My approach to valuation
I currently own no position in Gilead Sciences (NASDAQ:GILD) but was impressed by their recent results, their good balance sheet and yet puzzled by the tepid reaction of the market via the falling share price.
In order to understand if a stock is trading at a favorable value I like to consider a hypothetical scenario where I am wealthy enough to buy out all the shares in a business. I appreciate the approach is by no means perfect but it gives me some idea of value and it is an approach used by many buyers of small private businesses.
Today GILD can be purchased outright for $125B. GILD has $23B bank debt. GILD has $25B cash on its balance sheet. So cash and debt essentially cancel each other out. Free cashflow of $20B was achieved in 2015.
So a buyer of GILD can take the view that he is buying a business for $125B with a free cashflow stream of $20B per year or about an 18% yield.
But what does a real shareholder get?
First of all you are not the owner of the business and have no real discretion on how surplus cash generated should be used. You must trust that the GILD management will pass on this bonanza and/or invest it wisely to grow your slice of equity in the business. Over the course of 2015, GILD management has returned substantial Free Cashflows to investors in the following ways:
- repurchased $10B worth of stock
- repurchased $4B worth of warrants (that reduced share count)
- paid out $1B and change in dividends
So minority shareholders seem to be getting a good deal. In 2015, GILD returned $15B to them. This is a massive 12% combined dividend and buyback yield. Not quite the full 18% yield that total ownership of the business would command but it's a great overall yield.
Was the buyback effective?
Per Google Finance, the current share count was about 1.47B on Dec 31 2015 and on Dec 31 2014 the share count was 1.6B. GILD repurchased approximately 150M for $14B (the sums of stock and warrant repurchases). So the average buyback price was $109. The current share price is $88.
Whatever one thinks about the price paid, the share count was reduced impressively by 8% over the course of 2015. If prices persist in the sub $100 range for 2016 the share count could well be reduced by 10%+. Gilead has authorized an accelerated share repurchase of $5B for Q1 2016 alone and then will authorize a new buyback programme of $12B after Q1 2016. So it is very likely GILD will spend a further $14B in repurchases again in 2016.
GILD pays $1.72 annually in dividends per share. This represents a 2% yield at current share prices. GILD has announced a 10% increase on the dividend to $0.47 after Q1 2016. Given the vast share count reduction that will occur I actually think the total dividend payment to shareholders will still be around $1B i.e. the dividend increase is purely a function of the share count reduction.
So what are the risks with Gilead?
Gilead generated $32B in Sales in 2015 and $20B in Free Cashflows.
Gilead is guiding the same again for 2016.
The main observation is the massive operating margin. It's 60%. This would be a good gross margin but this is Gilead's operating margin. Is it too good to be true? Can it last? Gilead is on the regulatory radar for its high pricing albeit the high pricing is somewhat justified by the quality of its products. The consumer will pay a premium for a very convenient and sure treatment. Furthermore, Merck and Abbvie are going after Gilead's key markets. The Abbvie and Merck treatments are cheaper but the treatments are not as effective or as convenient.
(Please note I have very little expertise or knowledge of pharmaceutical products. My vice is financial analysis. For more detailed information on Gilead products you should read up some of the articles of the Seeking Alpha contributor, DoctorX, as part of your research into Gilead).
Another crucial observation is the exposure of the Revenue platform to 2 products:
- 2015 Harvoni Sales $14B (44%)
- 2015 Sovaldi Sales $5B (16%)
- 2015 Total Sales $32B
But remember that GILD has a market cap of $125B. If GILD generated $12.5B (or 10%) Free cashflow then I would probably still think it's reasonable value and this is probably how the market is valuing the stock.
Looking at Free Cashflow history we can note the following:
- 2015 $20B
- 2014 $13B
- 2013 $3B
- 2012 $3B
I am not fully convinced that Gilead can grow free cashflow any further but that isn't baked into the valuation at the moment. In fact, I think the market is baking in a 40% FCF decline into the stock.
Whilst the 12% combined buyback and dividend yield is welcome. One must keep in mind that only 2% of this is cash. For the buyback to have value the share price must increase from where it is now: $89. As I believe the market is valuing the stock on $12.5B of Free cashflow Gilead management just needs to convince the market that the Free Cashflow is really $15B-$20B for the long haul. If this happens then there will be big upside in Gilead.
Converting the Gilead pipeline into revenue generating franchises that can broaden the revenue base is one way to convince the market that Gilead is capable of generating $15-$20B year-in year-out. Gilead has over 10 products in Phase 3 development but I have no view on the possible sales these products may generate.
Gilead can also broaden its revenue platform by acquiring another company. Gilead has $25B in the bank to do this and cash is very valuable if we get a prolonged bear market with a US Presidential race focused on cheaper drug pricing.
I like Gilead at these levels. I like Cisco too. I want to look at Apple and a few other stocks before making a decision on what I do.
The background storm of the markets is helping me to be patient.
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.