The bull case for owning Gilead has become bleak.
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“There’s nothing quite like market instincts. They can’t be taught from reading textbooks, in the classroom, in a valuation model, or even with years and years of experience. It’s the intangibles that sometimes count the most…When we removed Gilead (GILD) from the portfolio of the Best Ideas Newsletter, “Alerts: High-grading! GILD–>JNJ… (Jan 2016),” we just knew something wasn’t right. Sure the introduction of Merck’s (MRK) once-daily single-tablet combination therapy, Zepatier, a significantly less expensive therapy to Gilead’s prized hepatitis C franchise was one major concern at the time, but the market is often not this inefficient when valuing equities. Almost counterintuitively, it became worrisome to us that for a company that was generating so much free cash flow and had just initiated a dividend that the market wasn’t even coming close to assigning it a mere market multiple. We had been holders of Gilead for some time, and the recent stock-price performance just wasn’t adding up.” – “What Gilead’s Patent Miscue Means for Shareholders,” March 23
The relative underperformance of Gilead’s shares continues. The company reported weak second-quarter results July 25 on a year-over-year basis, and while operating cash flow generation and its balance sheet remain very healthy, when it comes to equity pricing, however, the trajectory of future fundamentals matters most. The executive team’s downward revision to expected 2016 revenue has weighed heavily on shares (now $29.5-$30.5 billion, was $30-$31 billion), and the path to a return to revenue growth remains murky at best. Gilead declared a $0.47 per share quarterly dividend, good enough for a ~2.1% yield at current prices.
The number of people infected with hepatitis C offers a long road of growth for Gilead, but the urgency of treatments among less sickly patients is causing a vast slowdown in therapies sold. Not only this, but Merck’s new Zepatier, which is priced materially lower than Gilead’s Harvoni is taking a big bite out of market share, at least when it comes to looking tangibly at Gilead’s year-over-year performance. Through the first six months of 2016, Harvoni sales have dipped to ~$2.9 billion from $5.8 billion, simply a rout to its most profitable and high-profile drug. Though the market is large for hepatitis C treatments, the economics of the business have come under considerable pressure. Management’s comments on the conference call were most telling (emphasis added):
“We are lowering net product sales guidance to a range of $29.5 billion to $30.5 billion. While we are seeing continued strength in non-HCV product sales, given the current trends in payer and patient flow dynamics for HCV, our updated models suggest net product sales will range from being slightly above to slightly below $30 billion for the year. As such, we believe it is prudent to update our full-year 2016 guidance.
The factors contributing to this conclusion include lower HCV revenue per patient as a result of a mix shift towards more heavily discounted payer segment in the U.S. and continues with a lower net average price in Europe, a trend toward slowing patient starts in the U.S. commercial segment and some earlier launch markets of Europe, a continued gradual trend towards shorter duration and loss of some market share to competition.
We are seeing a modest downward trend in patient starts among payers that have had full access in place for longer periods of time…The sickest patients have largely been treated, and the movement we are seeing is towards treating genotype 1 patients with lower fibrosis scores and thus greater use of the eight-week treatment regimen for Harvoni.
As we’ve reached the midpoint of the year, we now see the market maturing to a slower rate of treatment for HCV-infected individuals. And as we think about this more normal pace of patient starts, there are a few things to keep in mind… there are three million people who are infected in the U.S. and slightly more than half of those have been diagnosed. Many of these diagnosed patients have less advanced liver disease upon reentering care.
For example, in the United States, in the second quarter this year, we estimated that only 13% of patients starting treatment had F4 fibrosis scores compared with more than 21% the year prior to that. With less severely ill patients, there’s less urgency to immediately treat patients and this may explain the slower rate of treatment versus last year. However, we do believe these patients will eventually benefit from treatment and this means the flow of patients will continue for many years to come.
So while there has been a slowing of treatment compared with the rush of patients when Sovaldi and Harvoni were first approved, the HCV market is attractive over the longer term, providing good revenues, strong cash flow and earnings per share on top of our base business of chronic therapies.”
Gilead’s hepatitis C franchise isn’t going to go away, but the dramatic slowdown in Harvoni sales in the US is troubling, and management’s commentary reveals that a return to the go-go years won’t happen anytime soon. In light of the quarterly performance, where total revenue dropped nearly 6% and non-GAAP net income dropped 14%, we were pleased to hear that management is slowing share buybacks. The very worst long-term scenario, for example, is the board working to evaporate its hefty cash position on the balance sheet with repurchases as both earnings and its market multiple erode, the end result a significantly smaller Gilead due to what we’d describe as capital mis-management. Increasing the dividend may be its best bet to stave off selling pressure in shares, but ongoing investment in its pipeline remains the only viable long-term solution to right the ship. An acquisition may be too costly to bear in light of recent comparable transaction multiples. The bull case for owning Gilead has become bleak.
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