Biotech and pharmaceuticals are two of the hottest sectors in the stock market in the past several years. Along with the declining market, however, biotech and pharmaceuticals stock prices have also fallen significantly. Value investors might take advantage of the lower stock prices to buy good biotech and pharmaceutical firms at the moment. Recently, I have noticed Gilead Sciences (GILD, Financial), one of the great research-based biopharmaceutical companies. Its stock price has plunged from $122 per share in June 2015 to only $87 at the time of this writing. Valeant Pharmaceuticals (VRX, Financial) is another one, which fell from nearly $260 per share to only $85 per share now.
Growth is not created equal
Both Valeant Pharmaceuticals and Gilead Sciences have grown significantly over time. In the past five years, Valeant’s revenue consistently increased from $2.46 billion to nearly $10 billion, while its operating cash flow jumped from $640 million to $2.45 billion in the same period. Gilead Sciences experienced similar growth, raising its revenue from $8.38 billion in 2011 to more than $32.6 billion in 2015. Its operating cash flow surged from $3.7 billion to nearly $18.5 billion in the past five years. However, looking deeper, the two companies' growth are not created equal. While Gilead focuses on both internal R&D and acquisitions to grow the business, Valeant has chosen to grow itself mainly via acquisitions and drug price hikes. On their balance sheets, the difference between the two companies is really eye opening. Out of $48.4 billion in total assets, Valeant’s goodwill and intangibles, which had been generated from business acquisitions, accounted for as much as 82%. Gilead has a similar asset size of $51.8 billion, but has a much lower percentage of goodwill and intangibles, accounting for only 22.2% of the total assets.
Charlie Munger (Trades, Portfolio), a 91-year-old legendary investor of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), has considered Valeant’s practice of acquiring rights to treatments and increasing prices significantly as “deeply immoral” and “similar to the worst abuses in for-profit education.” Thus, the company had created a “phony growth record” by using acquisitions and price hikes. It has played with its accounting, but it was not as bad as Enron.
Munger mentioned that Valeant still had some valuable properties such as portfolio of drugs and treatments. What makes it more dangerous is the leverage Valeant has taken over the years. The market capitalization is more than $29 billion, but because of the large long-term debt, the enterprise value is quite high at more than $60 billion. The current trailing 12-month operating cash flow is $2.45 billion; however, the depreciation and amortization is running high at nearly $2.26 billion. Thus the free cash flow comes in at only $190 million. Along with Bill Ackman (Trades, Portfolio), another legendary investor who is also bullish about Valeant, ex-CIO of Geico Lou Simpson (Trades, Portfolio) increased his holdings of Valeant by more than 38% during the fourth quarter.
Gilead’s big bet pays off
While Valeant grows itself through many acquisitions, Gilead made one big bet in 2011 that dramatically increased its operating performance. The company spent around $11 billion to acquire Pharmasset Inc., an 89% premium for Pharmasset shares at that time. In 2014, Gilead more than doubled its sales to $22.8 billion, greatly attributable to the sales of Sovaldi. Sovaldi and Harvoni, which were launched in December 2013 and October 2014, are HCV products. Since their launch, more than 170,000 patients around the world have been treated with these two medicines. Although Sovaldi’s price is very high now, it has significantly improved lives of patients with HCV. It has shortened the duration of treatment from up to 48 weeks to only 12 weeks. At $87.44 per share, Gilead’s enterprise value stays at $122 billion. In 2015, it generated around $17.4 billion in free cash flow. Thus, the EV/FCF multiple is only 7 times, extremely low compared to its business potential and in the biotech fields. Gilead is currently in the portfolio of Jim Simons (Trades, Portfolio), T Rowe Price Equity Income Fund (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio) and Julian Robertson (Trades, Portfolio).
Between the two companies, I would prefer Gilead with its huge potential, growing business, ample balance sheet and low multiple.
