MagicDiligence
Magic Recipe -0.19%
Deep Value 0.31%
Star List -0.32%
S&P 0.22%
Today's Performance (see long-term performance)

The Only Stock In ALL Of Our Screens

We have 4 "Spells" (pre-created stock screens) that focus on pretty different criteria:

Magic Recipe Spell: An analog to Joel Greenblatt's Magic Formula screens, focusing on a combination of value of stock and efficiency of company.

Deep Value Spell: A strict focus on value based on earnings yield and free cash flow yield only.

Quality Growth Spell: Focuses on revenue growth rate and efficiency of cash flow generation. Looking for fast-growing cash producers.

Star List Spell: Looks for a wide combination of top ranked stocks by value, efficiency, and growth methods.

Those are 4 pretty wide-ranging ranking stock screens. It is not a big surprise that there are only a handful of stocks that appear in more than one of them.

In fact, there is only one that appears on all 4.

This is the stock I want to overview today.

Big Time Growth and Profits

This "growth and value champion" in all 4 of our Spells is biotech giant Gilead Sciences (GILD).

Gilead's 3-year average revenue growth is a robust 56%, driven by the launch and expansion of its hepatitis C drug Sovaldi in early 2014 and its follow up Harvoni last year. These two drugs have exploded out of the gate, and in 2015 accounted for an unbelievable $20 billion in sales - 2/3rds of Gilead's total revenues. This kind of growth is smiled upon by the Quality Growth and Star List screens.

Sovaldi

This revenue has converted substantially into cold, hard profits for Gilead. The firm sports an amazing 68% pre-tax operating margin - one of the highest you will see in the entire business world. Even more impressively, Gilead converts 62% of its revenues to free cash flow - the company generated over $20 billion in FREE cash flow last year! It is hard to express how incredible that is - I've been analyzing stocks for a long time, and Gilead's current performance is almost unprecedented to anything I've seen, particularly at this scale. This is one outstanding business.

As you can imagine, those insane profits and cash flows make Gilead an extremely efficient business. It's return on total capital for 2015 was 135%, and its cash return on total capital was 123%. So the efficiency metrics - used by Magic Recipe, Quality Growth, and Star List - are all covered quite well.

Big Time Value, Too

Clearly the Gilead story is a healthy one... but the market doesn't seem to think so. Look at these valuation statistics:

Earnings yield: 16.2%. This is in the 96th percentile of the market (e.g., only about 4% of profitable companies are valued more cheaply than Gilead on an earnings basis).

Free cash flow yield: 14.6%. 93rd percentile of the market (only 6% of free cash flow positive firms are valued cheaper).

For traditionalists, Gilead's P/E ratio is 7.9, which is far below the S&P 500's ratio of 23. Compare it to competitors like Abbvie (ABBV) (18.4), Merck (MRK) (34.4), or other biotechs like Biogen (BIIB) (17.0) and it still looks incredibly cheap.

Gilead's stock valuation is unquestionably, undeniably cheap against its recent results. There is simply no arguing that.

Why Its Cheap

For this kind of value and quality, there has to be a reason for it.

Simply stated, the market does not think Gilead's success in the hepatitis C market is sustainable. Sovaldi burst onto the scene as the first approved CURE for the previously chronic disease, but as you can imagine, other big drug companies want a slice of this massive pie as well.

Abbvie fired the first shot in early 2015 with the release of Viekira Pak, which was quickly made exclusive by distributor Express Scripts (ESRX). The market was sure this was going to be a killer for Gilead, eating its market share and forcing price drops on Harvoni/Sovaldi. The result? Due to safety concerns, more difficult dosing, the need to use ribavirin (which has substantial side effects), and overall physician comfort with Gilead's regimen, Viekira generated just over $1 billion in 2015 sales, vs. Gilead's $20 billion in HCV sales.

Big threat... averted.

Zepatier

Still, the market is unconvinced. The next thing it is sure will "kill" Gilead's sales is the launch of Merck's Zepatier, approved in late January.

Zepatier does look like a more credible contender. It is a once-a-day dosing for 8-12 weeks, same as Gilead's regimen, and it doesn't need ribavirin. Efficacy rates are similar to Harvoni/Sovaldi. But the biggest competitive weapon is price. Merck is pricing Zepatier at $54,600 for a 12 week regimen, compared to the $80,000 "sticker price" for Gilead's drugs.

Drug pricing has been a hot topic this political season, and the market is convinced that this lower price will lead to Merck eating up a lot of Gilead's market share. In a nutshell, that is the main justification for Gilead's cheap valuation.

My Opinion: The Risk Is Overblown and Gilead is Attractive

Let's make this clear right out of the gate: the 56% revenue growth rate is not sustainable. That much is clear. Even if the competitive threats never materialize, Gilead doesn't have the "green field" to grow at those rates going forward.

However, even if Gilead can just reasonably sustain its current revenue levels, this is a VERY cheap stock. The market is forecasting a substantial DECLINE in revenue. But consider this. The worldwide HCV market is about 185 million people, while to date, Gilead has treated less than 700,000!

HCV Patient Population

Yeah, its a BIG market.

So in my opinion, a little competition isn't going to make a debilitating difference to Gilead. The company was never going to maintain 90%+ market share in such a large space. Pricing may come down but volume will remain high. And given Gilead's lead, track record, and pull with physicians, competing with this company in HCV is going to be quite difficult.

And that's not giving Gilead much credit for the enormous amounts of green being generated right now. There is over $26 billion in cash on the balance sheet. Shares are being repurchased aggressively - they declined almost 8% last quarter. The next big Triangle or Pharmasset purchase could be right around the corner to ignite Gilead's next leg of growth.

At such a cheap valuation, and with such a great track record, Gilead looks like a real solid buy candidate right now. It may not be clear what the stock should be worth... but it is certainly clear that it is worth substantially more than it sells for today.

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