Shares of Gilead Sciences Inc. (NASDAQ:GILD) are back to where they were trading in April of 2014, in large measure because they released guidance the market didn't like. Specifically, the market reacted very negatively to the hepatitis C guidance the company offered for 2017. In my view, this is an overreaction and presents a fantastic opportunity for investors who can see the potential here. For those investors who can tolerate some short term volatility, the shares represent good value at these levels in my view. I'm going to go over my reasoning by first remodeling some of the financial statements, treating R&D more like an asset than an expense. I'll then forecast the dividend and will finish by talking briefly about why it is a good idea to buy when others are fearfully selling.
In my view, a large portion of research and development expenses meet the definition of an asset, in that some of the cash spent on such activities will turn into the basis for long term positive cash flows into the future. Thus, some of the research and development expenses here should be moved from the income statement to the balance sheet. In this exercise, I'll offer the impact of moving 40% of R&D expenses to the balance sheet, thus eliminating them from the income statement. I know this exercise is peculiar to me, but at some point it is foolish to blindly follow accounting conventions that may not help us to provide a reasonable valuation to a company. Some percentage of research and development will eventually provide a long term economic benefit to the company. For that reason, a strong argument can be made that R&D is a different class of expense than many others and should be modeled accordingly.
Here are the figures stated in the financial statements (please note that I've used the most recently available cash flow statement data).
Here are my modifications to the financial statements, assuming 40% of R&D expenses are actually assets.
Using my methodology, the PE falls even further to the 5.6 range. Perhaps 40% of R&D is too aggressive. The point isn't to come to a precise measure of how much research and development will provide economic benefits and how much is actually an expense. The point is to think about this business and understand that some of the expenses present more closely resemble assets. Perhaps there's more value than in the posted numbers that the market seems to react very hypercritically to.
Modeling The Dividend
The dividend here is one of the most compelling reasons to buy the shares in my view. Interestingly, the shares have been in a long term decline since they started paying a dividend in May of 2015, which is obviously problematic for those who bought the shares based on their frothy expectations a year earlier. On the other hand, though, the current yield represents an excellent opportunity for those of us who managed to avoid the narrative infused siren song and wait for the market to swing from irrational pessimism to irrational optimism.
When modeling the dividend there is obviously very little data, which makes predicting the future more challenging, obviously. That said, this is a company that has returned about 60% of its net income over the past seven years to shareholders in the form of buybacks. We can therefore safely conclude that dividends will at least grow, perhaps aggressively so. Even if we cut the dividend growth rate to a quarter of what we've seen so far, the dividend will be 12.5% higher in 3 years than it is today. Thus, even the most severely conservative predictions about dividend growth will add continued support to the stock price in my view.
As I've said repeatedly, it's fine to talk about the quality of the business, but the returns that investors actually enjoy are mostly a function of the price they pay for the stock. Gilead demonstrates this principle perfectly. Those who bought when the market was excessively optimistic about the company have negative (in some cases severely negative) returns. They bought when others were greedily buying and they are now paying the price. Those of us who waited can buy the shares on sale, now that the market has flipped its polarity. We can now buy when others are fearfully selling, which is the essence of the investing game. At the moment, the PE is either 6.6 (or 5.5 if you subscribe to my R&D as asset model). In either case, the shares currently trade at an approximate discount of about 75% relative to the overall market. Additionally, with an EV/EBIT of 3.36, the shares at trading at an earnings yield of about 30% (!).
As I stated at the beginning of the article, the shares of GILD are now trading at the same level they were trading at in April 2014. The weekly chart below shows that the shares are at the $65.00 support level from which the stock rallied back in April 2014. We believe that the $65.00 support level will once again act as a pivot point for the direction of the stock. We see the shares rising back to the $80.00 level over the next twelve months.
Today we bought the GILD 16JUN17 65 Call Options which will provide us with approximately 10x leverage on our LONG trade. Our initial stop-loss exit signal will be a daily close below $65.00.
For investors in the shares we recommend holding for twelve months or $80.00, whichever comes first.
I understand that there are risks associated with buying stocks when they are inexpensive, and things don't always work out. In this case, the hepatitis C division is obviously a point of concern for the market. Additionally, analysts that were recently pounding the table on this name have suddenly turned pessimistic. That is all true. What is also true is the fact that every very profitable investment was made when few others could see the value of a given asset. At the very least in my view, there is a robust dividend story here, which will itself buoy the stock. At most there is an excellent long term return as the market eventually wises up to the value here. I rate Gilead at these prices a strong buy.
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.