Is There Balm in Gilead?

Even with a strong track record of growth, profitability, and cash generation, Gilead Sciences Inc. (Nasdaq: GILD) has significantly underperformed both its sector and the market during the past two years. Is this the beginning of the end for Gilead, or can the company win back investor confidence and move forward?

Gilead is a biopharmaceutical company that focuses on developing and commercializing treatments for life-threatening diseases, primarily HIV/AIDS. With outstanding growth in the past decade, Gilead is now fighting through adolescence, awkwardly positioned between stable biotech and small pharmaceutical without a dividend.

What first caught my eye about Gilead was how it lined up compared to competitors and similar companies.

With the lowest P/E, highest margin, and best PEG ratio in this cross-section analysis, we see a potential strong value buy, pending further fundamental analysis. As is consistent with most biotech companies, a dividend is non-existent, with management indicating there is no plan to implement one in the near future. The growth strategy is to use free cashflow for acquisitions.

In contrast to other biotech firms, however, Gilead has made a long-term commitment to repurchasing shares, which has an effect similar to a dividend. You could make the argument that this keeps future cash purposing flexible for acquisitions and other growth opportunities, while still taking care of investors’ need for capital appreciation in the mean time.

In the first quarter this year, sales and profits were lower than during the same period a year ago, signaling a fundamental breakdown to some investors. Looking closer at the most recent earnings report (issued in April), management highlighted a 79% ($235.3 million) year-over-year Q1 drop in royalty revenues from Tamiflu as influenza pandemic fears eased, causing sales and earnings to disappoint. In my mind -- and analyst FY12 estimate revisions appear to agree -- there is no long-term impact from this news.

Estimating a wide long-term growth range of 5% to 14%, and using a reduced margin range of 23% to 31%, we arrive at a 1-year price target of $47.34 using a discounted cashflow model.

I believe there are two major risk factors for Gilead that warrant consideration of the low end of my valuation inputs: generic HIV medications, and growth through acquisitions. Because more than 85% of sales are from HIV medications, the availability of generic substitutes can certainly threaten to stifle the growth of that major segment and, consequently, Gilead as a business.

And although acquisitions provide a (hopefully) solid business opportunity without the upfront risk of R&D, relying on outside developments for growth demands significant effort and diligence from the management team. It can be a challenge to acquire the right portfolio for the right price even as competitors with potentially deeper pockets court the same candidates.

In light of these risks, Wall Street analysts have been revisiting Gilead recently to raise price targets and ratings. The popular aggregator of analysis from the masses, Motley Fool CAPS, gives the stock a solid 4-star rating, while the ratio of “buy” to “sell” recommendations among their top members is 665 to 11.

So what's my take? I believe Gilead has upside worth buying. It's certainly worth consideration for biotech and pharmaceutical exposure in your portfolio.