Description

Overview

Gilead is a leading biotech company with two key product franchises: Hepatitis C (HCV) and HIV. It is the market share leader in both categories with ~80% and ~75% market shares, respectively. GILD is a high-quality, highly-profitable business whose two core franchises should continue to generate well over $10 billion of FCF annually for a long time.

GILD has two main drug franchises, one of which is growing and the other is shrinking. The declining HCV franchise has caused earnings and revenues to decline over the past couple of years. However, this should begin to reverse course sometime next year as the decline moderates and as the growing HIV franchise takes control of overall company growth. Investors see great uncertainty around the path of the HCV business and what the pipeline will produce, and therefore the stock has been undergoing multiple compression for three years and is now valued at a ridiculously low valuation.

Thesis

• HCV – GILD acquired the HCV franchise by buying Pharmasset in early 2012 for $11 billion. This turned out to be an amazing acquisition, as HCV revenue peaked at over $19 billion in 2015. Because GILD introduced a cure for HCV, the number of patients spiked rapidly beginning in 2013. After the pent-up demand worked its way through the system, the number of new patient starts has been declining rapidly. However, once this stabilizes, future declines should be much more manageable.

• HIV – HIV is a growing category with an increasing number of patients on anti-retroviral therapies (ART). Infections in developed markets tend to grow 3-4% per year and pricing has been increasing at the rate of inflation. This business has substantial operating leverage. AIDS patients in developed markets don’t die anymore, but they have to be on ART for life. New products introduced in the past few years (TAF) have revolutionized HIV treatment and propelled GILD to the forefront of HIV treatment. GILD’s original HIV patents expired at the end of the current decade, but with the new TAF regimen, patents have been extended until the end of the next decade and GILD has been turned into the leader in HIV treatment. Finally, one of GILD’s HIV drugs is the only one approved for prevention in the U.S., which increases the addressable market by ~50%.

• Pipeline – GILD’s pipeline looks promising, with drugs in trial for Hepatitis B and NASH (a liver disease affecting 2-5% of the population). Liver disease is a core competency at GILD and NASH is a primary focus. With the obesity epidemic in recent years, the prevalence of non-alcoholic fatty liver disease has sky-rocketed. It is estimated to afflict 20-25% of Americans, and NASH is the most extreme and severe form (15% prevalence). 25% of NASH patients have fibrosis, which is correlated with shorter life span, which translates to ~3 million people with fibrosis in the U.S. This is the population that GILD is targeting. There are also a few smaller oncology drugs, and the company hired a key person in oncology from Novartis.

• Capital allocation – GILD has over $20 billion of excess capital. Management has been quite vocal about their desire to expand their portfolio and focus on both internal and external opportunities. I have already mentioned the outstanding acquisition of Pharmasset in 2012. In the absence of an acquisition, GILD has bought back over $25 billion of stock in the past 3 years and currently pays a 2.8% dividend yield. Ultimately, the company is likely to execute on a business development strategy that should prove transformative and render the outlook for the existing business less relevant. To that end, the company announced that they are purchasing Kite Pharmaceuticals for ~$12 billion. The acquisition will be dilutive for the first few years before becoming accretive after year 3. This should serve as a platform to grow the oncology business. So now they have a liver specialty that they acquired from Pharmasset that should eventually include Hep C, Hep B, NASH, etc, they have an HIV specialty that they developed internally which continues to grow and innovate, and they now have an oncology platform from the Kite acquisition.

• Management alignment – Management is aligned with shareholders through their share ownership. The Chairman (ex-CEO) owns $250 million of stock while the current CEO owns $75 million worth of stock. This should help ensure that the company doesn’t do anything stupid with its excess capital.

What is the market missing?

• HCV franchise has longer tail than assumed – The HCV market has been declining rapidly since 2015 as the pent-up demand has subsided. This has caused the top-line and earnings to decline. The market is assuming that this persists into perpetuity. However, given that less than a quarter of the US HCV population has been cured, this business should stabilize and decline at a much slower rate than it has recently. Additionally, the HIV market should grow robustly, overwhelming the declines in HCV. Both franchises have patent protection until the end of the next decade.

• No credit for the pipeline – The market is ascribing little to no value for the pipeline despite the fact that they have spent $15 billion in R&D over the past 5 years and $20 billion over the past 10. Given the company’s history with respect to its HIV franchise, this R&D spending is likely to produce material revenue going forward. In order to estimate this future revenue opportunity we can assume some level of return on past R&D spending. The company’s HIV franchise has produced a phenomenal return on R&D spend, but we will assume that this was essentially luck and that going forward the company will earn a much lower 25% return on this spend. Given the $20 billion of R&D over the prior 10 years, I estimate that the company should be able to produce an additional $4 billion of revenue from its pipeline by 2021. This is 18% more revenue than the street is modeling for 2021.

• No credit for $20 billion of excess capital – Similarly to the pipeline, the market is giving no credit to the excess capital that GILD has, either from business development or share buybacks. If we assume that M&A productivity matches the industry’s assumed R&D productivity, then deploying $30 billion of cash into M&A in 2018 could yield $7.5 billion of additional revenue by 2021. Again, this is not included in the Street’s numbers.

Absurd valuation

• The stock is currently trading at 9x my estimate of 2018 P/E and a >10% FCF yield. Peers currently trade at an average P/E of 12.5x 2018 EPS. Put another way, GILD currently trades closer to TEVA and VRX in valuation, companies with excessive leverage and business continuity concerns, than it does to its actual peers.

• Assuming 12x PE and $20 billion deployed into M&A in 2018 at 25% productivity, I estimate the stock is worth ~$100 based on 2020E EPS, which is ~50% upside.

Summary

In summary, the market does not appreciate the high quality, growing nature of GILD’s business. The market currently has a narrow focus on near-term revenue and earnings momentum, and misunderstands the likely stabilization of HCV, the growth of HIV, and the future opportunities from the pipeline and capital allocation. The stock has been undergoing multiple compression for 3 years as a result of declines in the HCV franchise revenue. However, I expect the multiple to expand as HCV stabilizes and HIV growth overwhelms HCV declines, and the company continues to execute on business development.

Catalyst

• HCV stabilization
• HIV growth
• Business development