Everyone is aware of what happened to Gilead Sciences (NASDAQ:GILD) and why shares tanked after the February 7 earnings release. The key message is that HCV sales are expected to fall by more than 40%, and a lot about the implications has already been written on Seeking Alpha. The 2017 guidance is a disaster, and far worse than anticipated, but I am concerned about five more things which are not as obvious as the downturn in the HCV business.
I am long GILD, and my rationale for holding the stock with an investment horizon of 2-3 years has been the assumption that the company could return to growth as soon as declining HCV sales are overcompensated by growth in the non-HCV franchises. Once the market anticipates such a development, it should assign a higher multiple which should drive the stock higher. That's the theory, but unfortunately, reality turns out to be different.
1. No Visibility Beyond 2017
Using the midpoint of Gilead's guidance, product sales will drop from $30B in 2016 to $23.5B in 2017. That's a $6.5B decline or more than 20%. Several analysts asked about an indication how 2018 could develop in the earnings call, but Gilead's management did not comment. I did not expect an answer but I fear that Gilead really has no clue. The 2017 outlook for HCV sales is shocking, but there is no visibility what might happen next year. Will 2017 be the single big drop and revenues will consolidate more slowly in years after or must we fear another 40% decline? Anything is possible, and nothing is predictable. If the HCV market continues to shrink faster due to lower prices and increased competition, it becomes more difficult for the non-HCV businesses to generate enough growth to overcompensate this development which brings me to the second unpleasant surprise.
2. Sluggish Outlook For Non-HCV Franchises
If HCV sales shrink rapidly, the non-HCV franchises need to grow faster, but unfortunately Gilead's guidance only calls for a 1% topline growth. Non-HCV product sales (both HIV/AIDS and "Other Products") were $15.1B last year and are expected to grow to $15.0-15.5B, well below the 16% increase in 2016. There is nothing tangible which could lead to additional growth in the near future, unless Gilead decides to make an acquisition. This directly leads to the third observation.
3. Gilead's Cash and Debt
Many authors and commentators on Seeking Alpha mention Gilead's huge cash pile which can be used to fund an acquisition. Yes, it is true, the company has accumulated a lot of cash ($32.4B at the end of last year), but it also has a lot of debt ($26.6B) which leaves a net cash position of $5.8B. If we consider that the majority of cash lies outside the US which means it is not available for acquisitions, dividends or share repurchases, the picture does not look so bright any more. This might change in the very near future, and for the sake of simplicity, let's take the following scenario: 90% of cash lies abroad and a repatriation tax of 20%. If all cash was brought to the US, Gilead would end up with $26.6B after taxes and a net cash position of zero. Should Gilead come to the conclusion that the time is finally ripe for a (major) acquisition, it will have severe implications for the company's balance sheet.
4. Any Larger Acquisition Would Be More Expensive Than One Year Ago
Until now, Gilead has been reluctant to buy another company of significant size to reduce its dependency on HCV. There are good reasons for and against such an acquisition, but my fear is that management will soon be desperate enough to consider a significant deal, just because the pressure is mounting, and there are no other options. If this really happens, Gilead essentially has two ways to fund an acquisition which are either new debt or the issuance of new shares at depressed prices. A major takeover would most likely be paid using Gilead shares, at least partially. One can speculate whether an acquisition target is cheaper today than a year ago when biotech companies were more expensive, but there are few stocks which suffered as badly as Gilead. When shares traded at $100 or $110, they were an attractive transaction currency, at $65 not so much anymore. If Gilead makes an acquisition and issues new shares today, it means more dilution than 12 or 18 months ago.
5. Buybacks Halted
Imagine, Gilead could issue new shares to fund an acquisition, but the new shares would be worth less than the old ones which were repurchased by the company one year ago. Wouldn't that be ironic? Do not get me wrong, there is nothing official that Gilead's strategy has changed. Robin Washington, Gilead's CFO said during the earnings call that expanding the R&D pipeline through acquisitions will be the primary focus. Share repurchases will only take place to keep the share count constant, in other words no more buybacks. This means there will be no support for the stock from buybacks anymore and no further EPS engineering through a reduction of the share count. Diluted EPS and non-GAAP diluted EPS "only" fell 17% and 8% in 2016 because 10% of shares were repurchased last year. Gilead spent $11.5B to buy back shares at an average price of $87, a great job! All of the debt which Gilead carries today can be attributed to buybacks, and now that the share price is the lowest in three years, the buyback is halted.
After the 2017 guidance, I can hardly imagine a trend reversal anytime soon. In addition to the obvious HCV disaster, the five issues which I mentioned concern me as a Gilead shareholder. I am carefully thinking about what to do now, and until last week, I was willing to add more shares if they fell below $70, but this is not the case any more.
Disclaimer: Opinions expressed herein by the author are not an investment recommendation, any material in this article should be considered general information, and not relied on as a formal investment recommendation. Before making any investment decisions, investors should also use other sources of information, draw their own conclusions, and consider seeking advice from a broker or financial advisor.
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.