Monday, July 28, 2014

Gilead Sciences, Inc. (GILD) – Can the Hep-C market size justify Sovaldi’s implied valuation? A plausibility check

As the maker of Sovaldi, Gilead’s 2Q14 net income grew an explosive earnings 376% yoy. Yet it is trading at 10x 2015E earnings, what’s the catch?

I see bloggers and even professional analysts projecting earnings for Gilead then apply a single multiple to the entire company’s earning. This approach has two problems. First, as Sovaldi now constitute over 50% of product sales, it’s better to value it separately. Second, it ignores Sovaldi’s unique ability to cure patients and decrease its own target market size. In other word, Sovaldi is a melting ice cube, thus has to be valued with a different multiple.

The approach
Ideally I would project out Sovaldi earnings versus other parts of Gilead; value them separately, then add up the 2 parts. Before committing the time however, I’d like a shorter plausibility check. Here I will do the reverse. First, value GILD ex-Sovaldi; second, back out Sovaldi’s implicit market valuation; third, check this again the Hepatitis-C market size to see if that valuation is reasonable. This approach saves me from having to forecast whether revenue and earnings should be up 400% vs 300% (or 200% for that matter).

1) Ex-Sovaldi valuation & implied Sovaldi price per share

Gilead’s management is kind enough to give us assumptions for 2014E excluding Sovaldi, so projecting the ex-Solvadi income statement is relatively easy.

Management’s assumptions are below including and excluding Sovaldi:

With ex-Sovaldi EPS going from ~$2 to $2.7 per share the next 2 years, apply a 20-18x multiple would get roughly $40-55 per share for the non-Sovaldi business.

2) Implied Sovaldi valuation and years to break even (at current cure rate)

With GILD trading ~$91 per share, this would imply the market is valuing Sovaldi at $35-50. Sovaldi is expected to contribute $5.9 per share of gross profit for 2014 ($10bn 2014E sales and ~95% gross margin), so the current price requires 5-9 years of 2014E like gross profits.

Is the Hep C market big enough to last 5-9 years before Sovaldi and its competitors cure everyone? Keep in mind the analysis so far eases the hurdle for Sovaldi: 1) the payback period is probably longer because we assumed Sovaldi gross margin falls right to the bottom line. In reality some cost is incurred by Sovaldi. 2) the EPS numbers shown above assumes $8bn of share buyback per year, this boosts the ex-Sovaldi valuation and lowers the Sovaldi break even.

3) HepC market size

A simple market size analysis below shows that at a current annual cure rate of 139k patients, the market can support 6-11 years at the current pace of Sovaldi monetization. The management case assumptions below mostly came from p31-33 of 2Q14 presentation slides. I got the annual cure rate of 139k patient as follows:  for the first 2 quarter of 2014, total Sovaldi patients and revenue were 80k and $5.75bn, respectively. So $10bn of expected 2014E revenue scales to about 139k patients.

At the surface, this should easily be able to accommodate the 5-9 years of sustainability implied by the stock price. Keep in mind though, this is assuming the following:

               i.            No price cuts. Regulators and PBMs have been making some noises here. However, their sabre rattling is based on some really high patient assumptions. CVS for example, cited 3mm of eligible patients versus my forecast of 390 -800k U.S. patients under care above. If we ever get to 3mm patients getting treated then clearly there needs to be a steep cut in Sovaldi prices. But then again, if that’s what regulators and PBMs are using to justify the price cuts then we’re not anywhere near that.
             ii.            GILD takes 100 %mkt share. In reality Merck and Abbvie are both about to come out with their own HepC products. Merck is more of a threat to take market share but ABBV can cut prices in its desperation to drives sales and recoup its investments.
           iii.            Same pricing and margin outside of US.  This is unrealistic as gross margins will likely be lower in Europe due to some of the single payer systems there. GILD is getting about $60,000 in Europe for a course of therapy with Sovaldi.
           iv.            Same volume & pricing mix across all genotypes. There could be some shift here and I may need to break it down further.  For example which genotype is more profitable?  And do those get treated earlier or later
             v.            No discount for time value of money. This is less material

With the above negative factors (and gun to my head), I’d guess the HepC market supports 7-8 yrs of current monetization. So GILD’s stock price at least passed the plausibility check. The market is pretty efficient after all.

So now what - do I suck it up and do that long form detailed model? Just because something is plausible doesn’t mean it’s worthwhile.  What’s the upside?

Counter-argument & other factors
·         Maybe ex Sovaldi GILD is worth more. Stribild is a blockbuster in its own right and has been growing >100%.  20x multiple may actually be too low for the non-Sovaldi business.

·         Market size could turn out much larger. Diagnosed rate and treatment rate assumptions can make huge differences. I already adjusted management assumptions upward in my base case. What does a realistic upside case look like? 
·         Other countries outside of US/EU5/JP.  Other parts of Europe, China, India and others won't be very profitable but they are still worth something.

·         Sovaldi revenue will likely ramp up from its current 2014E levels. This is irrelevant because faster cure rate just shifts revenue forward. Remember the HepC market size is finite no matter how fast your ramp up. In real life faster sales gets you some benefit because a back ended revenue is exposed to competition and price cuts. On the other hand, faster cure rate also lowers the market size because now you have fewer patients to infect others (taking away that already low new patient growth rate of 1-3%).

The search for inefficient markets - are we all trying too hard?

Time and time again I hear people saying investing is about exploiting market mispricing. Sophisticated investors search the globe to find that hidden gem, that scuttlebutt that leads to the earning beat, the thesis that says "I'm right, market is wrong".  To find market inefficiency, people look for under-covered companies, spin-offs, bankruptcies, penny stocks in Kazakhstan…etc.

I don’t dispute that inefficient names may present better risk/return profiles. But how if you are just trying to achieve some satisfactory return target? Did Buffett shy away from Coke just because it’s one of the most liquid and well covered companies in the world? And how about all these people who made fortunes from Apple, Google, and Microsoft – where’s the market inefficiency in that?

People forget that the market can be perfectly efficient and investors can still make money. I’m not talking about buying the SP500 index. It is conceptually similar though - you’re just picking up that required return on equity.

It’s easier to illustrate this with an example. Let’s say company A disclosed a plan to grow earning at 10% CAGR for next 3 years. The market takes that and builds the 10% into consensus EPS outlook. Here are consensus EPS and forward multiples.

The market assigns a 15x forward multiple to expected year 1 earnings of $1.1, for price of $16.5 per share.  Year 2 forward multiple is thus 13.6x. After one year passed, company achieved its 10% grow and EPS reached $1.1/share. So everything went exactly as planned and market was right. Your model would look something like this:

Mr. Market now looks at year 2 consensus EPS of 1.2/share. Is it going to put a 13.6x multiple on it?  No, market will assign the same 15x multiple if outlook has not changed. So price goes up to $18.2 (15* $1.2/share), a 10% gain from the initial $16.5.  Even if company misses earning, say earnings grew at 9% instead of 10%, and multiple contracts slightly due to lowered growth expectation, you might still make money.

The point is there’s nothing wrong with picking up a nice solid return in plain sight. The blogosphere is full of smallish, speculative names that nobody’s heard off in search of market inefficiency. Not saying those are bad ideas. On the other hand, if your goal is 8%-10% return a year and CVS has a reasonable plan to get you there at a reasonable price, do you really need to say “No, I’m not buying it because 20 sell side analysts already cover it, and everything’s priced in?”.  Or do you say, maybe, just maybe, upon through analysis of industry dynamics, competitors, management strategy, financials..etc,  the stock promises safety of principal and a satisfactory return?

Tuesday, July 15, 2014

Reynolds - Lorillard merger arbitrage considerations

Background. On 7/15/2014, Reynolds (RAI) announced that it plans to buy Lorillard (LO) for $50/share in cash and 0.2909 share of RAI stock. The cash portion will be funded with debt raise, investment from BAT, as well as selling off Blu eCig & other brands to Imperial. LO stock traded down to $60/share.  RAI traded down to ~$59.

o    The trade:  Buy LO; short 0.2909 shares of RAI.  Pay $60 for LO, get ~$18 for shorting RAI = Net cash outflow of ~42/share. This effectively locks in $50 of cash for an 18% gain if deal closes.

·         I have not decided to enter this trade - still taking notes and gathering some considerations here. Regardless, due to the asymmetric risk and reward profile, this would not be a large position.

RAI-LO merger arbitrage considerations
o    Deal expected to close 1H 2015. Let's say June and we're looking at a little less than a year, so IRR will be > 18%.  Call it 20%.

o    Likelihood of success?
·         Lots of approval needed.  From shareholders of LO/RAI/Imperial, as well as FTC. Should be no problem from RAI' end as it is 42% owned by British Tobacco.  But will LO shareholders approve?  LO shareholders might not like that they'll be selling off Blu brand..
·         Does the deal make sense?    I question the value of the deal without Blu, and the fact that RAI just took on more menthol risk.
o    Risk of failed deal - partially protected/offset by RAI short.
·         Regulatory approval is an issue but in that case RAI would get hurt as well.
·         Both Imperial Tobacco PLC and RAI will be using debt financing so there's a capital market risk

o    Risks that are not protected by RAI short
·         If menthol regulation get worse then that would hurt LO disproportionally. This risk has been around for at least 3 years and all parties are well aware of it.
·         Due diligence finds something wrong with LO.
·         Management positions beyond CEO roles are still being sorted out.  Politics could sink the deal.
·         LO has union employees who might oppose this.

Risk & Reward: 
o    18% gain if deal closes.
o    What kind of losses am I looking at if deal fails?  If LO falls back to ~$48 (before media speculation started), then we're looking at 20-40% loss depend on cost of closing out RAI short. I think losses would be at the better end of that range since RAI stock also had benefited from the potential merger.

o    Correlation between the stocks increases the chance that shorting RAI will be an effective hedge 

Notes on deal impact
  • Combined RAI/LO:  
    • Camel and Pall Mall, Natural American Spirit, Grizzly and VUSE; + Newport
    • Pro-forma: $10 billion in revenue, ~32% market share
  • Imperial gets
    • KOOL / Salem  / Winston  / Maverick  / blu brand.
    • In addition to the brands, Imperial will acquire certain assets currently owned by Lorillard including our headquarters, manufacturing and R&D facilities in Greensboro, North Carolina, as well as LO's facility in Danville, Virginia and approximately 2,900 employees, including its national sales force.
  • Management placement:
    • RAI’s CEO, Susan Cameron, will lead the combined RAI / Lorillard.
    • Murray Kessler, Lorillard’s CEO, will be joining the Board of Directors of RAI.
    • Martin Orlowsky, former CEO of Lorillard, will be joining as Executive Chairman Designate of Imperial’s U.S. business 
    • The remaining management positions will be named at a later time. 
  • $800 mm of cost saving on runrate basis - I question how this works as RAI will have no job reductions and LO will have minimum cuts...Can this really be just from selling to Imperial?
  • LO Retirees:   "no effect on your pension or benefits. All retiree benefits are fully-funded and you will continue receiving all payments and benefits as you usually do."
  • RAI side:
    • RAI to its employees:  "shut up its none of your business"
    • Reynolds American will be raising $9 billion of new debt to finance the transaction. The company anticipates leverage of 3.6x debt/EBITDA at closing, moving to less than 3x within 24 months.  They are confident the IG rating will be maintained
    • R&D and technology-sharing initiative with BAT

Friday, July 11, 2014

Why I like Managed Care Organizations (MCO)

** Draft: This will go through several iterations of updates. 

Why I like Managed Care Organizations (MCO)
The secular growth story of healthcare sector is not hard to understand.  Aging population and Obamacare expands the size of the pie; while government budget constraints means private sector gets a larger share of that pie. This applies not only to PBMs (which I have written about in another article), but also helps MCOs. For MCO’s specifically, the exchanges mandated by ACA also provide opportunities to lure some of the Administrative Services Only (ASO) business to full risk business, which has higher profit per member (by 4x in some estimates).

These are good businesses that are relatively simple. Compared to say, a life insurance company where you have all kinds of derivative exposures and quality of earning concerns, health insurance is much simpler because these are annual contracts. Furthermore, MCO’s are not pure risk businesses. In general there’s a large service component which is less capital intensive and high return (Nice ROE in the mid/high teens). Low capex also means strong cash flows and thus optionality to deploy capital.

Industry structure is fairly attractive. This is a fairly concentrated industry with several established national players (will discuss later). Other than the government, customers are fragmented and have low bargaining power. While some parts of the supply chain have consolidated (PBMs, distributors for example), providers (hospitals, physicians…etc) will likely remain fragmented. As large customers MCO will exert power to push prices lower for the benefit of consumer.  Keep in mind that health plans are essentially commodity products so brand recognition is important. When you’re selling what’s basically a financial service, there’s just not much differentiation. How many customers can really tell the difference between UNH, CIG, AET?  In my old company, where it comes time to pick health plans, most people just ask their friends (blind leading the blind) or randomly choose one. Despite being a commodity, barrier to entry is extremely high due to state level regulations, capital requirements, and the need for a provider network. 

Why now?
1.       Valuation. Managed care is one of the few sectors that are still reasonably priced. The chart below shows that valuation has increased but still not high by historical standards
2.       Mitigate risks in portfolios. People always need healthcare. In the past health plans do get hurt by unemployment in a down cycle, but I’m guessing demand should be more constant in the future due to individual mandates.  Although I don’t know where rates will be headed, higher rate is a general risk factor, and Managed Care is one of the few sectors where rising rates would help (through higher investment income)

Key players:

UnitedHealth Group Inc (UNH)
  • Large & diversified business:  UnitedHealthcare + Optum Health Services
  • Exposure to NY where competition is intensifying according to management. Bad star ratings hurt its MA business.
  • Amazing streak of beating estimates all the way back to 2009.  Aggressively retuned capital to shareholders 2010-2013
  • Has its own PBM

Wellpoint Inc. (WLP)
  • Largest provider of Blue Plans. About 20% of members from government business (12% from Medicaid)
  • Management levers
    • Uniquely positioned to consolidate other Blue plans
    • PBM “optionality”.  WLP currently uses Express Scripts.  However there’s a good chance they that WLP will either renegotiate better terms or otherwise extract another payment from ESRX.
  • Consistently the lowest margins and ROE among big 4.
  • Has hedging value if you own ESRX

Aetna Inc. (AET)
  • EBITDA Mix:  39% large group insured, 24% commercial fee business, 22% government; 15% small group/individual/group insurance. Membership mix: ~15% government (7% Medicare)
  • Sensible goals and strategies in my view. AET aspires to double revenue by 2020 and achieve double digit EPS growth with 5% organic and 5% capital deployment.  To that end, management plans to increase government profit substantially over next few years.
    • Grow Medicare Advantage (MA) & dual eligible.  AET is well positioned in MA to do this as they have strongest STAR scores.  AET is also aggressively getting into the public exchange business where clients are more likely to be full risk, which has higher margins.
  • PBM relationship with CVS. 

Cigna (CI)
  • Traditionally has the least risk business (more of ASO)
  •  “Go Deep. Go Global. Go Individual” strategy. Low commercial member growth but go for deeper product penetration.
  • Has Catamaran as its PBM
Humana (HUM)
  • Medicare focused, roughly 35/35/25 in retail/employer/healthcare services
  • 68% government business almost 90% risk). Particularly Retail MA & Medicare-PD.  Not much Medicaid
  • Looking to sell its PBM

At this point, I favor Aetna.
·         Actually, I’d buy all of the above. So it’s a matter of maximizing value by buying at the best prices.
·         I particularly like Aetna. It has a coherent strategy to increase earnings matched with action. For example management wanted to get more Medicare business, so they bought Coventry and have a high percentage of members in high STAR rating plans. I also like how they’re aggressively getting into exchanges.
·         Good operator.  AET consistently has one of the higher margins in the group.  Both AET and UNH aggressively bought back stocks over the past few years which in retrospect were greatly accretive. Compare to UNH however, AET trades at a lower multiple and is more of a pure play MCO.
·         Key things to watch out for in 2014 are how they manage to offset MA rate pressure & ACA fees; progress in Coventry integration.

Saturday, July 5, 2014

Reviewing Express Scripts Holding Company (ESRX)

Express Scripts Holding Company 

ESRX is a very well covered stock so I will just comment on recent performance and then focus on valuation. I did find 2 buy side write-ups that are particularly insightful. The first can be found in SumZero (by Jason Spilkin) and the second one can be found on (by Alex Bak) here. Seeking Alpha has a couple of nice ones also.

Thoughts on Recent Events
1Q14 results were disappointing as ESRX missed both top and bottom line. Growth came in below expectations even after taking the loss of UNH contract into account. This is in comparison with Catamaran having a strong quarter. Gains in EBITDA per claim were offset by volume shortfalls, for which management blamed “delayed client implementation” and of course, the weather, among other things. (By the way did anyone else notice management repeatedly pass the buck by saying “Dr. Miller is not here”?). It looks to me management is not telling the whole story and that ESRX is losing ground to competitors.

What is the market pricing in?

On 6/29/2014 ESRX traded at $69.6/share, which represents 14x 2014 earnings (consensus), 12.6x 2015 P/E, and ~11x LTM EBITDA. These are multiples that reflect pessimistic long term growth prospects. For the next few years though, consensus is expecting 5-6% CAGR in EBITDA.

Levers & Upside

Is that consensus realistic? I think so. EBITDA/Claim has been growing double digit rate the past 2 years (see below table for key drivers).

Business mix is one of the levers that management can pull. They have been focused on home delivery/specialty. (ESRX reports them together). These were only 12% of claims in 2013 but 36% of revenue and growing. As specialty drugs costs are inflating 15-20% per year, ESRX (and other PBMs with strong specialty offerings) will get a growing cut of that. Overall I don’t think EBITDA growth of 5% CAGR is that tough to beat. In fact If ESRX just stabilizes its volume we can look at some easy beats.

Financial flexibility is a big plus as ESRX can use its very strong FCF for buybacks, dividends, acquisitions…etc. They also have room to raise leverage further (currently ~2-2.5x EBITDA). If all else fails, ESRX can grow its earnings and free cash flows per share just from financial engineering.

Despite the weak 1Q14, ESRX just have too much scale, name recognition, and destructive power to not be able to overcome these short term pressures. I mean, this is the company that gave Walgreens a black eye for messing with them. Could Catamaran have done the same to Walgreens with their < 10% market share? I don’t think so.

Why is it cheap? Risks

1. Short term. Weak 1Q14 indicates that ESRX may be losing market share to competitors. ESRX also received 3 subpoenas over relationships with drug makers. Management did not offer details on these during the 1Q14 call.

2. Longer term, pressure from managed care clients. In my write up about PBMs, I mentioned pressure from managed care client as a big concern. Wellpoint (WLP) is the company’s largest client and contributed 12.2% of revenue in 2013. Its contract expires 2019 and WLP has been making noises about its PBM “optionality” lately. Specifically, Glenview Capital made the following point about Wellpoint at the Ira Sohn coference:

“. Improve terms of the current outsourcing arrangement with incumbent (ESRX) or another PBM, closer to comparable recent transactions. Achieving terms similar to AET/CVS (2010) or CI/CTRX (2013) would add ~$750M to WLP EBIT (+19%).
. Receive another up-front payment to renew the “long-term lease” on the outsourced PBM from the incumbent or another PBM. ESRX paid $4.7B for the contract in Dec 2009. A new deal could be worth >$5B in 2017 (+16% of WLP market cap after taxes)”

Large contracts typically have lower margin, so a loss of Wellpoint contract might lead to 10-12% decrease in EBITDA. While this is certainly material, it is not a devastating loss. Renegotiation will not occur until 2017, so ESRX has plenty of time to diversify its revenue base in the meantime. In my opinion managed care is also an attractive area, and investors can buy WLP as a hedge for ESRX.


Here are the scenario matrices with volume growth and EBITDA per claim at 12.5x and 14x 2016E earnings. These are conservative multiples, and I think ESRX can easily reach 15x P/E once growth stabilizes. The results show that ESRX just needs a 5% volume CAGR and 5% EBITDA /claim CAGR over the next 3 years for the stock to be a winner. I think that’s a pretty good bet. Keep in mind this is without factoring in share buybacks.

Using 14x P/E: