The Difficulty Of Valuing Gilead Sciences

Gilead Sciences caught my attention in February when the price of the stock fell to $82 from its 2015 high of $125 per share. I wrote it about it then, likening the anxiety that was dragging down the price of pharmaceuticals to the anxiety that dragged down the price of weapons manufacturers Lockheed Martin and Boeing during the political talks of sequester.

Gilead, whose signature drug is Sovaldi, has come under scrutiny for pricing its Hepatitis C drug at $1,000 a pill or $84,000 for a three-month regimen. France, Spain, and India have threatened to invalidate Gilead’s patents for Hepatitis C, and the Veterans Administration in the United States has sought to add political pressure to Gilead’s American operations by using media pressure and the threat of congressional regulation to get Gilead to voluntarily the price of Sovaldi.

Unlike Sovaldi, that proposition may prove a tough pill to swallow because Gilead had to pay $11 billion to purchase Pharmasset and acquire the ownership rights to distribute Sovaldi. This is a very expensive drug to produce, and it’s a very expensive drug to consume. You can’t really argue that there is an injustice about Gilead Sciences creating shareholder wealth from this drug because it took a significant risk in paying so much to bring this drug to market, and it has been fortunate that Sovaldi has managed to cure (not just merely treat) Hepatitis C in over 90% of patients and it doesn’t bring the tremendous side effects that have been associated with previous drugs aimed at treating Hep C.

Gilead paid $11 billion for a drug that will generate about $100 billion in net profits over the course of its patent exclusivity, which seems fair as a best-case scenario result for cultivating and bringing to the market a new, complex drug to the international markets that cures rather than treats and doesn’t attach side effects as well.

But what makes the valuation of Gilead Sciences more difficult is trying to figure out the role that stock options will play in diluting the total returns experienced by shareholders. Less than three years ago, Gilead only had $4 billion in debt on its balance sheet. It has increased that figure to $22 billion, and $15 billion sits on the balance sheet as cash.

The Gilead Management team collects $44 million per year in cash compensation, but also have created over 120 million shares of Gilead options that will start to dilute the shareholders between this May and roll throughout the next five years.

The first big batch of options that will affect Gilead shareholders will become effective in two months, as Gilead management will have the option to purchase 55 million shares at a price of $30.05 per share. If the current price of $93 per share holds, the options basically permit the executive team plus convertible holders to purchase a chunk of Gilead stock at a nearly 70% discount. The Gilead Treasury will get $1.652 billion, but it will award $5.115 billion to executives plus convertible holders. The long-term harm to shareholders created by these options is difficult to calculate with precision because the value of an option is inherently tied to the price of the stock at the time it is exercised, though my ballpark estimates target an additional $7-$10 billion that could be used to pay executives in the coming seven years if the company’s stock price continues to perform the well. The alternative is that the performance of the stock languishes and the stock options expire worthless or contain a diminished value. Either the shareholders lose outright by poor performance, or the magnitude of their gains is noticeably diminished by the dilutive effect of all these options.

Right now, the share count at Gilead is 1.471 billion. Even though Gilead announced a $12 billion stock buyback program in February, the share count isn’t going to come down all that much because it’s going to be used to mop up the additional shares created for the management team. Despite the lofty headlines about the Gilead buyback, I’m no longer convinced that it’s going to be reduce the share count by that much because a great chunk (the majority?) of this year’s buyback will be used to cover up the dilutive effects of the stock options.

The stock options issued this May, and over the next five years, make Gilead more difficult to value because Gilead has added $18 billion in debt to its balance sheet, and has a little over four years remaining of patent exclusivity. By my estimates, Sovaldi stands to generate somewhere in the $70 billion – $85 billion range in net profits from Sovaldi before it loses patent exclusivity.

The trick of valuing Gilead, then, is relating those expected profits to the $22 billion in debt obligations (which don’t start maturing until 2022) and then comparing that to the aggregate $15 billion in executive compensation that may be incurred over that time, and then adjusting for whatever Sovaldi and Harvoni are expected to generate in profits after the loss of patent exclusivity.

Gilead will note that John Martin has collected $75 million in compensation from Gilead since 2009, in line with his pharmaceutical industry peers. But you are only studying the part of the iceberg that is above the water when it’s the big chunks underneath that might sink ya–Martin has collected $600 million once you start adding the stock-based compensation to the totals as well. Gilead has also jacked up its balance sheet from $4 billion to $22 billion in debt, and I expect that Gilead’s stock buyback will start to look a bit like a Bank of America buyback–the kind of buyback that doesn’t reduce the share count all that much because it is being used to covering much of the stock-based compensation that would otherwise be noticeable in a ballooning share count that would otherwise occur in the absence of a large share repurchase plan.

Gilead is an incredible cash cow. It is making around $17 billion in net profits per year, and with the dividend only eating up about a tenth of that, there is a lot of retained earnings that can be used to diversify and plant the seeds for fertile growth. But most people focus exclusively on the patent cliff as the only demerit to hold against Gilead when there’s more to it than that–there’s very dilutive executive compensation and rising debt that also take away from the obviousness of Gilead as an investment candidate. It’s the kind of thing that changes the character of a Gilead investment from “highly likely excellent investment” to “you got a good but not great shot of beating the S&P 500 with it over the next few years.” Despite its excellent track record of creating extreme shareholder wealth, I don’t think I’d ever want to it to constitute more than 3-4% of an overall portfolio. I would not relax the rules of traditional diversification for an allocation of GILD stock even though that has been a way to maximize personal wealth in the past.