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%).

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