Counting the Ways I Love Your Free Cash

Gilead Sciences (NASDAQ:GILD) isn't getting the love it deserves. Perhaps it's because it doesn't pay the large dividends that appeal to stodgy investors. Maybe its market cap makes it too large to attract risk-loving development stage biotech investors.

Sigh. ... But wait.

Shares have fallen 9% since the beginning of June despite positive developments with its drug pipeline and an excellent quarter of top- and bottom-line growth. Stock price down, business prospects up, I smell an investment opportunity!

Fun with free cash flow
Free cash flow is the source of any company's continued existence. Looking for ones that generate loads of free cash flow and then use that cash wisely is the best path to long-term investing success. Pharmaceutical companies are particularly suited to generating copious amounts of cash flow with exceptionally juicy margins on approved drugs.

Putting this free cash flow to good use with shareholder-friendly actions like paying out a dividend, well-timed stock buybacks, or smart acquisitions creates continued stock price appreciation. Drugmaker Johnson & Johnson (NYSE:JNJ) has seen shares appreciate more than 1,000% since 1990, and it pays out a dividend today equal to almost a third of its stock price 17 years ago thanks to the joy of strong cash flow growth.

While much of the heady multibagger returns are likely behind it, Gilead's potential to generate future free cash flow is extremely strong and shows no signs of slowing. Using the simplest definition of free cash flow, which is cash from operations minus capital expenditures, here is how Gilead's free cash flow has looked over the past several years and trailing 12 months.

At a market cap of $35 billion, Gilead is cheap based on its free cash flow generating potential. For example, Gilead could afford to pay out $1.5 billion in dividends annually, yielding an annualized 4.3%. If it grows free cash flow another 30% in the next 12 months, it would still generate an additional $600 million in cash flow to use on share buybacks or acquisitions.

Gilead isn't guiding for harder times in the coming years either. It forecasts year-over-year sales growth of at least 27% in the remaining six months of 2007. Sales growth will remain strong in 2008 as well, with potential new product launches like its cystic fibrosis treatment, AIR-CF2, which could gain regulatory approval in the first half of 2008, following two successful phase 3 studies.

The risks
Any drugmaker is obviously subject to numerous difficult-to-quantify risks such as unexpected safety issues with its lead drugs or patent litigation defeats allowing generic drugmakers like Barr Pharmaceuticals (NYSE:BRL) to bring copycat drugs onto the market sooner than expected.

Gilead is in a strong competitive position, though. It expects key patents on many of its HIV franchise products to be good until at least 2017. In addition, dislodging HIV combination therapies such as Gilead's Atripla or competing agents such as GlaxoSmithKline's (NYSE:GSK) Combivir from their spots as recommended first-line treatments of choice in HIV/AIDS treatment guidelines would take years of expensive and complicated clinical trials for other drug developers.

New HIV therapies on the market like Pfizer's (NYSE:PFE) maraviroc or other treatments in development from the likes of Panacos or Progenics (just to name a few) are generally tested as second-line agents for patients failing to improve with Gilead's Atripla and the other front-line drugs.

The main near-term risk to Gilead's future free cash flow growth comes from the royalties it receives from marketing partner Roche for influenza pandemic treatment Tamiflu. In 2006, Tamiflu royalties accounted for 12% of Gilead's revenues. Since governments are the primary purchasers of Tamiflu, future sales of the drug are unpredictable and could decrease as government stockpiles fill up. 

Compared to the competition
No biotech could ever be declared undervalued without looking at it in relation to its peers. Looking at its enterprise value to last year's free cash flow and sales numbers shows shares of Gilead to be trading at a comparable market-cap-to-FCF multiple to its peers but with by far the fastest growth rates of FCF and revenue in the below group.

Relative to its drugmaker peers (even those not on the above list) Gilead appears to offer one of the best valuations. Because of the nature of its drugs and the diseases that they treat, it could even be argued that it suffers from much less competitive, clinical trial, and regulatory risks compared with its peers, and thus deserves a premium multiple.

It's also important to note that Gilead's FCF growth hasn't come at the expense of its research and development spending or progress with its drug pipeline. Spending on R&D is growing at solid double-digit rates in the past two years and Gilead has some exciting blockbuster opportunities in phase 2 and 3 studies.

Foolish final thoughts
As long as Gilead's management team remains good stewards of the piles of cash that the company is generating, investors who buy into Gilead at today's prices aren't likely to be feeling any pain several years from now.

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Johnson & Johnson is an active Income Investor pick. Biogen Idec and Barr are active Stock Advisor picks. Panacos is a Rule Breakers recommendation. Pfizer is an Inside Value selection.

Fool contributor Brian Lawler thinks another Bay area hometown team, the 49ers, is also undervalued and owns shares of no company mentioned in this article. The Fool has a disclosure policy.