Gilead Sciences (NASDAQ:GILD) may have a management problem -- at least if the market's sentiment toward this top biotech is a reliable indicator. After all, ever since John Milligan replaced John Martin as Chief Executive Officer last March, Gilead's shares have dramatically under-performed the broader biotech industry, evidenced by its performance against the iShares Nasdaq Biotechnology ETF:
Putting Gilead's dramatic slide into more concrete terms, Milligan's brief tenure has been marked by approximately $41 billion being wiped off of the biotech's market cap from its most recent highs:
As a direct result of this beeline move lower, Gilead is presently trading at a rock bottom 3.3 times its projected 2017 revenue, which is by far the lowest valuation among any large-cap biotech stock right now. Biogen, for instance, is currently trading at 5.3 times its 2017 revenue forecast, and Celgene comes in slightly higher at 5.8 times the Street's consensus revenue estimate for next year.
What's wrong with Gilead -- and can it be fixed?
The overriding issue is that Gilead's net income fell by a whopping 22% in the second quarter, compared to the same period a year ago, as a result of rising costs and a steep decline in sales of its megablockbuster hepatitis C drug Harvoni. If we look beyond these dreary quarterly numbers, though, the bigger threat to Gilead's outlook seems to be that its core hepatitis C franchise may have already peaked from a commercial standpoint. Gilead now faces competitive threats from several rivals, after all, and there is a major push within the industry to slash treatment times from 12 to 24 weeks down to bare minimum of perhaps four to six weeks through the advent of novel combination therapies.
The bottom line is that Gilead's hepatitis C cash cow is on the downhill slide, and its descent could rapidly accelerate over the next two years. Unfortunately, the biotech's pipeline currently lacks a late-stage megablockbuster candidate to reverse this trend in the near term, although it does sport some less advanced drug candidates for non-alcoholic steatohepatitis and oncology, which could fill this revenue gap later down the road.
How can Gilead patch up its growth engine? It's no secret that Wall Street has been pushing Gilead's management to break with its conservative past to acquire a revenue-generating peer. And a recent $5 billion capital raise via a public offering of senior unsecured notes in mid-September sparked rumors that the biotech was finally getting serious about a large acquisition. Gilead, after all, should now have something along the lines of $35 billion in cash, cash equivalents, and marketable securities when it announces third-quarter results Nov. 1.
But building ample firepower to execute a value-creating acquisition and locating a suitable target at a reasonable price don't necessarily follow a linear path. The stark reality is that Gilead's management could have pulled the trigger on a bolt-on acquisition long ago but instead chose to plow a whopping $9 billion into share buybacks this year.
Is management at fault for not identifying a suitable target?
A $41 billion market cap decline is no laughing matter, especially when it's coupled with a $9 billion share repurchase effort. To be fair, management did decelerate Gilead's share repurchase program starting in the second quarter when this steep drop-off began. But the fact remains that management simply hasn't done enough to console the market's deepening fears.
The problem, though, is that Gilead is fairly unique in terms of its historical strengths compared to the current spate of available biopharma targets. In a nutshell, Gilead excels at developing small molecule antiviral drugs and combination therapies for infectious diseases like hepatitis C and HIV. The biotech hasn't, however, had much luck in expanding into biologics or branching out in a big way to other markets, like cancer and inflammatory diseases, despite significant efforts to do so.
Nevertheless, "fit" might be the major sticking point for Gilead when it comes to M&A.
Celgene, for instance, didn't buy out Receptos or sign a billion-dollar development deal with Juno Therapeutics (NASDAQ: JUNO) simply because it had cash to burn. The Receptos deal dovetailed nicely with Celgene's emerging inflammatory disease franchise, and the Juno partnership is a natural extension of the biotech's work in blood-based malignancies.
Where does this leave Gilead? The heart of the matter is that Gilead's management is entering entirely new territory for the company -- namely the growth-by-acquisition game employed by almost all large-cap biopharmas. Given the lack of targets that fit seamlessly into Gilead's core area of expertise in infectious diseases, though, the biotech's management may have to broaden their horizons to stave off further value destruction in the near term.
The market's patience, after all, has clearly run out. And that's not surprising, since shareholders and analysts alike have been pushing management to make a splash on the M&A front for over a year and a half at this point because of the headwinds surrounding the hepatitis C market. Viewed this way, it's becoming increasingly difficult to defend management's exceedingly cautious approach on this keystone issue -- even if it will require a substantial change in direction.
More of the same won't change Gilead's near term outlook
To be blunt, Gilead's historical strategy of buying smaller companies and leveraging their clinical expertise to develop new products simply isn't going to get the job done at this stage from a growth or valuation standpoint. If you want proof, Gilead did go out and strike a $1.2 billion deal for Nimbus Therapeutics, LLC earlier this year, which has -- so far -- had zero impact on the performance of its share price.
The core issue at play here is that the Nimbus deal -- along with Gilead's other fairly recent acquisitions of Phenex Pharmaceuticals and EpiTherapeutics ApS, as well as its licensing deal with Galapagos NV for the experimental anti-inflammatory drug filgotinib -- are years away from producing any commercial-stage products. And that's a significant problem growth-wise, given that Gilead's top line is forecast to fall by more than 10% over the course of 2016 to 2017, relative to 2015 levels.
So if management does decide to execute yet another series of smaller, clinically oriented deals to stick to their guns, so to speak, the market's reaction probably won't be pretty -- and such a lukewarm move could necessitate a change in leadership.
A change of direction could be coming soon
The good news is that there are some really intriguing mid-cap buyout targets available at the moment outside the realm of infectious diseases, such as the cancer specialists Ariad Pharmaceuticals (NASDAQ: ARIA), Exelixis (NASDAQ:EXEL) and Tesaro (NASDAQ: TSRO), that could significantly impact the biotech's top line next year. Gilead has also been trying to build out its oncology portfolio for awhile now, although its most promising cancer drugs remain in the early stages of development, perhaps making these three companies fairly enticing buyout targets for this biotech giant.
Ariad, for instance, appears to be close to becoming a two product rare cancer company, with its second-line ALK+ non-small-cell lung cancer drug candidate, brigatinib, now under review with the FDA. And, Exelixis' tyrosine kinase inhibitor cabozantinib has the potential to rake in over $1 billion in sales within the next four to five years. Tesaro, for its part, sports the experimental PARP inhibitor niraparib that has the potential to quickly rack up hundreds of million in sales upon approval, and possibly reach $2 billion in peak sales as a treatment for ovarian cancer.
Perhaps the best part is that Ariad, Exelixis, and Tesaro could probably all be had for somewhere around $13 billion in total, giving Gilead plenty of remaining ammo to target additional companies or make one largish acquisition in the $20 to $25 billion range. As an added bonus, Gilead's top line would likely flatten out in 2017 by bringing just these three mid-sized companies into the fold -- and that's not even considering any additional moves the biotech may make to improve its near term growth prospects.
While flat revenue year over year may not be particularly exciting, it certainly beats Gilead's projected 3.8% decline next year, implying that these or similar types of acquisitions would be a far better use of the biotech's monstrous cash position than more share repurchases.
All told, Gilead's management appears to be boxed into considering buying either one large company or a series of mid-sized companies with products already on the market in order to stop the steady flow of cash out of the company's stock. At the very least, Gilead needs to acquire a company with a compelling late-stage candidate -- like Tesaro's niraparib -- to reinvigorate its shareholder base. Shareholders, after all, haven't shown much patience for Gilead's long term view when it comes to value creation and product development of late. Unfortunately, the biotech's managerial team has been hesitant to break with its core strategy of buying early to mid-stage clinical assets. And that decision has cost its shareholders dearly.