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Gilead Sciences (GILD)

Founded in 1987, Gilead Sciences (GILD) is one of the world's leading biotech companies. The firm's 10,000 employees operate in more than 35 countries worldwide, researching, manufacturing, and distributing various medications to treat liver diseases, HIV, and immune, respiratory, and cardiovascular diseases.
Source: Gilead Sciences Investor Presentation
Gilead has historically focused on antiviral products for infectious diseases, which made up 91% of sales in 2017:

  • HIV and Hepatitis B: 55% of sales (10% increase in 2017)
  • Hepatitis C (HCV): 36% (38% decline in 2017)
  • Other (non-antiviral drugs): 9% (5% increase in 2017)

The company's drug portfolio is fairly concentrated. Gilead's largest products are Genvoya (18% of fourth-quarter 2017 sales - HIV), Truvada (13% - HIV), Harvoni (11% - hepatitis C), Epclusa (10% - hepatitis C), Atripla (7% - HIV), and Descovy (6% - HIV). 

Geographically, Gilead is focused on the U.S. market:

  • US: 70% of sales
  • Europe: 20%
  • Other International: 10%

In 2017, Gilead's total product sales fell 14% due to continued declines in its very cyclical hepatitis C drugs, specifically Sovaldi and Harvoni. This decline was partially offset by strong growth in its far more stable HIV drugs. 

Going forward, Gilead plans on diversifying into oncology (cancer) treatments, thanks to its 2017 purchase of Kite Pharmaceuticals, a leader in the field of T-cell cancer therapy, for approximately $12 billion. 

Business Analysis

Biotechnology companies (who use biological processes to create drugs compared to pharmaceutical companies who focus more on chemical-based treatments) operate in a challenging and complex industry.

For example, the highly regulated and expensive nature of drug development (FDA approval can take up to 12 years and cost well over $1 billion per drug) means that biotechs like Gilead must spend a lot on R&D (12.8% of revenue in 2017) in order to bring new products to market.

However, if a drug is approved and successful, then the long patents granted on these very high-margin medicines (up to 90% gross margins) mean that drug makers can be free cash flow machines. For example, despite its massive declines in HCV sales and declining margins, Gilead's 2017 free cash flow (what pays the dividend) was still $11.3 billion, representing a very impressive free cash flow margin of 44%.

Gilead's superior margins are also a result of its lean operating structure. For example, the company has a relatively small but highly specialized salesforce. In addition, Gilead's manufacturing is highly automated which gives it relatively low production costs to further boosts its profitability. 

Gilead's long-term success is due to its skilled management team (all PhD's) that has shown impressive discipline and strong capital allocation skills. Management bonuses are also tied to R&D targets, not short-term financial results, helping to promote long-term strategic decision making.

The biotech industry is replete with major acquisitions, as companies attempt to buy their way to growth through the acquisition of rivals' development pipelines.
However, since its first acquisition in 1999, Gilead has only purchased 14 companies and has one of the industry's best success records in mergers.

Take Gilead's $464 million deal to buy Triangle Pharmaceuticals in 2003, for example. This acquisition added HIV drug Emtriva to the company's portfolio.

Emtriva would go on to become the cornerstone of Gilead's Truvada HIV drug series and other single pill HIV antiretroviral products. This ultimately allowed Gilead to become the world's most dominant HIV medication provider, with leading market positions in the U.S. and Europe.
Source: Gilead Earnings Presentation

In fact, in the U.S. Gilead's Tenofovir Alafenamide, or TAF-based, medications (the latest generation of antiretroviral HIV meds) have about 80% market share (global market share 75%).

HIV medications are Gilead's largest and steadiest source of recurring cash flow because not only have they proven to be some of the most effective in the world (with superior safety profiles), but they must be taken everyday for life.

Another major competitive advantage for Gilead is that it has continued to be the industry leader in continuing to innovate on highly active antiretroviral (HAART) treatments.  When Gilead first introduced its HAART drugs in 1996, patients had to sometimes take as many as two dozen medications a day. This was not only very inconvenient, but it also caused many unpleasant (and potentially life threatening) side effects.

However, in recent years Genvoya and Odefsey offer patients a single daily pill with far fewer side effects. In 2018 Gilead is planning on launching Bictegravir-based HIV drugs. These are the world's smallest single-pill regimen, and in the most recent studies it has shown 0% viral resistance (it remains effective far longer than existing medications) as well as much improved kidney and bone safety profiles.

In other words, Gilead's latest and greatest HIV medication could be the safest and most effective yet, especially for older patients who often face challenges with declining kidney function and osteoporosis.

Going forward Gilead's growth plans call for diversification away from HIV and HCV-based treatments, upon which its heavy reliance makes for very volatile sales and earnings growth.

Specifically, the company is focusing on two new areas of treatment, oncology and Non-Alcoholic Steatohepatitis, or NASH. NASH, which effects 12 million people just in the U.S., is caused by obesity. Fat builds up in the liver and causes damage and inflammation that eventually results in decreased function and organ failure.
There is currently no treatment available for the condition, and analysts expect the market to be potentially worth $35 billion to $40 billion a year in annual sales.

Meanwhile, Gilead's oncology hopes stem largely from its $12 billion purchase of Kite Pharmaceuticals in 2017. Kite is a leader in T-cell therapy, in which a patient's own T-cells (part of the immune system) are extracted and then engineered to contain antigens against his or her specific tumor.

All cancers are genetically unique, which means that doctor's don't know how much radiation or chemicals it might take to kill a tumor. That's why traditional chemotherapy and radiation treatment can result in such severe side effects. Doctors are literally poisoning the patient in hopes that the faster-growing cancer will die first and the treatment can be stopped before the patient's health falls below recoverable limits.

However, with T-cell therapy, such as Kite's Axi-cell (expected 2021 sales of $1.5 billion), the patient's own immune system will target the tumor directly, hopefully curing the patient of cancer.

Since T-cells are part of the long-term immune system (that recognize invading antibodies), once a patient is cured with T-cell therapy, then they should also enjoy a long-term immunity from that particular cancer. Or to put it another way, Gilead's acquisition of Kite Pharma brings with it a potential cure and vaccine against patient-specific cancer.

All told, Gilead's pipeline of 36 drugs in development is believed to have the potential to eventually generate about $25 billion to $26 billion in annual sales. That would be more than a doubling off the $20 billion in 2018 sales that Gilead is expecting.

Theoretically, Gilead has potential to be a decent long-term dividend growth investment. However, while the company has many positives in its favor, there are also numerous complex risks to understand before investing.

Key Risks

Gilead is the perfect example of why biotech and pharmaceutical companies can make challenging investments. While the business model can indeed create somewhat of a moat thanks to patent protection, drug maker sales and earnings can be extremely volatile.

This can be seen with Gilead's most successful acquisition ever, its $11 billion purchase of Pharmasset in 2011. Pharmasset owned HCV drug Sovaldi, so this acquisition ultimately led to Gilead's blockbusters Sovaldi and Harvoni, which went on to dominate the global HCV market. For example, between 2013 and 2015 (drugs launched in 2014) Gilead's HCV patient starts increased 700%.

Over a two-year period, HCV boomed and Gilead's sales and EPS grew 290% and 560%, respectively. However, Gilead's HCV success has proven to be a double-edged sword for two reasons.

First, the drugs' popularity was based on the fact that they were the most effective products ever devised for treating hepatitis C. In fact, a 24-week treatment course would cure 95% of patients.

But of course, the downside to this is that once a patient is cured, they stop taking the drug. So unlike HIV, which patients take forever, HCV drugs are a "one and done" proposition.

In addition, as with every major blockbuster drug, even ones still under patent protection, rivals race to develop slightly different alternatives that treat the same condition.

So basically Gilead's drugs worked so well that they caused a challenge for the business, curing so many patients that the company now faces a continually falling patient pool. In addition, rivals have begun releasing rival drugs that offer similar effectiveness, but at lower price points.
Source: Gilead Earnings Presentation

This is why Gilead's HCV sales (which peaked at $16 billion in 2015, representing about half of company-wide revenue) and earnings have been going in reverse, at an accelerating rate for the last two years.

Management expects this trend to continue in 2018. In fact, HCV sales are expected to decline roughly 60%, with about 80% of that decline coming from lost sales to competing products such as AbbVie's (ABBV) Mavyret.

Worse still, Gilead's HCV margins will continue to decline as the company is expected to cut its price per cure to about $25,000 in order to compete with AbbVie's rival offering. Eventually analysts expect Gilead's price per cure for HCV to decline to $20,000, down 50% from the $40,000 figure it enjoyed at the start of 2017.

Fortunately, analysts also expect HCV sales to stabilize, with sales declines dropping to a low-double digit pace in 2019 and beyond). However, even with new oncology and NASH drugs, Gilead's sales and earnings are expected to continue sliding around 4% to 6% annually through 2021. That's due to the long lead times it takes to finalize drug development and scale up sales to offset declines in HCV.

Gilead, like all drug makers also faces eventual patent cliffs, which is why it's on a perpetual hamster wheel of new drug development and acquisitions to keep its top and bottom lines growing over time.

For example, Genvoya, Descovy, and Odefsey, Gilead's top HIV drugs, start to lose patent protection in 2021 and 2022 (patent expiration has already begun in Europe). As this plays out, generic versions of its drugs could meaningfully decrease its HIV sales starting in a few years, especially since both GlaxoSmithKline (GSK) and Johnson & Johnson (JNJ) are developing or have already launched competing medications.

All drug makers also face the risk that promising medications might end up failing in any one of the FDA's three stage drug trials. Not only do drug makers need to spend a lot on R&D, but there is no guaranteed payoff for this investment. The same goes for acquisitions, which can ultimately fail due to overpaying for a drug pipeline that might not ever hit the market.

Then there's the ever-present risk of Federal healthcare policy changes (allowing Medicare and Medicaid to negotiate bulk drug purchases at much lower rates), as well as legal risks (if drugs end up harming patients). In addition, private insurers and pharmacy benefit managers (PBMs), can sometimes force drug makers to drastically lower their prices in order to include them in their formularies. For example, in 2016 ExpressScripts forced Gilead to drastically cuts the price of its HCV medications in order to remain in its system.

Simply put, the drug industry is highly complex, and generally best left to more risk tolerant investors. Despite all of the challenges faced in this cyclical, highly capital intensive, and cutthroat industry, Gilead's strong management culture has proven capable of navigating the treacherous waters far better than most thus far.

And despite the company's shrinking margins and cash flows, Gilead's nearly $37 billion cash position and rich free cash flow stream still mean that investors can likely expect double-digit and secure dividend growth for at least the next few years. In fact, management recently boosted Gilead's dividend by 10% for 2018.

Closing Thoughts on Gilead Sciences

Gilead Sciences appears to be one of the best-managed biotechs in the world. Its disciplined and experienced management team has proven that it can overcome the various risks inherent in this industry better than most rivals to deliver profitable growth. 

Especially impressive is the company's track record on acquisitions, in which it has very rarely overpaid for a rival drug maker and usually brings that company's drug pipeline to market successfully. In other words, Gilead's asset allocation skills seem to be among the best in the industry. 

However, while the company's dividend appears to remain secure for now, Gilead ultimately represents a very complex and high-risk business model, one whose fortune's are largely tied to the success of just a handful of drugs. 

The stock isn't for everyone, especially given the high amount of uncertainty surrounding the company's ability to return to positive sales, earnings, and cash flow growth over the long term. 

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