Description

Investment Thesis:  I believe Gilead is a very well-managed biotech company.  While it is unlikely to increase market share in its core markets and competitors may eventually come to market, I believe that Gilead’s pipeline in its core markets remains strong.  I expect them to maintain most of their market share for a long time.  I also believe that Gilead will prudently redeploy capital into other markets such as oncology and liver disease where they already have some promising pipeline candidates.  They have already proven that they can be savvy acquirers with the Pharmasset purchase.  At less than 7.5x earnings the market appears to be pricing this company as if it is going to enter perpetual decline.  I don’t think that will come to pass.  In fact, I believe that the current meltdown in the biotech marketplace will prove to be the perfect opportunity for Gilead to acquire its next leg of growth.

Business Description:  Gilead Sciences, Inc. is a leading global biotechnology company.  It has two key product franchises that account for over 90% of revenues.  The first is in HIV/AIDS where Gilead is the market share leader with ~85% share.  The second is in Hepatitis C where Gilead’s drugs Sovaldi and Harvoni have over 90% market share.  Gilead acquired the Hep C franchise by buying Pharmasset in early 2012 for $11 billion.  It was one of the great purchases of all time.

HIV Market (~42% of revenues)

HIV should really need no introduction, so I won’t bother. There are over 1 million people with HIV in the U.S. and the estimated global HIV population is about 35 million. These numbers are expected to continue growing (unfortunately) as new people become infected.  All of these patients (that have access to care) so far are on drugs for life and the drugs are usually pretty expensive and often taken as a cocktail or as a combination of drugs in a single pill.  Gilead’s drugs dominate the market and the company has about 85% market share.  Gilead’s patents begin expiring in 2018 on the various current HIV drugs, bringing the threat of generics, but they also continue to develop new and safer drugs, so I think they will successfully convert much of their market to the new safer versions of the drugs they put out.

Existing GILD HIV drugs

Source: Credit Suisse

So there appears to be some revenue at risk starting 2018 in the HIV franchise, but Gilead has a new set of drugs based on Tenofovir Alafenamide (TAF) that have shown much better safety profiles in terms of bone and renal health than existing drugs with similar efficacy.  Since patients are on HIV drugs for life these safety considerations should be important.  The TAF drugs should start coming to market in 2016 and will probably offset much of the generic risk in our opinion.

Hepatitis C Market (~50% of revenues)

The global Hepatitis C market is estimated at 130-150 million people and there are an estimated 3.5 million people with Hep C in the U.S.  Hep C or HCV is a chronic disease caused by an infection of the hepatitis C virus that eventually damages the liver.  It is transmitted via sharing needles and many people also got it via blood transfusions pre 1992.  Until recently, it was like HIV: treatable with drugs, but not necessarily curable.  The genetics of the patient really impact the course of the disease, some 15-25% of cases will clear up with no treatment, but for many patients they need to take a specific drug matched to the genotype of their Hep C infection.  Before Gilead’s Harvoni and Solvadi cure rates for even the best drugs often cured 70% or less of patients taking them and had to be taken for 24 or 48 weeks with bad side effects.  Harvoni and Sovaldi have cure rates of 90%+ and a course is only 12 weeks with limited side effects.  Given how much better Harvoni and Sovaldi are than other drugs they have quickly captured 90% of the Hep C market.  

There is some fear that current sales are overstated as patients waited for the release of Solvadi to go on treatment.  The other challenge is that the drugs cost a lot. List price is $84,000 for a course of Sovaldi and $95,000 for a course of Harvoni.  Gilead did negotiate significant discounts of up to 46% on average with insurers in order to get the drugs covered.  The high prices, however, have put a target on Gilead’s back, particularly with the whole political debate about drug price increases, “pharma bro,” etc.  However, if you think about Hep C, the prior drugs were already fairly expensive.  Since the endgame for chronic HCV infection is often liver disease and/or cirrhosis, there is a lot of cost to be dodged by curing HCV early.  Hospitalizations and liver transplants can get expensive fast.  There is an interesting slide deck justifying Hep C reimbursements from the Center for Health Law and Policy Innovation at Harvard here: http://www.chlpi.org/wp-content/uploads/2014/01/HCV_DPH_Payer_4_5_15_combined_final.pdf

Needless to say, Solvadi and Harvoni aren’t Valeant’s overpriced toenail fungus drug with a 20% cure rate.  These are real cures that save the system money, especially once you factor in the discounts Gilead ultimately provided.

One thing to watch out for is a new Merck drug coming to market in 2016 (the approval decision is set for late January).  How much share it will take merits watching. Merck is targeting the drug for IV drug users and others who currently might not qualify for Gilead’s drugs with insurers (many have a policy of drug users having to be clean for a certain period of time before being given the drugs).  Abbvie also has a product on the market (Viekira Pak), but it has garnered very little share.

I am generally expecting international growth for Gilead’s HCV drugs (there is still a lot of runway in Europe/Japan) to offset any market share or pricing pressure from a domestic launch by Merck.

There are no immediate patent worries for these drugs as the patents don’t expire until 2029 or later.

Pipeline

Gilead’s pipeline seems pretty solid.  In addition to the aforementioned TAF drugs for HIV, they have a drug in trials for Hepatitis B and also a drug in trials that looks promising for NASH a liver disease affecting 2-5% of the population.  They also have a few promising smaller oncology drugs.  As a value investor, I don’t put much value on drugs in trial, but the pipeline appears to offer some reasonable optionality. The inherent problem is how does anything in your pipeline complete with an $18 billion franchise like the Hep C drugs?  If you want to see what the pipeline looks like it can be found here: http://www.gilead.com/research/pipeline

Valuation

So here’s the crux of the thesis.  At $90 you are paying ~7.5x FY 2016 earnings for GILD (street estimates are $12.20).  I think earnings are likely to stay around the $12 level annually through 2018 and then gradually decline as GILD loses some share in HIV to generics.  But, that assumes that GILD doesn’t redeploy its cash to purchase another promising drug franchise.  The company has an enterprise value of $132 billion and TTM FCF was $17.7 billion.  Even if Gilead is in “run-off” mode it is hard to create a DCF that doesn’t show a reasonable return from here.  And, of course, I don’t think Gilead is in run off mode.  If the company does a reasonably sized acquisition, I foresee it as trading at a multiple comparable to other old line drug companies who have been facing patent cliffs for years.  Pfizer and Merck trade at multiples north of 12x.  I think one major acquisition and you will see a similar multiple for Gilead and commensurate upside in the stock.  Another recent example of this kind of re-rating is Teva which faced a cliff with Copaxone (it represented about 2/3 rds of EPS at the time) which they were able to dilute with a significant acquisition and some product extensions.  Teva traded down to 7x when the fear of the Copaxone cliff was at its height in mid 2012 and traded back to 12x when they finally announced the Allergen Generics acquisition in July 2015.  One thing I also like about this setup is that the worse the market gets for pre-revenue biotech companies (and as far as I can tell the IPO window and other financing options are completely closed for them), the better off GILD is as a buyer.

Management’s Capital Allocation Track Record

Why am I bullish on Gilead even though earnings have peaked for their two main franchises?  Management.  These guys have been excellent allocators of capital.  In 2010, they faced a similar situation to what they are looking at today.  Their HIV franchise was very profitable but had peaked.  They were generating tons of cash.  Their game plan was to initiate a meaningful stock buyback of $3.5 billion (significant since the market cap was $30 billion at the time) and then in 2011 they bought Pharmasset for $11 billion which people thought was outrageous at the time (the drugs were still in trials) and was a very big bite for a $30 billion market cap company.  But today the Pharmasset drugs are bringing in $18 billion per year in revenues and will for the foreseeable future.  Management has not done lots of little meaningless acquisitions.  In fact, they have done only a handful of small tuck-in acquisitions outside of Pharmasset.  They have made a few big bets and otherwise returned cash to shareholders.  In 2016 we are now saying earnings have peaked and what is management doing? They are returning cash to shareholders with a 1.9% dividend and also nearly $8 billion of share repurchases in the last 12 months.  Did I mention the company borrowed $10 billion dollars in September at record low interest rates averaging 3.5%?  Either they are going to buy back a lot of stock or they are out shopping for acquisitions.  

Risks:

• The big risk is that Gilead fails to innovate and loses its strong position in its core markets.

• Another risk is pricing.  Gilead’s Harvoni and Sovaldi are very expensive drugs which can cost $95,000+ per treatment cycle.  Of course, they cure Hep C, so they are cheap relative to a lifetime of treatment and liver failure and patients obviously prefer being cured.  I don’t foresee huge price cuts as these drugs are delivering value to the system and patients.  But, there is headline risk in these “$1,000 per pill” drugs.

• Capital allocation.  Gilead has generated nearly $18 billion in free cash flow in the last twelve months and will continue to generate tons of cash going forward.  They must allocate all this capital wisely and not fritter it away on acquisitions that don’t work.  If they fail to allocate capital well it will be a problem when the HIV and Hep C franchises do eventually wind down many years from now.

Catalyst

• Gilead makes an acquisition assuaging cliff fears and driving a multiple rerating.

• TAF-based HIV treatments are approved and the life of the HIV franchise is extended.

• Cash piles up and Gilead buys back a lot of stock.