Here we go.
This is the final stock I purchased with the cash that was sent my way whenReynolds American, Inc. (RAI) acquired Lorillard Inc., upon which I received some stock in the former company and cash after relinquishing my holdings in the latter company.
I purchased 10 shares of Gilead Sciences, Inc. (GILD) on 6/16/15 for $118.89 per share.
Overview
Gilead Sciences, Inc. is a biopharmaceutical company that discovers, develops, and commercializes a variety of medicines designed to transform and simplify care for people with life-threatening diseases.
The company currently primarily focuses on HIV and hepatitis C treatments, with operations in more than 30 countries.
Harvoni and Sovaldi, hepatitis C treatments, generated approximately 50% of fiscal year 2014 product sales. The three single-tablet regimens for HIV, which are Atripla, Stribild, and Complera, generated another 24%.
Geographically, FY 2014 revenue broke down as such: United States, 73%; Europe, 22%; and other countries, 5%.
No one customer accounted for more than 25% of the company’s revenue.
Fundamentals
GILD sports some of the most unique fundamentals I’ve ever seen, especially in regards to the growth and the speed at which the company has increased revenue and profit.
Revenue was $2.028 billion in FY 2005. The company grew that to $24.890 billion in FY 2014. That’s a compound annual growth rate of 32.13%. Insane.
However, it’s important to keep in mind that while revenue growth has been pretty impressive and steadily increasing over the last decade, there was substantial growth from FY 2013 to FY 2014 – the top line more than doubled YOY. And almost all of that growth was related to the release and sales of Harvoni and Sovaldi. As such, the company is currently heavily dependent on the continued success of these drugs.
Earnings per share is up from $0.43 to $7.35 over this 10-year period, which is a CAGR of37.08%.
I don’t anticipate this kind of growth to continue for the firm looking out over decades to come, especially since the base continues to become larger, but there also appears no reason why the growth will dramatically contract.
S&P Capital IQ expects EPS will grow at a compound annual rate of 20% over the next three years, which, if it materializes, is still incredibly stellar.
This seems to be playing out in their recent results: Q1 2015 saw the company record revenue that was up 51.9% YOY and EPS that improved by 107.5%. They also increased guidance with the results, noting that full-year revenue should finish at between $28 billion and $29 billion. That’s a rather large increase in guidance, coming just a couple months after prior guidance. Things are moving in the right direction here.
Now, I already mentioned GILD doesn’t have a lengthy dividend growth track record. This is one of the very few times I’m investing in a company without at least five years of dividend growth. As such, for me, it’s a somewhat speculative play. No indictment on the quality of the business, but rather just noting that it doesn’t sport the type of quality dividend metrics I almost always look for.
But the company announced an initial quarterly dividend of $0.43 in February. There is no precedence of dividend growth nor is there any evidence that the dividend will grow. So, again, this is speculation on my part that the company will not only continue to pay a dividend for the foreseeable future, but also grow it regularly.
Along with the announcement of the dividend, that press release also gave notice that the company approved the repurchase of $15 billion of the company’s common stock. For perspective, that’s more than 8% of the company’s current market cap.
The stock yields 1.45% on my purchase price, which doesn’t offer much income. So this is a play for plenty of dividend growth as well as total return over the long haul.
With a payout ratio of just 19.5%, there’s a ton of room here for the dividend to grow, if the company decides to increase the payout.
The company’s balance sheet is really solid. The long-term debt/equity ratio is 0.76 and their interest coverage ratio is north of 36. In addition, as of Q1 2015, the company has more cash than long-term debt – about $14 billion.
Profitability is nothing short of phenomenal. Over the last five years, they’ve averaged net margin of 34.54% and return on equity of 48.86%. Sky-high numbers here that are excellent in both absolute and relative terms.
Qualitative Aspects
The company’s primary competitive advantages lie in the drugs it discovers, develops, markets, and patents.
As noted above, they are experiencing tremendous success in the treatment of both HIV and hepatitis C. They serve approximately 85% of the treated HIV patients in the US. That’s a massive share of the market. And their STR HIV medicines are patent protected for years to come. The company notes that its STRs positively affect tolerability and convenience, and more than 70% of newly-diagnosed HIV patients in the US are prescribed a GILD STR. This speaks to their reputation for efficacy.
Management acquired Pharmasset Inc. in 2011, which helped GILD develop some of its incredibly successful and profitable hepatitis C drugs. The $11 billion they paid is now obviously considered a steal, as Sovaldi and Harvoni are generating annual sales that, combined, exceed that number. Their market share in the domestic hepatitis C market also exceeds 80%. And the patent protection in this arena also indicates that the company is set up for a long runway for growth – Sovaldi is under patent protection until 2029 and Harvoni, 2030.
Harvoni is a revolutionary treatment for HCV because once-daily therapy over the course of 8-24 weeks results in cure rates of 94-99%. Their HCV drugs continue to roll out in new countries across the world, providing for even greater potential over the near and long term. The World Health Organization estimates:
…about 3% of the world’s population has been infected with HCV and that there are more than 170 million chronic carriers who are at risk of developing liver cirrhosis and/or liver cancer.
So there’s obviously a huge pool of potential customers still yet ahead for GILD. However, keep in mind that their HCV drugs are a cure for the most part, rather than a lifelong treatment. And that’s why their treatment courses range from $84,000 to almost $95,000, before discounts.
What this success, huge market share, and long runways for growth provide is a robust business model that allows for incredible profit margins, solid growth, and the opportunity for the company to also focus its R&D on new treatments. GILD is using that opportunity to develop treatments in the arenas of oncology and cardiovascular and respiratory diseases.
Risks
There are a number of risks to be considered here, which further speaks to my belief that this investment is somewhat speculative.
Primarily, there is competition and patent concerns. Although the majority of GILD’s blockbuster drugs in HIV and HCV are protected by patent for years to come, there is always concern that a competitor could develop drugs that are better and/or cheaper. In addition, the company is facing a lot of pressure from foreign governments to offer treatments at extremely affordable prices. Compulsory licensing is an omnipresent threat in many developing countries where cheap medicine is in high demand.
Another risk involves the very nature of their industry: Operating in the healthcare field means there is constant risk of litigation and regulation.
Gilead has had to offer heavy discounts on some of their products, especially their HCV treatments. Their high cost has received some backlash from government agencies and pharmacy benefit managers, which has led to pricing pressure.
The company also must maintain a robust pipeline of new drugs to replace lost revenue when other key medicines go off patent and face increasing competition from branded and generic drugs alike. GILD spent approximately $2.9 billion in R&D last year, much of which went to clinical studies.
A unique risk here is that their HCV medicines are cures, rather than lifelong treatments. As patients are cured, they no longer have need to use GILD’s medicines.
Lastly, there is integration and acquisition risk. The company’s rather large cash pile will likely be used for an acquisition at some point over the foreseeable future. Pharmasset Inc. was an excellent use of capital, but it’ll be difficult to replicate that success.
Valuation
The stock’s P/E ratio is 13.51, which compares extremely favorably to the five-year average P/E ratio of 20.9. In addition, that’s well below that of the broader market and the biopharmaceutical industry. It’s possible that the company’s incredible growth hasn’t been fully priced into the stock yet, which could also mean that there is doubt as to whether that growth will last much longer.
I valued shares using a two-stage dividend discount model analysis with a 10% discount rate. I used an initial dividend growth rate of 20% for the first ten years. I then factored in a 7% terminal growth rate. I think that growth rate is certainly reasonable and fair considering the historical underlying profit growth and the potential moving forward. However, the absence of a history of dividend raises means it’s difficult to nail down a growth rate with tremendous accuracy. The DDM analysis gives me a fair value of$175.08.
GILD appears severely undervalued to me. The P/E ratio is similar or even lower to other stocks that are growing at rates one-fourth as fast as GILD is. Even if growth were to permanently drop by 50%, this appears to still be a solid value here. And I don’t think that drop is going to happen.
Conclusion
I noted that this stock was a long shot when going over stocks that were on my watch listfor June. But the capital infusion I reluctantly received from the LO acquisition meant the opportunity was there to pick up GILD at what I feel is an extremely compelling long-term value.
Again, it’s a spec play, especially for a die-hard dividend growth investor like myself. But every 20-year or 30-year dividend growth streak has to start somewhere. And I’m willing to bet that GILD turns into the next Champion. They certainly have the fundamentals, growth, track record, and willingness to return value to shareholders.
You almost never see a high-quality stock that’s growing so fast also simultaneously valued so low. Apple Inc. (AAPL) is similar in this regard, but even it’s not this cheap. And its growth potential probably pales next to GILD just due to the size differential.
GILD is probably on the outer rim of my circle of competence. Understanding biopharmaceuticals is a lot less easy than, say, chocolate or cheeseburgers (and a lot less delicious). I may not understand the research, chemical compounds, or science behind it all, but I do understand that humanity has a lot of chronic diseases that need cures and medicines, and GILD is in a great position to help and capitalize on that. Medicine at its fundamental core isn’t a particularly complicated concept.
This purchase adds $17.20 to my annual dividend income, based on the current $0.43 quarterly dividend.
I’m going to include current valuation opinions from other analysts below, which I use to concentrate my reasonable valuation estimate:
Morningstar rates GILD as a 3/5 star valuation, with a fair value estimate of $114.00.
S&P Capital IQ rates GILD as a 5/5 star “strong buy”, with a fair value calculation of $195.20.
I’ll update my Freedom Fund in early July to reflect this recent purchase.
Full Disclosure: Long RAI, GILD, and AAPL.
Have any thoughts on GILD? Think it’s wildly undervalued? How speculative is it?
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