AMM Dividend Letter 35: Expectations Versus Reality & Gilead (GILD)
Our 2017 stock market prediction was wrong!
From Issue 32
The S&P 500 will return between -26% and 20%!
The total return for the S&P 500 in 2017 was 21.82%.
In our defense, the prediction was only within a 95% confidence range and we did say that we could still be wrong.
Our hope for 15+ years of correct predictions crashed and burned in its second year.
What do we see for 2018?
First, why are you asking us after failing to correctly predict last year?
Second, this chart from Hulbert Ratings starts our answer.
Our short answer is it will probably be up.
The long answer is…
Happiness boils down to a simple formula*.
Reality – Expectations = Happy/Unhappy
When your expectations exceed your reality. You’re unhappy.
When your reality exceeds your expectations you’re happy.
This applies to the stock market too.
High stock prices come with high expectations. When the future arrives and it does not meet expectations, investors are unhappy and sell their stocks.
Current all-time high U.S stock prices come with high expectations. Even if companies continue to report good earnings and good growth, if earnings come in below expectations then it is viewed as bad news and stocks will sell off.
There is a good chance we have positive returns this year. But because we started the year with such high expectations we should be ready for some disappointment.
We don’t invest your money trying to guess when the stock market will go down. We know that we don’t know when the stock market will correct. And we know that if we try and guess we’ll cause more harm than good to your portfolio over the long-term.
In Issue 28 we discussed a light guessing experiment pitting rats and Pigeons against humans. The subjects had to guess when the light would flash red or green to receive their reward.
In the experiment, people were measured against both rats and pigeons. Each subject received a reward after guessing correctly which light flashed next. The flashing lights were completely random but the green light flashed over 80% of the time. The optimal strategy is guessing green every time. You’ll be right 80% of the time.
The rats and pigeons figured out this strategy fairly quickly. The human subjects figured it out quickly too. So it was a tie, right? Wrong.
After a little bit of trial and error, the rats and pigeons guessed green every time and scored an 80% success rate. The people on average scored a 69% accuracy.
The human subject thought they had figured out the pattern. They saw the green light flash more than the red light but they still thought they knew when the red light would flash. The pigeons and rats understood that they should just hit green all the time to maximize their long-term rewards. They’ll be wrong sometimes but they won’t go hungry.
It is the same with investing.
This is one of our favorite data tables and it comes from Ben Carlson at A Wealth of Common Sense. It is the probability the S&P 500 will be positive or negative given a time period. The longer the time period the greater the odds that the S&P 500 is positive.
We approach investing with the expectation that the light will flash green; the stock market will produce a positive return. We know that it will flash red – produce a negative return – from time to time. But if we want to maximize long-term returns we need to see the flashing red light as an opportunity. It is when the stock market corrects that we get the opportunity to buy the businesses we love at a better price.
Your Portfolio Management Team
*This obviously excludes those who’ve been diagnosed as clinically depressed and/or with similar health issues.
Dividend Stock in Focus
Gilead Sciences (GILD): $75.57
price as of the close March 22, 2018
You know the old critique of drug companies.
“Drug companies don’t want to find cures. They’d rather keep you sick so they can sell more drugs and make more money.”
The truth is curing diseases with a pill is really hard.
But now with the advancements in biotechnology, drug companies are increasingly able to cure diseases.
Gilead and Hepatitis C is a prime example.
Hepatitis C is a chronic viral liver disease that can cause cirrhosis of the liver. People who suffer from Hep C on average lose 15 years of life expectancy on top of other health issues.
Gilead has brought to market several Hepatitis C drugs that can cure people of Hepatitis C. Most notably Sovaldi and Harvoni. Harvoni is actually a combination of Sovaldi and Ledipasvir. Both drugs have effective rates of 90+% depending on the Hepatitis C genotype they are targeting.
And contrary to the belief that drug companies want to keep you sick to make more money, Gilead made a lot of money selling its Hepatitis C drugs.
The problem for Gilead as a business was people were cured.
The initial high growth rate for Harvoni and Sovaldi were due to the large number of people suffering from Hepatitis C. But as people were cured patients starting treatment slowed. Also, other drug companies, like current portfolio holding AbbVie, introduced competing Hep C drugs.
The increased competition for fewer patients drove sales lower.
As expectations for Gilead far exceeded its reality investors soured on the company and drove its price lower. We think market participants drove the price of Gilead to a price point that compensates us for taking the risk to invest in it.
Gilead is a new dividend payer. The company paid its first dividend to shareholders in June of 2015 at a quarterly rate of $0.43 per share. Over the last two years, Gilead increased its quarterly dividend to $0.52 per share, a 20% increase. And soon after our initial purchase in Gilead earlier this year, management announced another 10% increase in its quarterly dividend.
Given Gilead’s strong cash flow, low payout ratio (23%), and large cash balance we expect Gilead to continue to increase its dividend as well as buy back shares.
Catalysts for Dividend Growth & Capital Appreciation:
We previously discussed CAR-T in Issue 13 when discussing Novartis (NVS). CAR-T is the process of extracting your T-Cells, editing them to identify a specific protein on your cancer cells, reintroducing them into your body, and then letting your immune system fight off your cancer.
CAR-T has been very effective for blood borne cancers. Gilead’s first approved CAR-T product is Yescarta Yescarta is authorized in the treatment of aggressive B-cell non-Hodgkin Lymphoma for patients whom two other types of treatment for their cancer have failed.
In trials after a single infusion, 72% of patients responded to Yescarta, and 51% showed complete remission.
Some estimates have the blood borne cancer market at a potential $8 billion market. In 2017 Gilead bought Kite pharmaceutical as a platform to launch CAR-T therapy for other non-blood borne cancers. The big goal is to develop CAR-T for solid tumors.
A solid tumor breakthrough opens up the therapy for all types of cancers including lung, colon, and breast. Three of the most common cancers and causes of death from cancer.
The amount spent on treating colon cancer in just the U.S, U.K, Germany, Japan, China, France, Italy, and Spain is expected to rise to $11 billion by 2025. CAR-T’s potential across all major types of cancer can quickly get into the $100’s of billions.
Cancer is predominantly a disease of aging. Unfortunately, the demand for cancer treatments will not subside. The good news is that with new technologies like CAR-T the possibility of curing people of their cancer is becoming a reality.
At year end 2017, Gilead had $36 billion in cash and marketable securities. Gilead is known for making timely acquisitions. It is how they got their blockbuster Hepatitis C drugs and expanded their CAR-T therapy platform.
Gilead has a large amount of available cash and generates a lot of free cash flow to fund further purchases.
One area that Gilead has discussed on earnings call is gene editing. CRISPR, a breakthrough gene editing process, is a tremendous help to CAR-T.
The Broad Institute and Jennifer Doudna of UC Berkeley are broiled in a fight over who owns the CRISPR/Cas9 patent. The Broad Institute had an early U.S. victory but recently suffered a loss in Europe. It is possible that Gilead is waiting for the patent battle to settle before making a purchase.
CRISPR Therapeutics (CRSP) seems like the best fit for Gilead. CRISPR Therapeutics is one of a few companies with a license from the Jennifer Doudna and UC Berkeley Intellectual Property (IP) portfolio to use CRISPR. CRISPR Therapeutics is creating their own IP on top of the CRISPR/Cas9 IP and their focus is on CAR-T therapies.
If Gilead is interested in CRISPR Therapeutics they are not the only ones. Bayer owns 11+% of the company and Celgene is CRISPR’s third largest shareholder. Celgene also just bought Juno Therapeutics a CAR-T competitor to Gilead.
HCV Market Stabilization
There are signs that the HCV market is stabilizing. Competing companies have retreated from the market leaving Gilead, AbbVie, and Merck to battle it out
Gilead and AbbVie (another holding of ours) are the two leaders. Gilead is the absolute leader. That may change because of AbbVie’s latest Hep C drug but more on that below.
During Gilead’s Q4 2017 Earnings Call management stated that they see the Hep C market stabilizing his year.
Going forward, we don’t see any new HCV product launches disrupting the market. This leaves two remaining variables, the number of patients to start therapy each year and market share versus our competitors. As Robin mentioned, we’ve set patient starts to continue to decline, although more slowly than in the past, and market share versus our competitors is expected to stabilize by the middle of this year.
Given these changes, Gilead’s HCV revenue should be a more predictable, albeit smaller, piece of our financial story. By removing most of the overhang of declining HCV revenues going forward, we can focus on the positive financial trends driven by the continued uptake of TAF containing regimens and short-term and long-term growth through Yescarta, selonsertib and filgotinib.
And AbbVie during their Q4 2017 earnings call confirmed this.
I would agree that it is our expectation that the volume should stabilize going forward, but I’d also say that there could be some single-digit pressure, downward pressure.
Gilead’s operating profit margins have dropped from a high of 68% back in 2016 to 54% in 2017. The margin decline is due to the HCV market. A stabilizing HCV market should equate to a stabilized operating profit margin. And a high operating margin leads to high free cash flow that can be used to buy back more shares, increase its dividend, and help fund further acquisitions.
Pre-Mortem (Potential Risks to our Thesis):
AbbVie is Gilead’s largest competitor in the Hepatitis C market. Late last year AbbVie launched its latest HEP C drug Mavyret.
Hep C has 6 major genotypes. Mavyret works on all 6. Gilead’s Harvoni works on genotypes 1 and 4 and some people with genotype 3. Sovaldi works on genotypes 2 and 3. The most common genotype in North America is 1 and Harvoni is really effective for treating genotype 1.
It is unlikely that Mavyret will unseat Harvoni. Mavyret’s real threat is in the other genotypes.
Gilead’s latest Hep C drug is Epclusa and it too works across all genotypes. However, Mavyret is an 8 week program versus Epclusa’s 12. AbbVie also priced Mavyret well below Epclusa.
The wholesale acquisition cost (WAC), the price at which the drug is sold to the wholesalers, for Mavyret is $13,200. Epclusa’s WAC is $24,920.
Epclusa accounted for 38% of Gilead’s total 2017 Hep C sales and 13.8% of its total 2017 sales.
Epclusa was also Gilead’s fastest growing HCV drug. Gilead will most likely match AbbVie in price and rebates to maintain Epclusa’s market share. And this will put further downward pressure on Gilead’s Hep C drug sales.
CAR-T Risk & Possibly Obsolete
CAR-T has a lot of promise in fighting and curing cancer. The market potential is huge if CAR-T can be used effectively on solid tumors too.
CAR-T has its drawbacks. It is very costly. Initial pricing for Yescarta is quoted at $373,000. Patients rarely ever pay the full price but the headline is shocking. But what price are you willing to pay for full remission of cancer?
A big issue with CAR-T is it can cause a major immunological response across your whole body called a Cytokine Release Syndrome also known more menacingly as a Cytokine Storm. A Cytokine Storm can lead to death, it was what caused the deaths of so many people who contracted the Spanish Flu (although it originated in China) in 1918.
It’s also possible that CAR-T might be rendered obsolete or unnecessary before it gains major traction.
Researchers at Stanford have developed a “vaccine”, it’s a shot like a vaccine, that achieves similar outcomes to CAR-T without the extra steps of editing your T-Cells
“The new method works to reactivate the cancer-specific T cells by injecting microgram amounts of two agents directly into the tumor site. (A microgram is one-millionth of a gram).
The first, a short stretch of DNA called a CpG oligonucleotide, works with other nearby immune cells to amplify the expression of an activating receptor called OX40 on the surface of the T cells. The second, an antibody that binds to OX40, activates the T cells to lead the charge against the cancer cells.
Because the two agents are injected directly into the tumor, only T cells that have infiltrated it are activated. In effect, these T cells are “prescreened” by the body to recognize only cancer-specific proteins.
Some of these tumor-specific, activated T cells then leave the original tumor to find and destroy other identical tumors throughout the body.”
87 of the 90 mice with transplanted Lymphomas were cured after a single treatment. The 3 mice that had their cancer come back were treated a second time and cured.
The Stanford researchers saw similar results in mice with colon, breast, and melanoma tumors. They are moving on to a study with 15 people who have low grade lymphomas.
Cancer is a Gordian Knot. There are a lot of biochemical pathways involved in treating and trying to cure cancer. This “vaccine” may not render CAR-T obsolete but if it even reduces the need it would be a big loss for Gilead and the potential total addressable market for CAR-T therapy.
On an Enterprise Value to EBITDA multiple comparisons, Gilead is very cheap next to its closest competitors. Currently, Gilead trades at an EV/EBITDA multiple of 7. If Gilead were to trade up to 10x EV/EBITDA, still low compared to its closest competitors, we get a share price around $100 per share.
Our base case economic profit model, continued low single digit decline in revenue, industry average Return on Invested Capital (below GILD’s average) produces a per share price of $87 per share.
Our base case doesn’t account for CAR-T yet nor does it factor in potential acquisitions because they haven’t happened yet.
We are being offered good potential upside reward for the price and risk we are taking buying Gilead today.
All previous letters are archived here.