Gilead Sciences (GILD) has been the laggard in the big pharma segment. Concerns about political interference with premium drug pricing and competition for its Hepatitis C franchise is to blame.
Many investors have penalized management for not pursuing large deals with the strong cash flows being generated, but so far management appears to be right holding off. Valuations of potential targets have only gotten cheaper as a potential big "rushed" deal might have been misplaced.
While sales and earnings are coming down, management continues to invest heavily into R&D and bolt-on dealmaking, securing a bright future. Given the decent cash flow yield, strong balance sheet and healthy pipeline, a scenario analysis suggests that current levels look quite appealing.
Sales Are Tending Down
When Gilead reported its second-quarter results, it was clear that sales were breaking a long-term growth trend. The company posted second-quarter product sales of $7.65 billion, a near 6% drop on an annual basis. Fortunately, the company expects revenues to stabilize in this area. As total product sales are seen at around $30 billion this year, the run rate for product sales comes in at between $7.2 and $7.3 billion in Q3 and Q4 of 2016.
The key growth in recent years has been driven by the Hepatitis C franchise which is now suffering from competition and pressure on pricing. The other reason for the decline in sales is a fortunate one. As these drugs cure patients instead of treats them, the patient target group naturally declines.
Sales of Harvoni, Sovaldi and Truvada as a group came under a lot of pressure. Harvoni's sales fell by 29% on an annual basis to $2.56 billion in the second quarter. This was in part offset by a 5% increase in sales of Sovaldi to $1.36 billion, and an 11% increase in Truvada, whose sales hit $942 million. Combined, the Hepatitis drugs generated $4.86 billion in sales, a roughly 15% decline on an annual basis.
Following this decline, the total liver franchise makes up 62% of total sales for the quarter. Note that the reliance on these drugs still stood at 70% of total sales in the corresponding period in 2015.
It is a guess what these nearly $20 billion in revenue streams will be worth, as it all depends on the rate of decline going forwards. With company-wide operating margins hitting 60% of sales, the profit contribution from these drugs still comes in at roughly $12 billion per annum.
If we assume that this revenue stream will decline in a linear fashion towards $5 billion some five years ahead in time, I see cumulative earnings of $45 billion for these products. If we attach a modest 5 times multiple to the terminal operating earnings of $2-$3 billion, I see another $10-$15 billion valuation, resulting from those earnings streams, suggesting that Gilead stands to make another $60 billion in operating earnings from these drugs.
In an extreme adverse scenario, sales could fall to $2 billion in three years' time. That results in cumulative operating earnings of some $25-$30 billion. On the bright side, if it takes up to 10 years for sales to gradually fall towards zero, cumulative cash flow generation can be huge. A $100 billion estimate in cumulative operating earnings seems justified in that case.
The pace of sales declines is extremely important. In an adverse scenario, operating earnings from the franchise come in at a cumulative $25 billion, while it could become $100 billion in a favorable case. Given these scenarios and assuming a 30% discount to factor in taxes, I end up with a $18 billion valuation for the adverse case, a $40 billion valuation for the expected scenario and a $70 billion valuation for the optimistic outcome.
Gilead Is Not A One Trick Pony
While Gilead is best known for its Hepatitis franchise, it has a lot more assets. The HIV franchise consists out of Atripla, Stribild, Complera, Genvoya and Viread. Sales of these drugs rose to a combined $2.06 billion in the second quarter, a 10% increase compared to the year before following the introduction of Genvoya which contributed $300 million in quarterly sales. New products such as Epclusa, Descovy and Odefsey, in large part modifications to existing treatments, contributed another $180 million in sales.
The overall HIV franchise is quite large as well, running at a sales rate of $8 billion per year. Unlike the Hepatitis C franchise, the unit continues to grow at a modest pace and seems more stable. While a typical 5 times revenue multiple might seem high, we can simply calculate the value under a few scenarios as well.
In an adverse case, a 2.5 times sales multiple seems conservative. In the expected scenario, a 4 times multiplier is applied, while a favorable outcome might value the franchise at 6 times annual sales. This translates into a valuation of respectively $20 billion, $32 billion and $48 billion under the different scenarios.
Gilead furthermore has a small portfolio of other drugs, including Letairis, Ranexa and AmBisome, among others. Revenues of these products come in at a rate of $2 billion a quarter, and these sales are fairly constant. If we apply the same multiples for the HIV franchise, a valuation of $5 billion in an adverse scenario, $8 billion in the expected scenario and $12 billion in the favorable scenario seems warranted.
The Valuation, A Lot Of Uncertainty
On things unclear, Gilead is an uncertain investment with many respects. Trends about pricing, volume erosion and the development of the pipeline are all highly uncertain. The company does stand at a solid footing, however, holding $24.6 billion in cash and equivalents. After backing out the debt, the company net holds a cash position of $1.2 billion.
While second-quarter profits fell by a billion compared to the year before, they still came in at $3.5 billion, equivalent to $14 billion per annum as it should be mentioned that some incidental items depressed earnings. With 1.33 billion shares outstanding, earnings per share comfortably exceed $10, at a time when the stock trades at $77. This results in a less than 8 times multiple, while the company continues to throw off cash and actually has a modest net cash position as well.
If we do the sum of the parts for the Hepatitis business, the HIV business and the remaining drugs, I come up with the following numbers. In an unfavorable scenario, we end up with a $43 billion valuation, assuming the worst for all 3 divisions. After adding back $1 billion in net cash, and anticipated $3 billion in quarterly earnings, this yields a $47 billion valuation. Note that this is equivalent to just $35 per share but it assumes a very poor outcome, with no value being attached to the pipeline.
The expected scenario results a $63 per share valuation while the favorable scenario yields a $100 valuation. Again, these valuations do not attribute any value to the company's pipeline. Note, however, that R&D expenses run at a rate of $5.5 billion per year at the moment. It can reasonably be expected that some real value can be delivered going forward from these drugs. The company has numerous drugs in development including drugs for inflammation, cardiovascular, hermatology/oncology and other liver diseases.
Valuing this pipeline is a hard thing as it all depends on approval, timeline and expected sales. Given the extent of the program and promising progress in some areas, I am awarding the pipeline a valuation of anywhere between $25, $50 and $75 billion across the three scenarios. If we add this pipeline value to the current business, I end up with a valuation of $50 for the stock in an unfavorable scenario, $100 in the expected scenario and $150 if things go really well.
Final Thoughts, Worth Owning
In the article, I tried to give a fair opinion about the prospects for Gilead but as you can see in the expected outcomes of anywhere between $50 and $150 per share, valuing a drug/biotech company is a daunting task. The added political and price uncertainty does not make it an easier job. This comes on top of the troubles of estimating which drugs get FDA approval, when competition kicks in and how severe competition may be, as well as uncertainty regarding (political) price developments.
At $77 per share, the company supports a $100 billion valuation and a 2.5% dividend yield as Gilead has plenty of cash and cash flow generation to support the dividend, share buybacks and investments into the pipeline. Given the health yield, significant sales discount versus the rest of the industry, strong cash flow generation and great track record, I believe that management deserves some credit and should be given the benefit of the doubt.
While the timing of some buybacks can be debated, you may also credit management for not rushing to make a huge multi-billion deal because it comes under pressure from investors. While many commentators would like to see Gilead buying Medivation (NASDAQ:MDVN), it seems that management remained disciplined in a bidding war. The focus is clearly on organic improvement to the pipeline, combined with bolt-on deals. This includes the $400 million upfront payment for Nimbus in a potential $1.2 billion deal, announced earlier this year. The deal with Galapagos is another good example of this strategy.
At current levels, given the scenarios outlined ranging anywhere between $50 and $150 per share, I feel that investors have sufficient risk-reward potential despite the political uncertainty.
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.