Gilead Sciences (GILD): Cheap Dividend Growth or Value Trap?

Gilead Sciences (GILD), the dominant antiviral and hepatitis drug company, is starting to draw a lot of attention from value oriented investors due to its decline of 23% over the past year.

 

Gilead’s stock now trades at a high-single digit price-to-earnings multiple which typically has many bargain hunters salivating, especially in a market where many quality blue-chip stocks and dividend aristocrats trade at over 20x earnings.

 

Furthermore, Gilead initiated a dividend in the second quarter of 2015 for the first time since the company’s founding in 1987 and now yields 2.4% with strong dividend growth potential.

 

With a low payout ratio, cheap P/E multiple, and a history of phenomenal growth, should dividend investors jump on the opportunity to own a stock that has returned nearly 400% over the last decade or are they getting lured into a value trap?

 

Business Analysis

Gilead Sciences is a global biopharmaceutical company that discovers, develops, and commercializes innovative medicines in areas of unmet medical needs.

 

Gilead’s main focus is on human immunodeficiency virus (HIV), liver diseases such as hepatitis, oncology and inflammations, and cardiovascular and respiratory conditions.

 

In 2015, they generated sales of $32.6 billion, the most in company history. Their main competitors in the industry include other large global biotechnology and pharmaceutical companies. Their products compete based on efficacy, safety, tolerability, acceptance by doctors, ease of use, insurance coverage, distribution and marketing.

 

Gilead’s main therapeutics are Harvoni (Liver Diseases), Sovaldi (Liver Diseases), Truvada (HIV), Atripla (HIV), Stribild (HIV), Complera/Eviplera (HIV), and Viread (Liver Diseases). All of these therapeutics generated sales in excess of one billion dollars in 2015.

 

Gilead has significant revenue concentration from its main drugs. The company’s top ten drugs generated around 97% of their revenue in 2015 with the top three generating around 69%.

 

Furthermore, their top therapeutic, Harvoni, generated sales of about $13.9 billion, or nearly 43% of their total revenue for the year.

 

It goes without saying that dividend investors need to be very comfortable with the outlook for these drugs to ever consider investing in Gilead Sciences regardless of the attractiveness of the valuation and the current important financial ratios.

 

The patent protection periods on their top drugs look okay with Harvoni covered until 2030, Sovaldi until 2029, Truvada until 2021 (but only 2017 in the European Union), Atripla until 2021 (but again only 2017 in the EU), Stribild until 2029, Complera/Eviplera until 2022, and Viread until 2018.

 

Thus, with the benefits of patent protection lasting for at least 4-5 years on their major drugs, and much longer on Harvoni, then why are the shares so cheap today?

 

It all comes down to the market believing that Gilead’s best days are behind the company. After all, it’s hard to imagine the company’s surge in margins earnings the last few years will be repeated (or possibly even sustained).

 

As seen below, Gilead’s operating margins surged from roughly 40% in fiscal year 2013 to nearly 70% in 2015 thanks to high-priced treatments Sovaldi (FDA approval in late 2012) and Harvoni (released in October 2014). Diluted earnings per share increased by a factor of 10 from 2013 to 2015.

 

 

Product sales for their HIV and liver disease areas were down 1.3% for the six months ended June 30th, 2016, with the decline accelerating in the second quarter for a nearly 6% slump.

 

Even more concerning, U.S. product sales were down 12% year-over-year in the quarter and HCV product sales were down 33% due to lower revenues per patient as a result of increased rebates, discounts from payer mix, and less new patients starting Harvoni.

 

Harvoni is a major concern because sales are down over 22% through the first six months of the year. This trend is not getting any better as the sales decline accelerated in the second quarter of 2016 with sales falling nearly 29% from Q2 2015 levels in this key drug.

 

Furthermore, during the second quarter, Gilead slightly lowered its expectations for full-year sales from $30 – $31 billion to $29.5 – $30.5 billion. This implies that management expects sales to fall around 6% year-over-year from 2015 levels.

 

Let’s dig in a bit further to understand the key drivers of the declining sales.

 

Here is the CFO, Robin Washington, discussing the trends on the second quarter conference call:

“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…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.”

These trends are clearly not good for Harvoni, which contributed well over 40% of their 2015 revenue. Sales could continue to fall if the current business trends continue and competition intensifies.

 

Furthermore, AbbVie and Merck have entered the HCV space with new products. If the competition’s new therapies continue to show promise, we would expect sales for Harvoni, and some of their other antiviral products to come under even more pressure.

 

Overall, there remains a lot of uncertainty surrounding the business. When looking for prospective investments for our Top Dividend Stocks portfolio, we do not like to see such sales concentration in top products because it significantly increases uncertainty and could lead to dividend cuts if a company’s financials really deteriorate.

 

While the biotech industry has numerous appealing qualities (e.g. high barriers to entry with steep R&D requirements and regulations; products can take 10+ years to develop; patent protection and intellectual property result in excellent margins for successful drugs), it’s nearly impossible to pick the winners beforehand and predict how new drugs in the pipeline will play out.

 

Making forecasts is further complicated thanks to healthcare reform changing consumers’ insurance policies, public funding issues for some of Gilead’s major customers, and increased industry scrutiny over pricing (e.g. Harvoni’s wholesale cost runs roughly $94,000 for a full treatment).

 

Dividend Safety Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Gilead’s dividend and fundamental data charts can all be seen by clicking here.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

 

Gilead’s Dividend Safety Score is 91, which indicates that the dividend is very safe relative to other dividend-paying stocks in the market.

 

Let’s investigate the drivers behind this exceptional Safety Score.

 

Current 2016 forecasts expect Gilead to generate $11.49 in earnings per share. If the company maintains the current dividend, they will pay out about $1.84 per share. This implies a very conservative payout ratio of 16%, but up slightly from when they initiated the dividend in 2015.

 

 

Furthermore, the company ended the second quarter of 2016 with $24.6 billion in cash and investments. This means that the company can cover the roughly $2.5 billion dollar 2016 dividend by nearly 10x with just the cash on hand.

 

However, the company does carry about $22 billion dollars in debt with the majority of it due in the next five years. If the company’s business remains stable, we don’t expect Gilead to have any difficulty refinancing this debt in coming years.

 

Overall, we would consider the company to be in excellent financial shape at this time. The largest risk would be the company making a large acquisition that would put the current capital structure at risk.

 

Here is management discussing capital allocation on the first quarter 2016 earnings conference call.

“…I think as we said all along, we look at how we leverage our cash as not only being share repurchases and dividends, but also we consistently look at investing in our core pipeline as well as M&A where appropriate. And similar to the amounts that you called out relative to cash, it’s actually about a 17% reduction in share count, as I mentioned on the call. We have done a lot of M&A as well. And I think we’ll continue to do that, as John said, when the right opportunities present themselves.”

Since the company sells recession-resistant products, the business is not susceptible to the general economic cycle. Rather, as mentioned in the business analysis section, the largest risks to the business and sustainability of the dividend are competition with their HCV product portfolio, payer mix, and patient flow.

 

Right now the dividend appears to be very safe given the low payout ratios and healthy net cash position.

 

The key factors dividend investors need to pay attention to going forward to have confidence in the dividend’s safety is M&A and further erosion of the key anti-viral products portfolio.

 

Dividend Growth Analysis

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Gilead’s Dividend Growth Score is 92, which indicates that its dividend growth prospects are very strong.

 

The main drivers of the fantastic growth score are the low payout ratio, outstanding historical earnings growth, and net cash position.

 

As detailed above in the Dividend Safety Section, the payout ratio is low – especially compared to other $100 billion dollar market cap stocks in this industry. However, very few companies of this size are so reliant on so few products.

 

While there is certainly room to move the payout ratio up, we do not believe it would be prudent to move it up to payout ratios of similarly sized companies within the industry given the aforementioned product concentration.

 

If management is able to skillfully diversify the revenue streams among more and more therapeutics, then we believe the payout ratio can substantially move up over time.

 

The company’s growth in recent history is nothing short of jaw dropping. Sales have gone from $8.4 billion in 2011 to over $32.6 billion in 2015 with EPS increasing from $1.77 to $11.91.

 

 

The main drivers of the growth are from blockbusters in the antiviral portfolio, namely Harvoni, Sovaldi, and Stribild.

 

These growth rates are clearly not sustainable given the current absolute sales level and the difficulties the company currently faces.

 

Future growth will come from the pipeline and successful acquisitions.

 

Gilead spent $3 billion dollars on R&D in 2015, a 6% increase over 2014 levels. At the end of 2015 they had 180 active clinical studies, of which 61 were Phase 3 clinical trials. Current promising new medicines include treatments for nonalcoholic steatohepatitis (NASH) and HIV.

 

Overall, we would expect Gilead to continue to raise the dividend in line with to slightly above EPS growth as long as they are able to stabilize the current product portfolio, successfully introduce new medicines, and maintain a healthy balance sheet.

 

Management raised the dividend by 10% earlier this year, and future dividend growth will likely be at least in the mid- to high-single digits over time.

 

Conclusion

While there is a lot to like about Gilead, including a seemingly cheap valuation and solid positions in difficult to treat diseases, there is a lot of uncertainty in the future of the company. While some high yield dividend stocks, including General Motors, have a lot of uncertainty, the drivers of that uncertainty are more knowable and easier to analyze.

 

In the case of Gilead, it is very difficult to have confidence given a number of factors that affect the business including product concentration, pricing initiatives by payers to reduce HCV spending, competitors launching new HCV products, discounts in new commercial payer contracts, and mix shifts in payers (VA, Medicaid, etc) which all can have large impacts on the value of the business.

 

The very cheap valuation is enticing, but we prefer to invest in businesses we can understand and have strong competitive positions, low customer/product concentration, and a narrower range of future outcomes.

 

Gilead could turn out to be a very good investment at this price, but frankly, the company is outside of our circle of competence and we will not be adding a position to any of our portfolios at this time.