Breaking up with Gilead Sciences
It's a great company and stock, but expectations are high and outperformance in 2013 will be tough.
By Nathan Sadeghi-Nejad
After more than a decade of being consistently bullish on Gilead Sciences (GILD) and watching the company's stellar management team build one of the most impressive and profitable businesses in healthcare, I'm stepping to the sidelines for now.
My decision isn't an easy one. Gilead has a great business model and earnings per share will grow substantially over the next few years, due to leverage from sales of Stribild in HIV and the inevitable initial sales boost from sofosbuvir (GS-7977) and GS-5885, the company's lead hepatitis C drug candidates.
Here's the problem:
Everyone knows Gilead is firing on all cylinders -- I wrote as much on TheStreet in late July -- and the company's massive $56 billion market capitalization already reflects significant future earnings growth. That will make relative outperformance in 2013 a difficult challenge.
Eventually, even perpetually bullish Wall Street analysts are going to realize the hepatitis C market is far smaller than current estimates suggest. Sanford Bernstein analyst Geoffrey Porges recently published a thoughtful analysis suggesting, based on two large managed care databases, that the U.S. hepatitis C market might be only a third as large as the most frequently cited estimates. Further, last month's lukewarm recommendation for screening Baby Boomers from the U.S. Preventative Services Task Force, which based its conclusion on the uncertain net benefit of widespread hepatitis C screening, supports my view that identifying patients will be a meaningful logistical obstacle.
Given these issues, it's hard to see how Gilead's $11 billion acquisition of Pharmasset will generate a positive return on invested capital. Even if sofosbuvir brings in $40 billion in cumulative sales, Gilead would only roughly break even on the deal. Not that most investors care about such metrics. Despite it's unarguably lofty price tag, the acquisition was clearly genius. (Few on Wall Street, myself included, thought so at first.)
In one move, management changed the conversation with investors from one focused almost exclusively on the still-distant HIV franchise generics "patent cliff" to one driven by excitement about a new hepatitis C franchise, which bulls perceive as one of the largest untapped potential markets in virology. As a result, Gilead shares are up an astonishing 81% year-to-date.
Gilead now trades at just under 17 times 2013 consensus estimates, a slight but reasonable premium to the expected earnings growth rate of 14%. The HIV franchise will continue to perform at or modestly above Wall Street expectations. Sofosbuvir and GS-5885 seem poised to be the dominant treatment regimen for hepatitis C, even with strong competition from Abbott Labs (ABT) and others.
To be clear, I'm not suggesting the company's valuation is outrageous, more that it's hard to see the upside surprise from here. (For the record, I think Gilead's $510 million acquisition of YM BioSciences (YMI) last week was a good, but incremental, deal.)
When I change my investment view, I always try to practice good discipline and think about taking the other side of the trade. Yet without a clear-cut negative catalyst, I don't think Gilead is a compelling short right now. Nonetheless, the stock could modestly underperform as we move into 2013.
I may be leaving the Gilead party a bit too early, but that's okay with me. It's the holiday season, and there's always another one.
Sadeghi has no position in Gilead.
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