Recent Buy – Gilead Sciences

Per the company website, “Gilead Sciences (Nasdaq: GILD) is a biopharmaceutical company that discovers, develops and commercializes innovative therapeutics in areas of unmet medical need. The company’s mission is to advance the care of patients suffering from life-threatening diseases worldwide. Gilead has operations in more than 30 countries worldwide, with headquarters in Foster City, California.”  GILD was founded in 1987, and since then has grown to become one of the world’s largest biopharmaceutical companies, employing over 8,000 people across six continents.  

Gilead’s primary areas of focus include human immunodeficiency virus (HIV), liver diseases such as chronic hepatitis C virus (HCV) infection and chronic hepatitis B virus (HBV) infection, cardiovascular, hematology/oncology and inflammation/respiratory.

I first recognized that maybe the market was mispricing shares in GILD, conducted research, and picked up my first couple of shares back in February and haven’t looked back since.  

The first thing I like to do when I first start to analyze a company is to pull up the financial statements and dig in.  Once I enter the available data in my google sheet, what kind of useful information can I observe?   In  Gilead’s case, I can see some interesting and useful information with the data captured in the table below.  

 

Shareholder Equity (aka Net Worth) has been accelerating at over 29% per year growing from $1.8 Billion to $18.5 Billion.  Shareholder equity is business speak for a company’s Net Worth; that is total assets minus total liabilities.  When you buy shares in a business, essentially you are buying a share of the company’s net worth and a share of the company’s future cash flows.  Ideally, both of these will be growing nicely.

Capital expenditures have been growing as the business grew, but are extremely low relative to the cash produced.  It takes very little capital for Gilead’s ongoing operations.  

Share buybacks have resulted in the decrease in outstanding shares from 1,836 million in 2006 to 1,521 million in 2016. A history of consistent share repurchases is helpful, because it shows that the company is willing to help out long-term holders of stock with increased proportional share of earnings and the business over time.

Free Cash Flow has been growing like mold on a 2 month old pack of bread which is interesting.  Diving into the annual report to learn more, I observed that Gilead experienced exponential growth beginning in fiscal year 2014 by introducing new therapies for Hepatitis C Virus (HCV) and cancer.  Their HCV drug Sovaldi received approval in the US in December 2013 and by the end of 2014; 170,000 chronic HCV patients had already been treated with the new drug in over 40 countries.  Also in 2014, Harvoni was approved and is identified as the first once daily single tablet regimen for the treatment of chronic HCV and provided cure rates of 94-99 percent.  This resulted in over a 320% increase in annual free cash flow and the stock price accelerated from a 2013 low of $39.45 to a 2014 intraday high of $116.83 accordingly.  In 2015, free cash flow rocketed to almost $19.6 Billion (an almost 60% increase from 2014) and the stock price hummed along to peak at an intraday level of $123.37.  Fast forward to today and the stock has been hovering in the $80’s and a quick look at the trailing twelve month Free Cash Flow is currently in the $17.741 Billion range, but 2016 is still underway so we shall see how the books align with the issue of the next annual 10-k report.

Circling back to the aforementioned table, I can take the FCF and divide it by the shares outstanding to derive the FCF per share.  From this I can calculate the cash yield.  Cash yield is a quick and dirty metric I use to determine if the business may be mispriced or not.  Cash yield is basically the amount of cash a company generates divided by the total purchase price.  It’s a high level big picture kind of metric.  An example may help.  If I were a billionaire and could purchase Gilead in its entirety, I would pay the market capitalization or market cap.  That is, total share outstanding x’s the market price.  As of June 12, based on Friday’s close of $84.45, would equal approximately $110 Billion.  Based on 2015’s FCF of $19.852 Billion (today’s price at last year’s free cash flow) translates into a cash yield of 18%.  Stated another way, if I purchased the entire company for $110 Billion and I earned $19.852 Billion the following year, my cash on cash return would be 18%.   This seems extremely high to me for such a fast growing profitable company and is definitely not the norm in today’s market.  If you glance back at my table, I took the time to calculate the Cash Yield utilizing the lowest price for each year over the last ten.  I’m using the lowest price because the cheaper the price you pay corresponds to a higher yield you receive.  The $80 price point in today’s market represents the best cash yield you could have received at any point over the last 10 years!

To provide a relative frame of reference, Johnson and Johnson has a market capitalization of approximately $322 Billion and 2015’s FCF of just under $16 Billion which translates to a 4.9% cash yield.  Stated differently, a hypothetical investor could pay $110 Billion to acquire GILD and immediately begin to earn $19 Billion or acquire JNJ for $322 Billion to immediately earn $16 Billion.  You can see this makes GILD seem very attractive relative to the cash generated.  But I’m not going to sit here and say that Gilead will be the next JNJ either.

JNJ has been around since 1886, has been paying increasing uninterrupted dividends since 1963 and essentially is a combination of over 200 companies that fall under the parent Johnson and Johnson holding company; so from a risk perspective, GILD does not have this type of rich history and still has a lot to prove to long term investors.

Additionally, the company announced its first quarterly dividend to shareholders in June of 2015 at $.43 per share, and in April of 2016 announced they would increase the quarterly dividend to $.47 which translates into a little over a 9% growth rate.  To  me this represents a certain level of comfort that management believes that earnings are stable enough to begin to reward shareholders and I’m glad to see this.  I try not to count my chickens before the eggs hatch, but there’s a small voice in the back of my head that’s somewhat excited to be able to invest in such a profitable business at the beginning days of the dividend being instituted.  Time will only tell, but I’m hopeful this could be the early days of what ends up becoming a long time dividend growth machine in the years to come.  A 9% increase for the first year is just the type of activity I like to see management make.  At this pace, the dividend could double in 8 years.  Bottom line, I’m willing to put my money where my mouth is to see if Gilead may become one of many lucrative winners that my future self in 20 years can be thankful for.

Calculating the intrinsic value for Gilead is very tough especially given that GILDs cash flow has significantly spiked in recent years.  The surest way I know to protect myself is to be very conservative in my FCF forecasts, and try to factor in one heck of a margin of safety.  A quick glance back at the table above, identifies that GILDs FCF has a 9 year compounded annual growth rate of 37.52%, but again, the majority of this long term historical growth has been somewhat obscured by the spike beginning in 2014 and 2015.  It would be great if that would continue, but It wouldn’t be good engineering practice to assume this type of growth at this early stage in the game.  If I pretend the last two years didn’t occur, GILD’s cash flow has compounded at over 14% from 2006 to 2013, which is still a very nice pace.  

So let me play with a few scenarios.  If I take the $19.52 Billion FCF from 2015 and assume zero growth for the next 10 years and then a terminal 3% into perpetuity, I calculate the intrinsic value of $255 Billion or $195 per share using a 9% discount rate.  At Friday’s $84.45 this represents a 56.73% margin of safety which is a lot to work with.  However, I’m not sure they can sustain this level, and none of the analyst at Morningstar or elsewhere seem to think they can either.  But if I discount the year one cash flow to say $16.5 Billion and assume a FCF growth of negative 5% for the next 10 years and then 3% into perpetuity using the same discount rate assumptions, then I still calculate an intrinsic value of $150 Billion or $114.47 per share.  With these assumptions, GILD still looks under valued with a margin of safety of 26.23%.  I don’t know if that’s correct either because the TTM is already higher at $17.7 B.  So what is the market valuing GILD right now?  If I reverse engineer the FCF forecast, I had to utilize a negative 9.5% FCF rate, and a reduced FCF of $16.5 B to arrive at a $110 Billion valuation, and I’m willing to bet money that Gilead will fair better than this.  So I’m comfortable that GILD is under valued at this price point and I’m happy to be an investor.

So how did I put all this together to conclude that Gilead was worthy of my hard earned cash?  Let me count the way:

• Shareholder equity and free cash flow have grown respectively at 29% and 37.5% annually

• Management has shown to be good stewards of the cash by buying back shares and implementing a dividend.  First year increase was over 9%.
• Cash yield is an absurd 16.02% for the current TTM (trailing twelve months)
• Margin of safety calculations suggest Gilead would need to earn less than they currently earn and continue to decelerate cash flow by 9.5% per year for the next 10 years and then grow at 3% into perpetuity to arrive at today’s value and that just doesn’t seem like a very logical and likely scenario based on their history, current revenues, and minuscule capital expenditures.
• Personal valuation takeaway: GILD is an undervalued growth story in the making and I don’t believe I’ve missed the boat at this price point.

For the month of May on two separate purchase dates, I picked up 15 additional shares for a total of $1,240.24 for an average per share price of $82.68.  I purchased these using a nondeductible contribution into my IRA and transferred into my Roth IRA.  You can see the impact to my portfolio via my monthly portfolio updates.  Brokerage disclaimer: I qualify for 30 free trades each month at Merrill EDGE via platinum rewards so I do not incur transactional costs.

 

Your feedback and alternate perspectives with respect to my analysis are welcomed and highly encouraged.  Have you considered adding Gilead to your portfolio?
Full Disclosure: Long GILD, JNJ