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«Studies in Applied Finance INVESTMENT THESIS FOR GILEAD SCIENCES, INC. (NYSE: GILD) Stephen Johannesson Johns Hopkins Institute for Applied Economics, ...»

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SAF/No.9/July 2016

Studies in Applied Finance




Stephen Johannesson

Johns Hopkins Institute for Applied Economics,

Global Health, and the Study of Business Enterprise

Investment Thesis for Gilead Sciences, Inc. (NYSE: GILD) by Stephen Johannesson

Investment Thesis for Gilead Sciences, Inc. (NYSE: GILD)

By Stephen Johannesson Disclaimer: These research reports are primarily student reports for academic purposes and are not specific recommendations to buy or sell a stock. Potential investors should consult a qualified investment advisor before making any investment. This study was completed in May 2016.

About the Series The Studies in Applied Finance series is under the general direction of Professor Steve H.

Hanke, Co-Director of the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise (hanke@jhu.edu) and Dr. Hesam Motlagh (hnekoor1@jhu.edu), a Fellow at the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise.

This working paper is one in a series on applied financial economics, which focuses on company valuations. The authors are mainly students at the Johns Hopkins University in Baltimore who have conducted their work at the Institute as undergraduate researches.

About the Author Stephen Johannesson (sjohann3@jhu.edu) is an analyst at BDT Capital Partners, LLC in Chicago, IL. He conducted the research for this paper while serving as a research assistant for Professor Steve H. Hanke at the Institute for Applied Economics, Global Health, and the Study of Business Enterprise in the spring of 2016. Stephen graduated from The Johns Hopkins University in May of 2016 with a B.S. in Biomedical Engineering and a minor in Applied Mathematics and Statistics.

Summary This working paper is an in-depth analysis of Gilead Sciences, Inc. Our analysis examines the economic factors that impact Gilead’s underlying business and how the firm has adapted to these ever-changing factors. This economic analysis is then combined with our proprietary, HankeGuttridge Discounted Cash Flow (HG-DCF) model to determine Gilead’s financial position. The HG-DCF model will be presented along-side Monte-Carlo simulations to reveal the distribution of probable free cash flows, the likelihood of future earnings, and the degree to which the firm’s drug pipeline is being considered by the current market valuation. In addition to these quantitative factors, we also examine the compensation plans of Gilead’s executives to assess alignmentwith shareholders. At the conclusion of this analysis, it is our intention for readers to understand Gilead’s business plan and the company’s financial standing to arrive at a sound investment decision.

Acknowledgements Many thanks to Professor Steve H. Hanke and Dr. Hesam Motlagh for their instruction and guidance over the past year. Additional thanks to Abigail Biesman for her meticulous attention to detail in the editing process.

Keywords: Financial Modeling, Pilgrim’s Pride, Discounted Cash Flow, Free Cash Flow, MonteCarlo Simulation, Investment Thesis, Management Compensation.

JEL codes: C63, G11 Investment Thesis for Gilead Sciences, Inc. (NYSE: GILD) by Stephen Johannesson

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Table of Contents Executive Summary

Company Overview

Risks and Firm Specific Issues

Model Assumptions

Results and Discussion of Model

Proxy Report


Investment Thesis for Gilead Sciences, Inc. (NYSE: GILD) by Stephen Johannesson

Executive Summary:

Gilead Sciences Inc. (NYSE: GILD) is a biopharmaceutical company that specializes in treatments for the human immunodeficiency virus (HIV) and cures for the Hepatitis C virus (HCV). The market currently prices GILD at $82.70, which lies in the lower end of the firm's 52week range ($81.70 - 123.37). This price is slightly below the probable free cash flow per share, $84.34, determined by evaluating the firm with the Hanke-Guttridge Discounted Cash Flow model (HG-DCF). While GILD’s newer drugs Sovaldi and Harvoni have been popular, there are two elements stinting the company’s confidence: patent expiration dates for many of their drugs are near, and competition from rival HCV drugs loom. Further, Sovaldi and Harvoni’s patents will expire in 2029.1 As the current market prices appear to entirely discount the firm’s drug pipeline and ability to grow through acquisition, our recommendation is to buy GILD. Under the stated assumptions about market prices, the firm’s projected cash flow does not take into account any possible revenues derived from current pipeline drugs. Thus, if any of its pipeline drugs and/or future acquisitions yield viable products, the firm will generate free cash per share in excess of its current stock price. For this reason, we rate the stock a buy.

Company Overview:

GILD is a global biopharmaceutical company, operating in over 30 countries, that focuses on the entire drug development process. GILD is part of the S&P 500 with a weight of.3021%, and is contained within 96 ETFs. GILD specializes in the human immunodeficiency virus (HIV), chronic hepatitis C virus (HCV), and chronic hepatitis B virus (HBV). The company is headquartered in Foster City, California. It splits its revenues by geography and product type.

Geography components include the United States, Europe, among other countries and product type is first divided into antiviral products and “other” products. Antiviral products include but are not limited to Sovaldi, Atripla, Truvada, Harvoni, Complera/Eviplera, Stribild, and Viread.

Other products include but are not limited to Letairis, Ranexa, AmBisome, and Zydelig.

In 2012, GILD acquired Pharmasset, Inc, which allowed GILD to create Sovaldi, which was approved in 2014.2 In 2013, GILD acquired YM BioSciences Inc, a drug development company focused on a candidate for hematologic cancers, momelotinib. After GILD introduced its HCV drugs, Sovaldi and Harvoni, in 2013 and 2014 respectively, the company practically doubled in size. In 2014, GILD continued to improve their products by reducing drug side effects and receiving approval of other drug components such as Tybost and Vitekta. Further, in 2014, GILD secured an agreement with Medicines Patent Pool (MPP) to license a generic form of their drug to companies in India and China. Research and Development (R&D) expenses have steadily been growing from $1.8 billion in 2012 to $2.9 billion in 2014. More recently, in 2016, GILD announced its acquisition of Nimbus Apollo, Inc, a company that primarily leads research on developing drugs to combat non-alcoholic steatohepatitis (NASH), a serious liver disease projected to plague many Americans in the next decade. The firm’s history of acquisitions demonstrates that GILD is a capital intensive business.

2015 GILD 10-K Filing, pp. 14 2015 GILD 10-K Filing, pp. 16 Investment Thesis for Gilead Sciences, Inc. (NYSE: GILD) by Stephen Johannesson GILD has massively outperformed the S&P 500 for the last five years, yielding a ~400% return.

Analyst recommendations are split between rating GILD a buy (18 ratings) and a hold (10 ratings), with no sell recommendations (Source: Bloomberg Terminal, function ANR). The target prices ange from $81 to $135 dollars. The firm’s massive stock gain from ~$20 per share in 2011 to ~$80 per share in 2016 has indisputably been driven by the HCV drugs Sovaldi and Harvoni. Both are approved for use across multiple genotypes of HCV, as well as some HIV cases. Sovaldi and Harvoni have captured the HCV market so well they have left little room for growth. Capturing 93% of the current HCV market, Gilead is left with the option to grow by acquisition, or by improving their current intellectual property (IP) base through organic R&D.3 GILD’s control of the HCV drug market is not necessarily secure, however. Competing company Merck released an HCV drug, Zepatier, priced at $54,600 for a 12-week program. In comparison, Harvoni’s list price is $94,600.4 Therefore, due to pricing power, GILD will most likely see shrinking revenues from its HCV drugs.

The losses it might suffer due to prices, though, will most likely not keep the company from being a buy. GILD’s long term asset turnovers and useful life have been significantly varied over the last 5 years due to Gilead’s acquisition of Pharmasset, Inc. in 2012 (Figure 1). Despite the massive drop in LTAT due to this acquisition, the $11 billion purchase has proved worthwhile as sales of Harvoni and Sovaldi now generate nearly $18 billion of revenue a year.

"Harvoni Continues To Dominate Hep C Market, Market Continues To Undervalue Gilead." Seeking Alpha. N.p.,

2015. Web. 14 May 2016. http://seekingalpha.com/article/3066586-harvoni-continues-to-dominate-hep-c-marketmarket-continues-to-undervalue-gilead.

Wasserman, Emily. "UPDATED: Zepatier Beats Harvoni, Sovaldi in Hep C Clinical-data Safety Showdown:

Advera Health Analytics." Pharma News. N.p., n.d. Web. 14 May 2016.

Investment Thesis for Gilead Sciences, Inc. (NYSE: GILD) by Stephen Johannesson Since 2012, Gilead has improved asset turnovers to ~1.2 as their revenue growth has stalled and the company has matured. Going forward, large acquisitions will likely cause huge drops in asset turnovers that may take years to recover. For this reason, it was difficult to use the asset turnover ratio as a driving parameter in the HG-DCF model.

GILD’s pipeline focuses primarily on the treatment of HIV and liver diseases. New formulations of existing tenofovir (TAF), emtricitabine, and other HIV regimens span Phase 1 through Marketing Application. Regarding liver diseases, sofosbuvir and velpatasvir formulations are tested for treatment of HCV, while Simtuzumab is an antibody being evaluated for the treatment of NASH, which is estimated to effect up to 2-3% of the general population.5 The firm also has approximately $19 billion of current assets and $13 billion of marketable securities with which it may choose to acquire drug companies with promising research without taking on heavy amounts of debt. Thus, it seems clear that pipeline and opportunities for growth look strong for GILD in the future, despite the short term headwinds in pricing.

Risks and Firm Specific Issues:

 Expiration of drug patents requires the firm to consistently innovate and/or grow by acquisition  Price competition from competitors  Prevalence of diseases treated or cured will heavily influence future demand  Pricing power may interfere with the firm maintaining its high prices.

Model Assumptions:

The primary difficulty in modeling Gilead using a discounted cash flow analysis was projecting realistic revenue. Therefore, to remain conservative, our revenue projections assume that revenues for each drug will drop to zero after the patents on each drug expires. Though this estimate is very conservative, we cannot assume that any significant revenues will remain after a drug loses protection. If we were to forecast any upside in GILD, the company would be significantly undervalued. In addition, we have assumed that Harvoni and Sovaldi revenues will decrease 2% year over year. We have not made assumptions about the value of any of GILD’s pipeline drugs. These assumptions help to secure as conservative a model as possible, so that the firm’s cash flow performance will be evaluated under pessimistic circumstances.

Cost of goods sold (CoGS), Selling general & administrative (SG&A), and R&D (as % of sales) dropped substantially between 2013 and 2014 due to the massive increase in revenues associated with the firm’s HCV drugs. Based on our models, these expenses will stay relatively close to their most recent three-year values (10%, 11%, and 10.5% respectively). GILD’s effective tax rate was approximately 18% last quarter, and even lower in 2014 and 2015. Thus, we estimated 18% to be a reasonable tax rate for the projection period. We also chose to forgo the standard assumption of a 1.5% terminal period revenue growth rate. As we assumed the firm would simply be generating cash from its existing IP until the terminal year, Capex was assumed to be 1.5% of revenue. Lastly, we have a decreasing long-term asset turnover metric for our model, as Bellentani, Stefano, et al. "Epidemiology of non-alcoholic fatty liver disease."Digestive diseases 28.1 (2010): 155Investment Thesis for Gilead Sciences, Inc. (NYSE: GILD) by Stephen Johannesson shown in Figure 1. This implies that the firm will become less efficient at generating revenue from its non-current assets over time. By assuming this range of pessimistic parameters, the HGDCF will provide us with a relatively poor outlook for the firm. If the free cash flow over the projection period still looks desirable despite the headwinds we place on it, then the stock is likely to be a good investment.

Results and Discussion of Model:

The probable free cash flow per share calculated using the HG-DCF model was $84.33 versus a market price of $82.70 (Figure 2). The current price falls in about the 30th percentile for the distribution. The model assumptions and GILD’s low deviations in its value drivers, however, make the distribution narrow. We see, then, that in the absence of any acquisitions or large developments in the pipeline, GILD is likely to produce free cash in excess of its stock price.

This is dependent on the assumption that GILD will not lose more than 5.5% of their revenue (year over year) for the next 10 years. We see this as a reasonable estimate considering that this would imply that management will do nothing to remedy hypothetical hemorrhaging revenue for up to 10 years.

Figure 2 – Results from the Monte-Carlo simulation show the probable free cash per share on the x-axis and the frequency with which each value was obtained during the simulation. The current stock price falls in the ~30th percentile of the distribution.

Our model predicts that long term asset turnovers will decrease to 0.78 by year 10, a relatively pessimistic assumption considering they only reached those lows during the doldrums in 2012 when their purchase of Pharmasset, Inc. had yet to generate revenues. We suspend our concerns about this idiosyncrasy because it is derived from a combination of the way in which long-term asset turnovers are calculated and the specifics of the pharmaceutical business. Long-term asset turnovers are calculated with a quotient of revenues and noncurrent assets. One of the largest noncurrent assets for any pharmaceutical company is its intellectual property. Unlike a business that relies on its physical assets to help generate revenue, a pharmaceutical company relies Investment Thesis for Gilead Sciences, Inc. (NYSE: GILD) by Stephen Johannesson entirely on its IP, and the drugs derived from it, for its revenue. As mentioned earlier, GILD has the option of growing organically or by acquisition. Acquisitions show up as capital expenditures, because noncurrent assets increase dramatically. Organic growth is not likely to show up on a capital expenditure calculation because those assets are paid for via R&D expenses. This is why we have estimated capital expenditures to be low over the coming years.

We cannot predict when or what effect acquisitions will have, nor can we predict the results of the funds spent on R&D. Therefore, we are unable to accurately determine what the long term asset turnover of GILD will be in the future.

Proxy Report:

To ensure that management compensation is aligned with the creation of shareholder wealth, we

analyzed the Securities and Exchange Commission’s proxy statement for GILD (SEC EDGAR:

Form DEF-14A).

Management Compensation:

Base salary: Fixed annual compensation. The base salaries of GILD named executive officers (NEO) in 2015 lay between $865,000 and $1.7 million.

Annual incentives: Consists of cash and stock options based on performance. Payment criteria for annual cash bonuses are based 75% on corporate performance and 25% on individual performance. The CEO’s bonus, however, is solely based on corporate performance. The graph below depicts how this amount is calculated (Figure 3).

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