Why Gilead Sciences Is So Cheap

Gilead Sciences and Google are the only two firms that have come into existence during my lifetime that I would feel comfortable classifying as very long-term buy and holds. After hitting a high of $123 in June, the price of Gilead has languished around the $100 mark–currently trading at $102 per share. This should seem at least a little bit mystifying. After all, Gilead has grown earnings by 36.5% annually over the past ten years and has an analyst consensus for growth of 22.5% in annual earnings over the next five years.

The Foster City, CA pharmaceutical giant currently earns $16.7 billion in annual profits, for a per share equivalent of $11.40. For a $102 share price, that amounts to a P/E ratio of 8.94. What gives?

There are two reasons why Gilead Sciences is trading at a valuation that seems to create such a mismatch with its historical and projected growth rate. The first is what I call the “Shkreli effect” in which pharma-investors are generally nervous about regulatory changes and consumer pushback from high prices in the drug industry after the former Turing pharmaceutical CEO put the issue in the spotlight by raising the price of an old legacy drug called Daraprim from $13.50 to $750. The boldness of the price hikes has created avid public interest in curbing high drug prices, with Democratic presidential candidates Hillary Clinton and Bernie Sanders expressing an interest in limiting pharma-prices for the industry.

The signature drug of Gilead is a cure for Hepatitis C called Sovaldi which costs $1,000 per pill and over $84,000 during the twelve weeks of treatment. The cure rate of the drug is over 90%, and the side effects are minimal, but there is significant market uncertainty over Gilead’s ability to maintain the high price during the aftermath of the public’s disgust with Shkreli. What’s the old saying? Pigs get fat, and hogs get slaughtered. The P/E ratio below 9 for Gilead is a product of investors whether the pharma industry has reached such a slaughtering point.

At this time, I do not find the threat of regulation for Sovalid’s drug price to be credible yet. It reminds me of the threats of sequester in 2011 in which the prices of defense stocks like Boeing and Lockheed Martin got unusually cheap. The composition of Congress didn’t make the plans of defense cuts feasible, and that seems to be happening in the 2015 drug industry as well. There is no indication that Republicans, in full control of both the House and Senate, seek to limit the free-market principles of capitalism.

The official platform of the Republican Party favors free market principles in drug pricing for three reasons (“justice” because there would be less freedom in a regulated system for developers to do what they want with what they have, “allocation” because free-market principles permit more value to be extracted from existing resources than with pricing regulations, and “motivational” because the incentive to create a drug in the United States is superior to that of other countries since drug developers in the United States stand to gain the most personal wealth for doing so). Absent a shift in the platform of the Republican Party, or a change in both houses of Congress, I do not expect the price of Sovaldi to be regulated in the near term.

In addition to near-term regulation of drug prices, another reason why investors have valued Gilead with a skeptical eye is due to Sovaldi’s overwhelming influence on the company’s growth (accounting for over 50% of profits by year-end 2015). Investors are already looking out to the early 2020s and wondering how Sovaldi will be replaced after Gilead loses its cash cow. Will it be like Pfizer after Lipitor, treading water for a decade?

Pharmaceutical investments always contain an element of the unknown, and a reliance on management to prepare for the expiration of a signature drug. It would not surprise me if Sovaldi came to dominate over 70% of Gilead’s profits in the early 2020s, and that will be very difficult to replace.

But a valuation of 8x earnings, I think investors are well-compensated with a margin of safety to wait and see how management eventually addresses the perils of its own success. Before Sovaldi came out in 2013, Gilead would sit on about $1.5 billion in cash. Now, it has nearly $9 billion in cash. Even with the dividend, there are still $3.5 billion rolling into headquarters each month. Most likely, this will be deployed into acquisitions over time.

Between 1999 and 2014, Gilead purchased fifteen companies at an average price of $515 million (for total M&A activity of $7.7 billion). Nowadays it will have that much money to deploy every six months. Gilead’s management has indicated a preference for purchasing companies with strong commercial potential that haven’t yet completed testing and struggle to secure financing to remain independent companies, and it is entirely possible that Sovaldi could generate nearly $100 billion for Gilead management to deploy between now and the date of the patent expiration. In short, I agree that the risk of a patent cliff is legitimate, but the important countervailing force to consider is the vast amounts of cash that Gilead will have to combat this (Eli Lilly and Pfizer, meanwhile, were shipping out so much cash to shareholders as dividends that it didn’t have the same wild flexibility to develop alternatives).

The P/E ratio of 8 for Gilead Sciences seems to compensate investors well for the risks associated with owning a stock heavily tied to the success of one drug. The risk of near-term pricing regulation is remote, and is something that remains headline rather than fundamental risk. The concerns about the patent cliff for Sovaldi are legitimate, but are counterbalanced by the amount of cash that Gilead will receive in the coming years to add ballast to the drug pipeline. When you have $10+ billion in annual retained profits showing up between now and the early 2020s, and you have a starting valuation of 8x earnings, you stand to beat the S&P 500 even if a whole lot goes wrong.