Gilead May Represent A Rare Value Opportunity In Biotech

| About: Gilead Sciences, (GILD)
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Summary

Investors are understandably skittish about Gilead’s long term revenue prospects because of the Gilead’s major reliance on revenue from sofosbuvir.

Gilead is aging and growing out of the biotech class and more into the established pharma company class.

Market pessimism driven by revenue concentration is limiting stock price.

Yet there are some considerable risks that should be taken into account before making an investment decision.

By Bernardo Teixeira and Liam Synan of NU Student Value Fund.

Following a very weak start of a year, value investors should start debating whether the Gilead Sciences' (NASDAQ: GILD) current price represents an opportunity (down 15% YTD). Overall we do believe GILD to be one of the best investments in the pharma sector today,l however we would like to leave the question of whether Gilead is a "value investment" open to readers. Our objective in this article is to show some of the reasons we think GILD may be a good investment and some of the key idiosyncratic risks of the firm.

Thesis Highlights

  • Marquee product is widely considered "worth it"

Exorbitant price ($84,000) justifiable when considered as a viable alternative to a liver transplant. The average "all-in" bill to the insurer for a liver transplant was estimated at $739,100 in 2014.

  • Balance sheet offers high degree of flexibility

Gilead has nearly $25B in cash on its balance sheet after raising another $10B recently in September. By staying out of the deal making frenzy of the past year, they've created cash reserves which grant significant innovation-sourcing flexibility.

  • International markets are opening

Sovaldi/Harvoni markets in the EU5 and Japan continue to open further to Gilead at favorable price points. HCV prevalence is estimated at 9 million in Europe and 1.3 million in Japan. Emerging markets like Latin America, Eastern Europe and Asia are expected to contribute more to overall pharma growth in the next ten years than any other segment. These countries are home to an estimated 80 million HCV sufferers.

Thesis Risks

  • Populist backlash over drug prices is worrisome to sofosbuvir franchise

Senatorial inquiries recently revealed that prior to being bought out by Gilead for $11B, Pharmasset received federal research grants. While Gilead acquired Pharmasset with significant phase III trial risk, initial risk was partially borne by taxpayers. This weakens the argument for Sovaldi's price, and threatens pricing generally.

  • International production of generics pre-patent expiry threatens pricing

While Sovaldi is patented through 2029 in the US, India recently approved the manufacture and distribution of generic versions of Sofosbuvir. The more widely distributed the product , the greater the pressure on price in "full fare" markets.

  • New product development is fraught with risk at all stages

The all in cost of bringing a new drug to market was estimated at $2.5B in 2013 and demand and pricing are not always stable after successful approval.

Pipeline and Current Products

Phase\TA

HIV/AIDS

Liver

Hematology

CV

Respiratory

Other

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4

0

3

1

II

2

6

3

3

4

2

III

0

2

4

1

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Submitted

3

0

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0

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Marketed

5

2

1

2

1

Management incentives are aligned with shareholder interest

CEO Compensation stands at 10% salary, 24% bonus and 66% equity, while general executive compensation stands at 15% salary, 22% bonus and 63% equity in 2014. Bonus incentives are well aligned with short term growth, though the specific measure of success varies by the individual executive's functional area. The equity awards are split 50-50 between long term performance based incentives and tenure based option awards. In total, executive compensation is about 60% performance based through bonuses and stock awards and 40% based on salary and tenure.

Gilead's competitive posture is strong in their main competency areas

Gilead maintains a lead in the HCV market with nearly 30 times the number of new scripts as Abbvie's competitive product Viekira Pak. Further, they've proved adept at extending patent life in their HIV franchise through the use of reformulations and recombinations. There is risk associated with this move because backlash against pricing builds quickly when patents are for new combinations and not new science.

Gilead will lose some patents in 2017 & 2018 in their HIV franchise, but are fighting back against this through the use of patent extension tactics. If these don't work, there's also a reasonably strong suite of products, with 10 in PI, 20 in PII and 10 in PIII. Given an average of 50% success for transitions from phase 2 to phase 3 and from phase 3 to market, and an average of two and a half years per phase, Gilead can expect to place between 5 and 10 current pipeline products over the five year forecast period, and steadily after that if R&D efforts continue similarly.

When the market responded to Hillary Clinton's proposal to force biopharmaceuticals to lower drug prices, Gilead's strong historical performance and dominating market share was not enough to prevent its stock from sliding 23% off its all-time high of $123.36 per share. Despite this sharp change of investor sentiment towards biotech companies, Gilead is in a great position to bounce back off its recent lows, and its current price presents an attractive entry point.

Marquee product is widely considered "worth it"

Gilead possesses a market share of over 90% of American HCV patients. Their premier HCV drugs, Solvaldi and Harvoni, are superior to those belonging to the competition. These drugs cost about $84,000 for a full treatment, which is inexpensive when compared to the average bill to the insurer for a liver transplant, estimated at $739,100 in 2014. Sovaldi and Harvoni are curative in nature, as opposed to drugs that require multiple treatments for several years of patients' lives. For a one-time cost of $84,000, patients can be completely cured of Hepatitis C. If Hillary Clinton does get elected and manages to push pharmaceutical reform legislation through Congress (which is a fairly big "if"), Gilead's drugs should be protected from regulation because they are widely considered to be worth the high price.

In addition to being highly effective, Gilead's hepatitis C drugs are very safe compared to the competition. Just last week the U.S. Food and Drug Administration warned that Abbvie Inc's (NYSE:ABBV) new hepatitis C drugs, Viekira Pak and Technivie, may cause serious liver damage to certain patients. This is a huge blow to the company that markets these drugs as low-cost alternatives to Sovaldi and Harvoni. Gilead saw a bump in its stock price following the news, suggesting they will maintain their firm hold on the HCV marketplace.

Gilead is developing a Pan-Genotypic Cure for Hep C

Gilead's strong product pipeline is topped off by a combination sofosbuvir and GS-5816, the first all-oral, single tablet regimen that seeks to cure all six genotypes of hepatitis C in twelve weeks. They've submitted a New Drug Application to the FDA on October 28, and an approval could prove vital in fighting off the constant threat of losing market share to the competition. The drug has been put on the fast track toward regulatory approval-the FDA has granted the drug a Breakthrough Therapy designation, and the EU is also accelerating their assessment. The approval of this drug should help Gilead increase slowing HCV revenue growth, which was down 2% to $4.8 billion from Q2 to Q3.

Gilead built a strong balance sheet, offering options and staying power

Gilead's FY 2014 was an absolute blowout, leaving them with a huge amount of cash on their balance sheet. After raising $10 billion in senior unsecured notes last quarter, Gilead is now sitting on $25.1 billion of cash and marketable securities, leading to speculation over what the company plans to do with the money. An acquisition could prove to be a significant revenue driver going forward, considering the company's impressive track record. Sovaldi and Harvoni are the products of Gilead's $11 billion purchase of Pharmasset in 2011. Acquiring a company in the hepatitis B or HIV space could help them completely corner the market, or they could try to enter the nonalcoholic steatohepatitis (NYSEARCA:NASH) market, which affects an estimated 2-5% of Americans.

Although Gilead can make a huge acquisition to fund new product development, that doesn't mean that they should. By staying out of the deal-making frenzy of the past year, they have avoided paying sky-high premiums on overvalued biotech companies. President and COO John Milligan recently described Gilead at Morgan Stanley's Global Healthcare Brokers Conference as a "value sensitive company," and Martin stressed the importance of looking for the companies that they could add more value to than anyone else in the market. The value in the biotech industry simply hasn't been there, so they have increased their investment in their own efforts by ramping up R&D and buying back stock. Gilead has spent a total of over $3.1 billion on R&D over the last 4 months in a market where product development is the key differentiator. Gilead is in a great position to weather the biotech beat-down; their cash stockpile creates a margin of safety that will allow them to continue to innovate even after HCV sales are expected to peak.

International markets are opening and there is massive unmet need

Since the start of 2015, Gilead has treated 80,000 hepatitis C patients in the EU, which brought in $870 million in Q3 revenue. In the UK, the government's health technology assessment agency found Harvoni to be effective in treating chronic hepatitis C and is recommending that the National Health Service fund Harvoni25. Regulatory approval by the EU means potential access to 9 million infected individuals living in Europe. Japan has another 1 million people living with chronic HCV, a market that contributed to $454 million in revenue last quarter.

There is currently a huge unmet need to cure the world's population of hepatitis C, as a very small portion of diagnosed patients have only just been treated. Emerging markets such as Latin America, Eastern Europe, and Asia are expected to contribute more to overall pharma growth in the next ten years than any other segment. These regions are home to an estimated 80 million HCV sufferers. While approaching these markets, Gilead's executives realize how their revenues could be constrained by country-specific budgets, rather than the number of patients. This will make it difficult to tap into the sheer size of the global HCV market, but they have been able to negotiate favorable price agreements with foreign governments thus far.

Thesis Risk Factors

1. Politicians and public sentiment are opposed to expensive drugs

A large risk that has been becoming more and more apparent in recent years to pharmaceutical companies is the public and political backlash against high drug prices. The increasingly common strategy of buying the rights to common drugs and raising the price has brought criticism to drug companies such as Valeant and Turing. These cases have brought to the forefront in politics the importance of bringing drug pricing reform through congress. Democratic presidential nominees Hillary Clinton and Bernie Sanders have both stated that caps need to be put on drug prices. Additionally, Clinton and Sanders have both discussed many different controls to be put on the pharmaceutical industry, from R&D investment requirements on profits to increasing the power of Medicaid to negotiate drug prices.

The possibility of comprehensive drug pricing reform is debated between experts in the industry. Some state the fact that presidential candidates have specifically been speaking on the subject, as well as public attention, point towards more controls being put on the industry in the coming years. Others state that the amount of progress that has been made on developing new drugs in recent years dramatically reduces the changes of significant controls being placed on the industry. Regardless of differing opinions, the fact remains that the backlash against high drug prices presents a significant threat to GILD.

Sovaldi, specifically, may come under increased scrutiny as senatorial inquiries recently revealed that prior to being bought out by Gilead for $11B, Pharmasset received federal research grants. While Gilead acquired Pharmasset with significant phase III trial risk, initial risk was partially borne by taxpayers. With the increasing amount of public scrutiny of the activities and profits of drug companies, this fact could have a detrimental effect on the case for the price of Sovaldi.

2. Market forces and reimbursement rates are squeezing prices too

GILD faces pressure on prices from numerous angles. There has been an increasing populist movement against drug prices, and consumers are becoming ever more powerful in negotiating down the prices of drugs. The Patient Protection and Affordable Care Act required GILD to further rebate or discount prices of treatments paid for by Medicaid. The minimum base rebate amount owed to Medicaid, ADAPs, and other Public Health Service entities was increased by 8%. GILD is required to provide a 50% discount on products sold to patients while they are in the Medicare Part D "donut hole."

Prices were marked down for private payers in the United States in order to obtain formulary status or to expand access to HCV products for patients. Abroad, GILD will rely on government reimbursement for treatments, as many patients will not use prescription drugs that are not reimbursed by government healthcare plans. Especially in recent years, these governments have been requiring increasingly heavy discounts on drugs added into government reimbursement plans. This is especially apparent in the European Union. Lastly, GILD faces increasing price pressure from competition. Nearly all GILD drugs face some degree of significant competition from global and/or specialty biopharmaceutical companies.

3. Intellectual property on key assets threatened

There is a risk in the patents that GILD currently holds on Harvoni and Sovaldi could be jeopardized by other patents and patent applications owned by other parties. GILD has disclosed that there are other entities that hold patents or patent applications that theoretically could be used to limit or prevent GILD's commercialization of Harvoni and Sovaldi. This is not an imminent risk, as there have not currently been any attempts to use these intellectual property rights to restrict GILD's sale of Harvoni and Sovaldi, but the possibility is a factor to be considered. This risk is complicated by the fact that patent applications remain confidential for a period of time, so we cannot be sure of how likely it is that a current patent application may come out as detrimental to GILD's intellectual property claims to Harvoni and Sovaldi. If any such action against GILD were successful, it would be hugely detrimental to GILD's revenues.

4. The HIV product franchise faces patent expiry concerns

The HIV franchise's future relies increasingly upon Gilead's continued ability to protect patents through reformulations and recombinations. As patents on HIV products like Viread and Truvada expire from 2018-2021, Gilead is unveiling products like Genvoya and R/F/TAF. These products aren't really new science or radically different treatment methods. Rather, they're fixed dose combinations that minimize harmful side effects of the active ingredients. While these are welcome developments surely, Gilead's ability to attract a pricing premium is reliant on patents being granted for what amounts to only incremental improvements. This is an uncomfortable position because insurers and are rarely obligated to include only the best in class treatment on their formularies, especially when there's no mortality and morbidity differential.

Should Gilead be Considered a Value Investment? Here are some factors that should be taken into consideration

Gilead's revenue prospects are strongly reliant on a few products, and this has caused investors considerable concern. This pessimism is a bit overstated and is driving the stock price below where it ought to be.

Market pessimism driven by revenue concentration is limiting stock price

Investors are understandably skittish about Gilead's long term revenue prospects because of the Gilead's major reliance on revenue from one molecule: sofosbuvir. In 2015, its produced more than 50% of the company's revenue and is the linchpin of Gilead's growth going forward. More broadly, Gilead is strongly reliant on only two franchises: HIV and HCV. Gilead generates almost 90% of their revenue in these two spaces. Investors have noticed, and their stellar short term performance is always tempered by the fear that it may not be sustainable. This pessimism prevents Gilead from achieving its fair value, but we believe as other revenue streams materialize, investors will realize Gilead's intrinsic value.

Gilead is priced well below biotech peers and below pharma peers

Gilead is aging and growing out of the biotech class and more into the established pharma company class. Biotech companies can trade at sky high earnings multiples in the 30X-50X range because they're generally quite small but with major potential. Gilead is too large to trade at those multiples, but its even trading well below other pharmaceutical giants. This implies that the market is not valuing

Not a Value Investment? Here are some factors against that statement

Change of capital structure pushing down cost of capital

In Q3 Gilead issued $10 billion in new debt while simultaneously buying back close to $7 billion in stock. This change in its capital structure has pushed down its weighted average cost of capital to a level that might not be sustainable. If Gilead acquires another company, its hard to say what that will do to their debt and equity levels. An increase in the discount rate could have adverse effects on our current valuation of Gilead.

Biotech is cheap, but maybe cheap for a reason

Hillary Clinton is determined to fight high drug prices, and she's proud of the enemies she's made doing so. While we argue that Gilead's HCV drugs should be safe from regulation, its HIV franchise could be affected. The Turing Pharmaceutical's drug that sparked the whole drug pricing debate is intended for HIV patients, a core target market for Gilead. The company stands to lose a sizable chunk of revenue if Hillary Clinton is elected and passes drug regulation through Congress

Valuation

In order to quantitatively estimate the factors that would have to become true in order to justify Gilead's current market price, we have used a reverse DCF model (for more information, visit my profile page). In this approach, we have identified what GILD's asset growth and return on invested capital would have to be for the next five years in order for them to be fairly valued today.

Presently, there are 18 street analysts that follow Gilead. The average expectation is that the company will grow its top line at around 32% this year and 9% in 2016. Assuming average analyst expectations are roughly correct and asset turns remain approximately the same as the historical average, this implies asset growth for the following two years will be in the range of 23-30%. Gilead' asset growth is further estimated in the graph bellow for 2017-2019, assuming a steady decrease in the growth rate as the company matures.

(Source: All market implied graphs were prepared by the author)

If the asset growth forecast presented above is roughly correct, it would imply that in order to justify its current valuation, GILD's return on invested capital (NASDAQ:ROIC) would have to decrease significantly. As you can see in the graph below, the ROIC would have to decrease from close to 121% LFY to around 15% in 2019. In our view, the market is currently being overly pessimistic about GILD' future, as both implied asset growth and ROIC rates are below historical averages and may not fully price in all the growth opportunities that this company has.

(Source: All market implied graphs were prepared by the author)

Valuation Details:

For further inquiries in the valuation details please let us know directly.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.