very efficient way, should I say. So our expectations, I think, are very reasonable around China.

Mr. Young is not a rookie. But it looks to me like a rookie mistake to volunteer that an absolutely critical market will receive not just a modest launch, but a very modest one. Is that the extent of the China opportunity for GILD? It can't be, because the company has previously suggested that China can be the most important market for Epclusa.

So, corporate messaging techniques aside, the question must be addressed: is there a bull case for GILD shares at a price around $82 as I complete this Tuesday morning?

I think there is, but only for patient investors, a point I've been emphasizing for some time. Here's how I think about the stock.

The case to own and hold GILD

The argument ties to relative valuation and long-term growth opportunities. All the elements are present, but need to be re-emphasized. The case first points to the S&P 500 trading at 25X TTM GAAP EPS; and GILD should use GAAP in my opinion. That would save all the adjustments and facilitate inter-company comparisons.

Then the bull case is straightforward. The points would be, in this order:

1. HIV/AIDS can grow for many years, even into the 2030s

I have addressed this recently. The downside, short term, is that Viread, Truvada and Atripla lose patent protection in the EU next year. However, the TAF-based products are all protected there until at last 2021.

With no cure for HIV infection on the horizon, with GILD and others working on it, GILD's growing portfolio of TAF-based products, supplemented importantly by the "Triumeq-killer" of the bictegravir-containing version of Genvoya, can see GILD regaining market share from ViiV.

In addition to the case to regain lost market share, other dynamics of the HIV market are commercially attractive. These include:

  • a constant flow of new infections
  • a higher percentage of infected people getting diagnosed
  • a rising percentage of diagnosed patients beginning treatment when diagnosed

So this may be a growth business for many years, especially after 2018/9 when the EU patent cliff is past and bictegravir largely replaces Genvoya.

Plus, the company has an active R&D program working on improved drugs, including but not limited to single tablet regimens, in HIV/AIDS.

2. The HCV line should be thought of as secondary, but has a long global tail while delivering massive free cash flows coming to shareholders

I also have covered this recently, so there's no need to repeat it. There are millions of people yet to be treated in the richer countries, and Harvoni and Epclusa can remain best in class for years. Then, the triple therapy that's in Phase 3 can dominate that part of the market.

Since GILD has now disclosed that it cannot project future cash flows from its HCV line, and since it's ramping up in multiple second tier markets such as Brazil and Mexico, I think that the company needs to encourage investors to consider this line secondary in importance to HIV/AIDS.

GILD ceased basic research in HCV two years ago, so only limited R&D costs will affect the profitability of what will remain a huge profit boon for years to come.

But the company needs to argue that "core GILD" deserves an industry multiple, due to the following major R&D efforts in addition to ongoing HIV R&D efforts.

3. Hepatitis B research for a cure

The company is actively developing a TLR-8 agonist candidate entering clinicals soon to join GS-9620, its TLR-7 agonist.

While this is not going to be as large a market as the HCV market, it's still substantial. GILD's Viread is said to be the world's #1 drug to control hepatitis B; the company thus knows this field extremely well.

So, the HCV era winds down with a very large, very profitable long multinational tail; the hepatitis B effort becomes more visible.

4. NASH, the untreated large liver disease market

Since GILD is the world's largest treater of liver diseases, it's natural that it would leverage its knowledge, academic contacts, and other insights into the field to go after treatments for this modern "epidemic." NASH, or non-alcoholic steatohepatitis (fatty liver and its complications), has come from almost non-existence (or non-recognition) 25 years ago to affect millions of people in the Western world. While much of the causation can be ascribed to dietary indulgences, the condition is leading to cirrhosis, liver transplants, and other serious health issues.

With four candidates for NASH, and with GILD professing optimism about three of them (it's backing away from simtuzumab, but one never knows), the upside potential here could be important even for a company with GILD's market cap.

5. Oncology

The company professes a commitment here. The in-licensed Imbruvica competitor, GS-4059, is in Phase 1 and is entering the clinic following formulation-related delays. Other oncology product candidates are in Phase 3 development, and the company continues to do research on combination therapy. Its focus is much more on kinase inhibitors than on immuno-oncology. Any success could end up being material to GILD's financial results.

6. Inflammation and kinase inhibition

Between the in-licensed filgotinib, the antibody GS-5745, and the ASK-1 inhibitor (an intra-cellular enzyme) for NASH, pulmonary hypertension and diabetic kidney disease, GILD has a pipeline of product candidates that address significant markets. While none of these specific indications can replace Harvoni and Sovaldi, if we assume industry-standard success rates, these may pencil in to be cost-effective, intelligent R&D programs.

Interim summary

What's happening is similar to what happened to GILD a decade ago, when it had a multi-year profit surge and then operations and the stock stalled. By 2010 and 2011, the P/E was in the low double digits, down sharply from pre-Great Recession levels. Of course, whether history will repeat in any manner is unknown, but then, the relatively low P/E ended up being a buy opportunity, as the company exploded upward with the Sovaldi product development and then launches of sofosbuvir-based products.

There's a big difference between 2010-11 and now. Then, general market P/Es were also relatively normal; now they are around peak 1929 levels and above peak 1965 levels. So the value case for GILD is superior now than then. I think the company can do a better job refocusing investors on looking past the HCV peak to viewing GILD as a strong pharma company with a potentially extremely valuable HIV/AIDS product line to anchor results, it will be hoped, for many years.

Now, before concluding, I want to make some other observations.

How can GILD regain credibility?

It's not just a matter of show biz and improved messaging. The company has now embarrassed itself over and over. Guidance has been affirmed, then altered. Confusing rebate charges have come and gone. The company has begun to take on a "deer in the headlights" aspect; severe price cuts in Japan were a surprise. The extent of demand drop-off in northern Europe may have been a surprise. The extent of price pressures in the US may have been a surprise. As an example of how poorly prepared the company was for an obvious, tough question, we have this from the Q&A:

Robyn Karnauskas - Citigroup Global Markets, Inc. (Broker)

Hi, guys. Thanks for taking my question. I guess, the question from me after hearing some of the comments about like thinking about volumes slowing or coming down and then thinking about gross to net changing over time is, how are you comfortable that you can provide guidance with these two variables? Do you have any bookends for how low we can go that gives you the comfort? And then, the question is, you affirmed guidance last quarter and lowered it this quarter. What was the one thing you think that really changed your view over the last three months that led to that? Thanks.

Kevin B. Young - Chief Operating Officer

... You know, Robyn, it's really hard.

Then, adding to Mr. Young's comment:

Robin L. Washington - Chief Financial Officer & Executive Vice President

...The other part of your question is, as we said earlier throughout the call, this is a really difficult area to predict... So it's a question we have in ourselves as we think in the outer years how can we continue or can we really guide around HCV revenues... It's very complex.

Well, so it is complex. But as a response, shareholders want to see more clarity. Specifically, it appears clear to me that the company knew some time ago that the HCV field was changing too rapidly for it to guide. So just follow best practices, a la Coke (NYSE:KO) and Alphabet (NASDAQ:GOOGL), and stop guiding. Public guidance is really a form of stock manipulation. Warren Buffett is as usual correct. In business as in medicine, first do no harm. In this case, bad guidance is harmful to investors who buy based on that guidance.

Thus it's my conclusion that the CFO is not up to the job. Investors deserve a clear message and should be presented with the financials with the one-time rebates and the like stripped away so the underlying data can be understood. The misleading guidance should be abolished. What matters, anyway, is the long term, not specifically what happens in any 3-month period. Finally, the non-GAAP stuff has gotten too large and intrusive. GAAP is generally accepted for good reasons. It should be the cornerstone of financial presentations, with all the adjusting factors presented as well for investors to do whatever they want with them.

Concluding thoughts

GILD has less of a handle on its largest profit producer than I thought. Plus, its latest message about China was off-the-cuff and (hopefully) incomplete. So what's the present value of future cash flows from the HCV line? I do not know, and apparently the company does not know. Maybe J&J (NYSE:JNJ) will even think about this and reassess its commitment to a Phase 3 program in HCV.

With GILD's HCV program uncertain from a commercial sense, then even the strong launch of the TAF-based line of HIV/AIDS drugs will not offset HCV-related sales declines in 2017 due to the EU patent cliff.

So it's difficult to see GILD as a prospective outperformer going forward for a while. Plus, it's too large to be a realistic takeover candidate.

Where does that leave GILD longs? Patient, as I've been saying for over a year.

In the real commercial world, however, the company is generating very large cash flows. Even assuming a 30% tax rate, or even 40%, on ex-US profits (which is where most of the profits are booked), the free cash flow yield is large. Using 20% as the tax rate, which could be valid if the company were to find a way to invert for tax purposes or with a very generous US tax holiday, the FCF yield is enormous. That's a rarity given the ability to, I think, forecast very large future profits from the global sales of HCV products and the ongoing HIV/AIDS line.

With the share count headed to 1.3 B or less, GILD remains a relative value play in a growth sector of the economy. As I've indicated, after buying some more stock in the $80s some time ago, I've noted the ongoing insider selling even at these levels and lack of insider buying, and have seen the management changes, and thus have avoided any new investments in GILD or any biotechs for some time. Yet, as with computer companies going back years, innovative companies with strong FCF in dynamic fields go through these sorts of issues over and over again. So my plan with GILD for now is to just sit tight and let the brokers make their commissions as people and machines exchange shares back and forth without any real knowledge of what the future holds for GILD's profit stream.

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.

Additional disclosure: Not investment advice. I am not an investment adviser.