Despite sporting the cheapest valuation among large-cap biotech stocks by a wide margin, Gilead Sciences (GILD 0.07%) has failed to find a bottom in the past year. As a result, the biotech's shares are presently trading at a 37% discount relative to the average forward price to earnings ratio of 14.2 within its large cap biotech peer group, and a 35% discount compared to the average price to sales ratio of 4.45. In other words, Gilead would be trading closer to $90 a share -- instead of $66 -- if its stock were simply behaving according to prevailing market norms.

Gilead's oddball valuation has generally been pinned on the biotech's struggling hepatitis C franchise, but this explanation isn't very satisfying, quite frankly. Although the biotech's hep C sales are forecast to fall by another 40% this year, this slippage appears to be more than baked into Gilead's valuation at this point. 

Stock falling.

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Cutting to the chase, Gilead's HIV franchise now appears to be the main culprit behind the company's rock bottom valuation. Here's why. 

Don't blame hepatitis C

If you take a global view of Gilead, the company can essentially be broken down into three main business segments: hepatitis C, non-hepatitis C antivirals, and non-antivirals. Percentage-wise, these three segments composed roughly 49.5%, 42.8%, and 7.7% of the biotech's 2016 annual revenues. So investors are right to be worried about the weakness emanating from the company's largest revenue source.

In 2017, however, non-hepatitis C antivirals (mostly drugs indicated for HIV patients) are expected to make up the lion's share of Gilead's annual revenues. Using the mid-point of the company's 2017 guidance, for example, non-hepatitis C antivirals should make up over 55% of total revenues, whereas the hepatitis C drugs Harvoni, Sovaldi, and Epclusa may end up only composing 35% of revenues this year. 

And that's where the real problem comes into focus. 

Tenofovir disoproxil fumarate, or TDF for short, is a key active pharmaceutical ingredient for the HIV medications Atripla, Complera/Eviplera, Stribild, and Truvada, and the main active ingredient in Viread. Unfortunately, TDF's patent is set to expire at the end of this year, potentially opening the door for generic versions of these older drugs.

To get ahead of this potential risk factor, Gilead has been implementing a pricing strategy that's seemingly designed to switch patients to its newer generation of HIV medicines like Odefsey and Descovy that contain a modified version of TDF called tenofovir alafenamide (TAF). The reason is that TAF will retain its market exclusivity until May 2022, and these drugs reportedly offer patients fewer side effects with comparable levels of efficacy.

Point blank: Gilead's HIV franchise -- and most important revenue source -- is under threat from generics.

What's next?

The problem for investors is that it's extremely difficult to decipher how this generic threat will shake out. Gilead's core HIV drugs like Atripla, after all, are combination therapies that would require separate prescriptions from doctors to effectively usher in a generic threat. Are doctors willing to ask their patients to switch to a more burdensome pill regimen to save a few bucks? Perhaps yes, but the answer remains unclear at this stage in the game. 

If you ask the key opinion leader Express Scripts, though, the answer is a resounding "no". Express Scripts' 2016 drug trend report, after all, predicts that most HIV patients receiving TDF therapies will eventually be switched onto TAF-containing drugs, which is certainly good news for Gilead. As an added point of emphasis, this report has total HIV drug sales growing at around 20% for the next three consecutive years, implying that generics won't make a major dent anytime soon. 

In all, Gilead's valuation is suffering mightily from the perceived generic threat to its HIV franchise, but this risk is almost certainly overblown based on the facts on the ground. Even the champion of the drug pricing debate, Express Scripts, has conceded as much in its annual drug report.