Gilead Sciences - Underneath The Smoke Is Long-Term Potential

| About: Gilead Sciences, (GILD)

Summary

Gilead Sciences earnings were clouded by a rapid drop in its Hepatitis C revenues which have hurt the company's profits.

The company has impressive future prospects as it continues to buy back shares, invest in its pipeline, and switch patients over from its old HIV drug.

The company has immense long-term potential and I recommend investors purchase it at the present price.

Introduction

On July 25, 2016, Gilead Sciences (NASDAQ: GILD) reported its 2Q 2016 earnings. The company reported product sales of $7.7 billion along with diluted EPS of $2.58. That gives the company a P/E of 8.58 based off of its Monday closing price. However, despite this low valuation, the company's stock is down almost 4% after hours after dropping earnings and revising its full year guidance briefly down.

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Gilead Sciences Logo - Smarter Analyst

Gilead Sciences is a research-based biopharmaceutical company that focuses on the discovery, development, and commercialization of new medicines. The company spends several billion per year on research and development both on compounds that it acquires from other companies and compounds that it finds in house. The company's most successful recent acquisition was its $11 billion purchase of Pharmasset in 2011 that gave rise to its current Hepatitis C franchise.

The company's earnings presentation had several things to worry about and several things to get excited about. However, at a P/E of less than 10, when the market as a whole (NYSEARCA: SPY) is trading at a P/E of 25 and reporting a 9% earnings drop for the Q1 2016, it is not unreasonable to expect Gilead to have several things to worry about. And the company has a large number of prospects that I expect will make it a successful and profitable company in the long term.

Financial Highlights

I am going to begin by providing an overview of Gilead's financial results. From here, I will discuss the geographic breakdown of these results before discussing major changes and the company's pipeline. After this, I will finish up by attempting to value the company.

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Gilead Sciences Financial Results - Gilead Sciences Second Quarter Investor Presentation

To start, Gilead Sciences saw its net production sales decline 6% from a year ago driven mainly by a 19% decline in the company's Hepatitis C franchise. However, the company managed to increase its HIV revenues by 15% making up for a substantial portion of the decline in HIV revenues. As a result, the company's net decline in antiviral products was 7%. For the quarter, 93% of the company's revenue came from its antiviral drugs while the rest came from the company's new expansion lines such as its cancer drug Zydelig.

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Gilead Sciences EPS Change - Gilead Sciences Second Quarter Investor Presentation

However, despite the decrease in the company's revenue, the company's earnings remained strong. The company had second quarter earnings of $3.08 per share up from the first quarter this year and just a 2% decline over the past year. The small magnitude of this decline can be attributed to the company's share repurchase program, which has spent billions over the past year. This share repurchase program means that its earnings are being spread out over fewer shares increasing their amount.

Geographic Breakdown

Now that we have discussed Gilead Sciences' financial highlights, I will discuss the geographic breakdown of the company's results.

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Gilead Sciences Revenue Breakdown - Gilead Sciences Second Quarter Investor Presentation

This next image shows the breakdown by region of Gilead Sciences' 2Q 2016. The largest region by far continues to be the United States, which made up 64% of the company's revenue. This region, along with the company's second largest region, Europe, both experienced significant decrease in year-over-year revenue with a 12% drop from the United States and an 18% drop from Europe.

This decrease in growth was partially made up by the company's growth in sales in Japan and Other International regions. In the future, I expect that these regions will become a much larger portion of the company's revenue. The reason for this is the company's new pan-genotypic Hepatitis C drug, Epclusa, which was approved just a few weeks ago.

In international markets, where the cost of Hepatitis C is much lower, determining the genotype of the disease is a difficult and expensive task. Epclusa negates the need for this genotype testing allowing the company to dominate the market in these regions. More importantly, Epclusa's lower introductory price compared to competing treatments along with the fact that Epclusa is the first single pill regimen approved for patients with genotypes 2 or 3 mean that the drug has a huge potential.

This potential is evident from the fact that the drug racked up $64 million in sales in 2Q 2016 in roughly 3 weeks. With 52 weeks in a year, that means that the company is already annualizing at $1.1 billion in annual sales. More importantly, these are sales from just the United States. The company expects that the pricing and reimbursement process in Europe could take up to 12 months to complete, and when it is completed, this should add at least another few hundred million dollars to Gilead's annual sales.

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Spread of Hepatitis C - Fix HepC

The above image shows the spread of Hepatitis C across the world. As you can see, Hepatitis C affects only roughly 7 million people in the United States compared to an expected 25 million people in China who have the disease. Another 15 million people in India and 5 million people in Indonesia have the disease. So why is the United States the largest source of sales? Because in terms of healthcare, it is the richest.

However, these other countries all have millions of people with the disease. And many of them like China or the European countries tend to have government run healthcare systems. As a result, Gilead Sciences signing a single major contract with one of these countries could result in potentially billions of exclusive revenue. That is an immense amount of revenue that could lead to significant profits.

Major Changes

Now that we have discussed Gilead's financial highlights before discussing the geographic breakdown of this revenue and the potential that may come from the company's pan-genotypic Epclusa, it is now time to discuss major changes in the quarter.

Above we already determined annualized revenue for the company's pan-genotypic Epclusa drug. Based on the few weeks of sales data we have, I expect that the company will have roughly $1.1 billion in annual US revenue from Epclusa. Since 64% of the company's revenue comes from the US, it can be expected that once the European and other negotiations are finished, the drug's revenue will annualize at roughly $1.7 billion.

However, Epclusa isn't the only change from the quarter. There are a number of other significant changes that occurred in the quarter.

The first was one of the major sources of the company's profit decline for the quarter. The company has updated its full year 2016 guidance to have its R&D expenses go up by roughly $0.5 billion.

That represents an announcement of a 10% increase in R&D expenses for the year. While the company did not specify the reason for the increase in R&D expenses, Gilead has an impressive history of successful R&D programs, which we will discuss in the pipeline section. A sudden increase in R&D expenses means that Gilead might have something on the horizon.

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Gilead Sciences Margins - Gilead Sciences Second Quarter Investor Presentation

The other thing I like to see is Gilead's increase in net margins. The most recent quarter had higher net margins than any other. And while a 4% increase in net margins might not seem like much, it shows two very important things. First, the company's effective tax rate remained the same while SG&A expenses have been revised downwards. This high net margin shows the company has been looking at rapidly cutting costs and should help the company's earnings.

More importantly, the higher net margins show that the company is making minimal price concessions. The company currently has to deal with competition from Merck (NYSE: MRK) and AbbVie (NYSE: ABBV) and has been forced to cut its drug prices to compete. One of the big fears is that competition will drastically hurt Gilead's revenue and therefore its earnings. Higher net margins shows Gilead's success is maintaining prices.

Pipeline

Throughout this article, we have discussed Gilead's financial highlights along with the geographic breakdown along with the major changes of the company, it is now time to finish up discussing the company's pipeline.

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Gilead Sciences Pipeline - Gilead Sciences Second Quarter Investor Presentation

While the company's pipeline also has oncology, inflammation, and other assets, the company's pipeline primarily focuses on HIV, and liver diseases. The company has several Phase 3 oncology assets and one Phase 3 cardiovascular asset, however, as we saw with the company's much fabled oncology drug, Zydelig, bad side effects can hold back the potential of any drug.

What the company does however are new TAF based HIV drugs. The company is cutting the prices of TAF drugs and increasing the prices of older drugs to convince patients to switch to the new TAF drugs. Since HIV is an uncured drug, and once a patient gets started on a drug they often stick with it, moving patients to the company's new TAF drugs helps its long-term potential. The reason for this long-term potential gain is the TAF drugs have patent expirations in 2022 as opposed to 2017 for the present HIV drugs. This later patent expiration will help Gilead's HIV earnings remain strong and continue growing.

More importantly, the company's largest sources of potential are in the liver disease market in both Hepatitis B and NASH. The company has one late Phase 3 asset in Hepatitis B and a slew of Phase 2 assets in NASH. Hepatitis C is currently the largest cause of liver transplants with NASH in second place. However, as Hepatitis C patients are cured, NASH is expected to become the largest source of liver transplants.

Gilead Sciences is currently the largest player in the NASH pipeline space. History has shown that companies that invest the most in their pipeline will eventually dominate that sector, especially companies like Gilead Sciences with a strong track record of successful pipeline investments. With the NASH market expected to reach $1.6 billion in 2020, it is reasonable to assume that Gilead Sciences will dominate a large portion of this market bringing new and increased revenue.

The potential in the Hepatitis B market is also immense. Gilead Sciences has currently spread its Hepatitis B pipeline across three targets and hopes to develop a cure for Hepatitis B. The global Hepatitis B market is expected to grow to $3.5 billion by 2021 and Gilead Sciences is well positioned to take advantage of this market.

More importantly, Hepatitis B causes half a million deaths annually through 50 million new cases. Curing this disease, will give Gilead Sciences the same pricing power it had in the Hepatitis C market. That will bring the company tens of billions in new profits and allow it to establish another successful franchise.

Gilead Valuation

Alright. Throughout this article based on Gilead Sciences' 2Q 2016 earnings, we have discussed the company's financial highlights, along with the geographic breakdown of these earnings, the major changes from the quarter, and the company's pipeline.

Now let us combine all of this together to attempt to value Gilead Sciences. It is important to understand that while I will make the best attempt to value the company in my assumptions and explain them where reasonable, a lot of these assumptions involve numbers that may or may not hold true and are very difficult to accurately estimate. I will attempt to keep my estimations conservative.

In the most recent quarter, Gilead Sciences had $3.2 billion in HIV sales, a significant increase in sales, annualizing at $12.8 billion for the year. The company's sales increased by 15% year over year and this $3.2 billion was responsible for roughly $1.7 billion in profits ($6.8 annually). Let us attempt to now value the company's HIV franchise.

Let us assume the company's HIV earnings continue to grow at half of the rate it grew in the last year (7.5% annually). Let us assume this growth continues until 2022, when the company's TAF franchise hits its patent expiration. That means that the franchise will throw off $60 billion in profits for this time frame. At this point, I will assume that the company doesn't manage to do what it did for TDF and replace patients going off patent. Instead its market share in the United States drops from 50% currently to just 10%.

That means at this point, the company's HIV franchise, which will be providing $10.5 billion in annual revenue will stabilize at $2.1 billion in annual profits. Currently, the S&P has a P/E ratio of 25 as we saw in the article's introduction. Again, to be conservative, let us give this franchise a P/E ratio of just 15 or 60% of the market's present valuation. That gives this franchise a valuation of $30 billion at this point which means we can value its entire HIV franchise at $90 billion ($60 billion in profits until 2022 along with $30 billion after that when the franchise stabilizes).

The company's Hepatitis C franchise is much harder to value. The company had $4 billion in Hepatitis C sales for the quarter down 19% year over year. The company's Hepatitis C franchise will never stabilize because its drug doesn't treat patients, it cures them. That cure means that it doesn't have patients coming back. More importantly, the company's new pan-genotypic drug along with slow international startups and European negotiations mean that the company's sales shouldn't continue to drop at 19%.

However, let's assume a worst-case scenario that sales continue to drop at 19% yearly to 0.

Year

Annual Hepatitis C Sales

Decrease From Prior Year

2016

$16.00 billion

-19%

2017

$12.96 billion

-19%

2018

$10.50 billion

-19%

2019

$8.50 billion

-19%

2020

$6.89 billion

-19%

2021

$5.58 billion

-19%

2022

$4.52 billion

-19%

2023

$3.66 billion

-19%

2024

$2.97 billion

-19%

2025

$2.40 billion

-19%

2026

$1.95 billion

-19%

2027

$1.58 billion

-19%

2028

$1.28 billion

-19%

2029

$1.03 billion

-19%

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Gilead's Sovaldi patents expire in 2029, so at this point, we will assume that the company's sales drop to zero (despite the company having other HepC drugs). Over the next 13 years, assuming the staggering 19% drop in annual sales, the company's Hepatitis C sales will total $80 billion. This should provide roughly $45 billion in profits, which means a total of $135 billion in profits from the company's combined Hepatitis C and HIV franchises.

As I mentioned above, the company's other franchises are relatively small. However, even using conservative valuations, that is the company's HIV market share drops by 80% upon the expiration of its patents and the company's Hepatitis C earnings continue to drop 19% year over year, the company's valuation should still be 10% above the company's present market cap.

To me, this represents a worse-case scenario for the company's valuation. This assumes no value to the company's pipeline or no value to the company's other drugs which despite being earning much less than the company's other drugs are still earning more than $1 billion in annual profits.

This shows why under the smoke surrounding Gilead's decreasing earnings, I think that the company still has immense long-term potential. I currently have a large position in Gilead Sciences and am looking to increase it if the company's stock price drops after earnings. With the market at its all-time highs, Gilead Sciences represents my favorite investment. I recommend investors invest in the company at present prices.

Disclosure: I am/we are long GILD, ABBV, SPY, MRK.

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.