Decoding Biotech and Finding Opportunity in Gilead $GILD

Biotechnology stocks have been on an upswing lately, pushing the iShares Nasdaq Biotechnology Index up roughly 20 percent through the first two months of the year – returning more than twice as much as the market’s 8 percent for the same period – and the high numbers are no fluke. Biotech is a unique industry. Most companies in this realm are able to boast increasing sales and high margins, even during the last recession. Rather, their success pins directly on their respective abilities to turn research into commercial money-makers. When they hit that proverbial gold, medical need is often so high that regulators accept virtually any price.

Gilead Sciences, Inc. (NASDAQ:GILD)

Take Gilead Sciences (GILD) for instance. Its main focus right now is on developing products for the treatment of HIV. The majority of its revenues were generated from its HIV franchise and the company has a leading position in the HIV drug market in US. Recently, the company has been working on products that allow for the detection of HIV earlier and, as a result, starting anti-viral treatments sooner. Gilead is also developing certain new HIV combination drugs, which we believe will help the company expand its franchise significantly.

Gilead is also engaged in developing and selling medicines for the management and cure of other diseases, like Hepatitis C. To that end, the company acquired Pharmasset Inc (VRUS) in January this year for a total of $11.2 billion. Pharmasset’s GS-7977 has robust cure rates to date and is widely recognized as a potential leader in the next generation all oral regiments for hepatitis C. As such, the acquisition of Pharmasset helped Gilead advance its pipeline for hepatitis C treatment drugs considerably. The drug is expected to reach the market in 2014 or 2015. Patients who had failed prior treatments with Interferon had a high relapse rate after a GS-7977 and Ribavirin combination regiment without Interferon. Gilead is taking active actions in looking for combinations for other oral anti-viral drugs with GS-7977.

Gilead had roughly $10 billion in cash and about $7.9 billion of debt on its balance sheet at the end of 2011. The large cash position helped the company to fund its acquisition of Pharmasset. It had used its cash on hand plus $6 billion of new debt to finance the deal. We think the interest expense will be higher in the near-term because of its new debt issuance, increasing pressure on its margins. The new debt is also expected to slow down Gilead’s share repurchases.

The company has bought back about $6.2 billion worth of its shares since the beginning of 2010, which represents about 18 percent of its shares outstanding. The company completed a $5 billion share repurchase program at the end of September 2010 and announced that it would initiate another $5 billion share repurchase program. However, those plans were put on hold. In November last year, Gilead announced that it would suspend its share repurchase program as the company plans to focus on reducing its debt first.

Gilead is currently trading at $46.48 per share. It is priced at just 12.5 times its forward earnings, which is a significant discount to its industry’s average of 22.58 and a pretty good price given that the company’s earnings are expected to grow by a rate of 15 percent (its industry is estimated to grow by 12.12% over the same period).

Looking at its competitors, Biogean Idec (BIIB) is priced considerably higher with a forward price to earnings ratio of 17.26 and has a lower rate of expected growth. According to Yahoo Finance, analysts expect the company’s earnings to increase by an average of just 11.43% a year over the next five years – making Gilead quite the bargain in comparison. Rival Amgen (AMGN) has even less expected growth at just 9.38% but it is also priced lower at 9.90 times its forward earnings. We would rather pay a little extra for growth. Competitor Celgene (CELG) fits that bill nicely. It is priced higher than Gilead at 13.55 times its future earnings but it has considerably more expected growth. Analysts estimate this company’s earnings will increase by 24.61% a year on average over the next five years.

We like Celgene for a more aggressive position but find that Gilead makes for a better long-term performer. Some of the top hedge funds in the industry seem to agree. As of December 31, 2011, there were 41 hedge funds with positions in Gilead, up from 35 funds at the end of the third quarter. Together, these funds had over $2.4 billion invested in the stock at the end of December, a considerable increase from a collective $828 million at the end of September. Including amongst these funds is Jacob Gottlieb’s Visium Asset Management. It boosted its stake in Gilead by nearly 300% over the fourth quarter, bringing its position to $167 million invested by the end of December 2011.

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