Gilead Sciences: Up Over 1,100% And Still Cheap
One of the characteristics I look for as a long-term investor is a business that produces products or services that are almost assured of being critical to their customers as far into the future as can be seen. It is nice to find a business offering products and services that customers really want; it is great to find one with products or services the customers need and just might need for the rest of their lives.
Gilead Sciences (GILD, Financial) is one such business. Gilead is a biotech company that develops and markets drugs primarily used in the treatment of serious and chronic medical conditions such as HIV/AIDS, hepatitis B & C, pulmonary arterial hypertension and chronic angina among others. Once acquired, most of these maladies remain with the victim for life and require continuous medication and treatment to control or at least hinder.
The bad news for their customers is actually the good news for the company. These conditions are persistent and becoming more prevalent year after year and as available therapies continue to extend the life expectancy of those afflicted the need for the products produced by Gilead continues to expand. This is a business with a lot of staying power; making it a compelling candidate for consideration.
A little gift from the market
10-YEAR
1-WEEK
As investors, it is our job to always be on the lookout for the opportunity to buy assets at a discount. Sometimes these opportunities come along when the overall market declines and pulls great business valuations down along with everything else. Then there are the times where a great business engages in some type of less than desirable conduct that temporarily depresses its share price. Finally, and this is the case I believe confronts us today, there are those times when shareholders misconstrue a positive or neutral event as a negative. In these cases, investors hear news that concerns them and sell first while asking questions later.
In the case of Gilead, the news that the company would allow generic drug makers to produce and sell some treatments in developing countries such as India at huge discounts to the prices commanded in the developed world. At one point in last Friday’s trading, the stock had fallen from its Thursday close of over $106/share to as low as $97.54 before closing at $105.34. What many existing shareholders who sold in panic on Friday didn’t seem to understand that it does not hurt the prospects for Gilead if they allow a third party to produce and sell their products at a discounted price when those people would have never been able to afford to purchase them from Gilead in the first place. You can’t lose business you never had and could never hope to have; but, it is hard to put a value on the goodwill that a drug company can earn by virtually giving products away to those who have no hope of being able to afford them and virtually no hope of longevity without them.
Right now, Gilead sits about 5% below its 52-week high. And, believe it or not, it is screaming for investors to buy.
Can a stock already up 1,100% still be cheap?
When Gilead first started to appear on some of my screening programs last March, when it fell into the middle $60’s, I asked can a stock that had been selling for less than $10/share at the beginning of 2005 be “cheap” in the middle $60s in April of 2014? The answer can be found in the first three paragraphs of this article. They produce products that extend or save the lives of their customers in markets where the need is growing. And growing fast.
In 2004, Gilead had total revenue of approximately $1.32 billion. By the end of 2013, the total revenue number had risen to $11.2 billion. During that same period, net income increased from $449.37 million to $3.07 billion. So, even though the share price had risen seven-fold from $9 to $65, the proportionate value of the business had remained unchanged, even though it had established a spectacular 10-year track record of positive results.
Now, most of us, myself included, are going to look at this kind of track record and believe we will have to pay a hefty premium to acquire an asset like this. That is not really the case when it comes to Gilead. The business is expected to earn $7.26/share this year and, based on Friday’s closing price of $105.34, trades at a current price to earnings multiple of only 14.5, which is a significant 27% discount to the 2014 S&P 500 P/E of 19.91. This is an astonishing discount for a business that has delivered actual results that have trounced the broad market over the last 10 years.
Investors can always look at past results for an indication of what was; but investing is about what is and what is going to be. Once again, Gilead shines. Over the last 90 days, the consensus analysts’ earnings estimate for Gilead has increased from $5.98/share to the current level of $7.26/share. This represents an increase of 21.4% in a relatively short period of time. But the rising expectations extend beyond 2014. The consensus earnings estimate for 2015 has also increased by 7% over the same period.
I often cite the fact that it is relatively easy for accountants to “massage” earnings numbers and one way I help to compensate for that and verify the validity of the numbers being reported is to evaluate returns on equity, assets and capital. Over the last five years, Gilead has annualized returns for the metrics of 40.8%, 21.1% and 27.4% respectively which are outstanding numbers for a business this size. As businesses get larger and larger, we expect to see growth rates and returns on objective measures to decline. For that reason, it is never a bad idea to compare the 5-year averages for these measures against the most recent 12-month figures to determine if the past growth and performance is being sustained or showing signs of slowing. In this case, with 1-year returns on equity, assets and capital of 54.91%, 27.73% and 34.89%, all three performance measures for the most recent year are superior to the 5-year averages.
It seems pretty clear that we have a solid business that continues to grow at a brisk pace and a management team that is doing an excellent job of producing well above average results when it comes to building shareholder value.
How does the business look in the present?
As mentioned earlier, analysts covering this stock have been very busy increasing their earnings projections for Gilead in 2014, Â raising them by 21.4% in just the last 90 days. Businesses that are priced at a discount to the market and have currently improving outlooks can be great homes for investors’ capital. That is as long as there are not some seriously negative issues hidden somewhere in the financial statements.
While it would be possible to write a book on the complete financial reports published by Gilead, you don’t need to dig that deeply to get a general picture of the financial health of this company. At the end of June, Gilead reported cash, receivables and inventory on their balance sheet worth $14.304.6 billion. The total liabilities (both short-term and long-term) for the entire business were only $15.1155 billion. It is pretty astonishing for a business of this size to have enough current liquid assets on-hand to allow them to eliminate almost all of their short and long-term obligations. This is what could be referred to as a rock solid balance sheet. Strong balance sheets allow management to conduct business in a way that will be most beneficial to shareholders' long-term interest without being subjected to short-term concerns over capital availability.
A very profitable business, a market valuation substantially below the S&P 500 and a rock solid balance establish that this business is well positioned financially to perform going forward. The history and track record management has built over the past 10 years shows that the talent is in place to produce exceptional results. And we have a misunderstood event that has provided us with a brief window of opportunity to acquire the asset at an even slightly better discount than was available just a few days ago. Most importantly, this business has products that literally save lives.
That seems to establish that this business has a very attractive present.
But isn’t successful investing about the future?
There is no question that successful investing is much more about what is to come than what has already been. The interesting thing about Gilead is that what is yet to come appears to be just as good and maybe even a bit better than what we have already seen from this remarkable business.
I understand how difficult it is to imagine a business with a stock price up 1,100% in just ten years as possibly having better days ahead. But, the past doesn’t matter when it comes to assessing present and future intrinsic value of a business. What we must do is determine the fair market value of this business today and then form a range of reasonable forward projections of what the value should be in the future.
In order to establish current fair market value of this business, we can look at the projected earnings growth rate from 2014 to 2015 and use that as a multiple against the projected earnings for 2014 and for 2015. Prior to performing this exercise and in deciding how much weight should be given to the results of the calculations, it is helpful to review how well the business has performed against recent earnings estimates with their actual results. In this case, Gilead has beaten the analysts’ estimates in four of the last five quarters. For those quarters, the company exceeded the estimates by as little as 6.12% and as much as 92%. On average for these four quarters, the company beat the estimate by 37.15%. In the fifth quarter of the last five, the company matched the analysts’ estimate exactly. If that is included in the calculation for the average earnings beat, the company has averaged earnings 29.72% above what the analysts expected over the last five quarters. This provides us with a reasonable margin of safety when using these estimates to calculate fair value.
Using this year’s earnings estimate of $7.26/share multiplied by the projected increase in earnings of 24.83% from 2014 to 2015, we produce a current fair value for this stock of $180.26/share. This figure represents an increase of 71.1% from the current level. Keep in mind that this value is achieved using a price to earnings growth multiple of 1 where many investors deemed 1.5 to 2 times the earnings growth rate to be the appropriate measure.
If we use a more forward looking calculation to establish our current fair value, we can use the estimate for 2015’s earnings times the 2014 to 2015 growth rate of 24.83%. Once again, many investors would consider this to be a relatively conservative approach to establishing current fair value. I like to use conservative measures as I believe they help to mitigate the potential for losses. The consensus earnings estimate for 2015 is $9.07 per share and the result of this fair value calculation is a current fair price of $225.21. This price would require an increase in the current share price of 113.8% from the current level.
There is a school of thinking in the fair value calculation methodology that believes the projected 5-year average earnings growth rate is the appropriate measure to use as the multiplier to the present or next year’s earnings. As the analysts covering the stock expect the earnings to increase at an average rate of 28.6%/year over the next five years and that would produce a higher price than either of my other two calculations, I will stick with my more conservative measures.
One of my personal favorite valuation calculations is to take the average of the 5-year average returns on equity, assets and capital and multiply the result of that times the current year earnings. The average of these three 5-year metrics is 29.76% and multiplied by this year’s projected earnings of $7.26/share produces an estimated current fair value of $216.10/share. Interestingly, this number is very close to the valuation of $225.21/share that resulted from using next year’s projected earnings multiplied by the 2014 to 2015 growth rate.
Simply put, this is a stock that could rise between 70% and 115% from the current level and still not be expensive.
Considering that the current projections of an earnings increase of almost 25% for 2015 from 2014 and the currently rising forecasts, it is hard to understand why this business would trade at a discount to the multiple applied to the S&P 500 when it is only projected to expand earnings at a rate of between 4% and 7% over the next 10 years. Even more difficult to understand is how this outstanding business could be priced so cheaply in relationship to its past results and future prospects; but it is.
Final thoughts and actionable conclusions
When I run across situations that sound too good to be true, I always take extra care to look more closely for whatever it is that I am missing in my analysis. When I can’t find anything tangible to justify a low valuation, I buy. I can’t find anything really wrong with Gilead other than the current low valuation of the stock.
Buy this stock and buy it now. It could easily double in price in the next year but even if my most conservative estimate proves to be twice as optimistic as the reality that comes to pass, this stock will rise by 35% in the next 12 months.
