Valeant and Gilead: Beaten Down Bargains or Truly Terrible?

Valeant Pharmaceuticals (BHC 0.95%) and Gilead Sciences (GILD 0.12%) are in the bargain bin, but first quarter financial results show that sales continue to decline at both companies. Are these companies making enough progress to make them worth owning in portfolios?

In this episode of the Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes and contributor Todd Campbell search Valeant Pharmaceuticals and Gilead Sciences first-quarter financials for clues to determine if now is a good time to buy.

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A full transcript follows the video.

This video was recorded on May 17, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is May 17, and I'm your Healthcare show host, Kristine Harjes. I'm on the phone with Todd Campbell, a Fool.com healthcare writer. Todd, welcome to the show, as usual!

Todd Campbell: Hi, Kristine! How are you today?

Harjes: I'm doing all right, I'm getting ready for a trip to Toronto tomorrow, so pretty wired that it's basically my Friday.

Campbell: Oh, excellent, I hope you have a great time. I've always wanted to go up there, I've yet to travel up there.

Harjes: Yeah, I haven't been either. Listeners, if you listen to this before I actually go, which is tomorrow the 18th, please shoot me a note at [email protected]. I'll take all the recommendations that you guys have for restaurants, and I hear there's a good music scene, and anything else that comes to mind. I'll be in Toronto and also Niagara Falls. So, that should be fun. Before I go, we are talking on the show today about two companies that have been incredibly beaten up by traders over the past couple years, and are both arguably value stocks right now. We're going to be talking about both Valeant Pharmaceuticals and Gilead Sciences. Todd, which one do you want to start with?

Campbell: Let's start with Valeant, because of the two, that's the one that's been beaten up most. If you've been an investor in Valeant, you're probably looking at this stock and going, "Oh boy, what's he going to say next?" The stock has gone from about $260 to around $13 per share. But, it dropped below $10 or something like that. It's been tough sledding for the stock, and there's a lot of reasons, we covered it before, Kristine, on the show. As a refresher, there was a lot of pushback regarding pricing decisions that they had made in the past that led to scrutiny that led to the closure of their specialty distributor, pushback as a result of that and declining sales volumes has caused income to drop, and as a result, there has been a lot of fear that they might have a hard time paying off their debt load. So, heading into the first-quarter earnings results, a lot people were watching to see what management would say, and see if they provide some indication that the corner is turning.

Harjes: By the reaction the market had, it seemed like people were pretty happy with their earnings, which they released on May 9. The stock is up 40% since they released those earnings. On the surface, the headline was pretty good. They had their first profit that they posted in six whole quarters, but there's kind of an asterisk there where they reported a GAAP net income of $628 million, but that was almost entirely due to this one-time tax benefit of $908 million, which was attributed to non-cash internal restructuring. So, they're fudging the numbers a little bit, not in a nefarious way, but there's a huge difference for this company between their GAAP numbers and non-GAAP numbers.

Campbell: Right. You almost have to be a CPA to be able to dig in here and figure out what's going on behind the scenes, to have to reconcile the GAAP versus non-GAAP and figure, quarter for quarter, what is going on with the company. You mentioned that they'd reported top-line GAAP profitability. As you've said, that was all due to this one-time benefit from this tax item, so don't count on that going forward, you have to X that out. Revenue, the top line, did fall again, it was down 11% to $2.11 billion. So, you still have deterioration in the top line, and we'll get into why in a minute. But, without a doubt, Kristine, if you were a shareholder going into earnings last week, right now you're smiling a lot bigger than you were last week, especially if you were one of the fortunate ones to have been able to pick this thing up at the low.

Harjes: Right, indeed. This is something where, I guess, if you timed it correctly, you could have made quite a profit. But I do imagine that the vast majority of shareholders are still sitting on a pretty big loss here.

Campbell: I think that's probably true. Unfortunately for those long-term investors who have ridden the stock down, when I dug into the numbers and started really going through the puts and the takes here on balance, I had to walk away a little bit unimpressed. Their crown jewel is Bausch + Lomb. That's their biggest segment, it does $1.1 billion roughly in quarterly sales. But that crown jewel gained no ground year over year. Sales were essentially flat on a reported basis. Sure, if you back out currency, operational growth was 4%. But currency is something that these international companies deal with quarter after quarter. The reality is, sales for Bausch + Lomb were flat. And if you dig a little bit deeper, U.S. volume for Bausch + Lomb declined, and was offset by some emerging markets, overseas growth. So, Bausch + Lomb, we'll call it a push for the quarter. Branded Rx, sales continued to drop there, fell 9% to $604 million. Then, because of generic competition and some pricing woes, their U.S. diversified business got absolutely clobbered. Sales fell 37% year-over-year to $355 million. Unfortunately, the threat of generics is not going away -- this is going to remain a headwind for this company over the coming year.

Harjes: Right, pricing is going to be a huge issue for them, because of all the bad publicity that they got way back in 2015 when this whole controversy started about their cardiovascular drugs that they boosted the prices on by hundreds and hundreds of percents. They kind of can't do that anymore, and that was a big part of how they were making money. So, now, when you look at their portfolio, a lot of drugs are either hit or about to be hit by patent expirations, and they don't really have the option anymore of raising prices to compensate for lower volume.

Campbell: Yeah. So, we have a situation where we have a company that's still seeing a lot of pressure on its top line. There was a little bit of evidence of some price stability in Branded Rx, to be fair. So, that's somewhat good news. But, on balance, you look at this, and it's like, this wasn't that great of a quarter. Why on earth is the stock up 40-50% since the report?

Harjes: Yeah, and I know you have an interesting theory about this.

Campbell: Yeah. It's really all tied to the size of the short position, in my view, and a $50 million bump-up in its guidance for the year in EBITDA.

Harjes: Right. Let me take the latter thing you just said and expand on that a little bit. People are very concerned that Valeant is going to default on its debt. It has a humongous debt load, and for a long time, it's been kind of unclear whether or not they would be able to meet this debt. So, when they say they are going to up their EBITDA guidance, that is a great thing for people that are concerned about the debt. So, when you trace that back to the first thing you said, which was the short position, that is where you start to get people potentially exiting their shorts.

Campbell: Yeah. Again, as a refresher, if you're going to short a stock, you're borrowing from your broker, you'll selling it with the hope of buying it back cheaper and then replacing the shares that you borrowed. So, as a stock rallies and people who have sold it short see that happening, you end up getting a domino effect where, "Oh, it's rallying, I have to cover, now I have to cover, and I have to cover." If you look at the short ratio, which is simply the percentage of shares that are sold short toward the shares that are out there that can trade, it was at a record high leading up to the earnings. A record high.

Harjes: Right, 15%.

Campbell: Yeah. So, it wouldn't take a lot to move the needle here. And it really didn't. The bump up in EBITDA guidance was $50 million. They went from basically guidance of 3.5%-3.65% to 3.6%-3.75%, a $50 million improvement. But, again, the big thing here is the debt. They have over $30 billion in debt. They've knocked about $3 billion off of that. That's good news, because what that does it is it, theoretically, improves their interest coverage ratio. And now we're getting really wonky.

Harjes: It's a wonky company.

Campbell: Yeah. When you have all these creditors, they want to know they're going to be paid back. And one of the ways they do that is calculate your interest coverage ratio, which is simply EBITDA divided by interest expense. So, you have debt, you're paying interest expense on it. Are you generating enough EBITDA to cover that interest expense? Typically speaking, if you get below 2:1, it starts to get you a little bit nervous.

Harjes: Right. At the end of Q1, they were at 1.83, which is below that 2 threshold, but it is above what their newly renegotiated level is, which is 1.5, which is what their lenders need to see.

Campbell: Wow. There are so many rabbit holes we could chase here. They had to renegotiate a lot of these covenants lower because they were going to run into a risk of default, because they weren't going to make the 2:1 ratio. So, you had various ratios that range from 3:1 and 2:1. They've knocked those ratios down to 1.5:1, so they're still OK. And by bumping up the EBITDA guidance, that led people to believe, if EBITDA improves, then it's less likely that creditors are going to end up knocking at the door demanding payment, because that interest coverage ratio falls below the threshold. It gets even more complex than that, though, Kristine, because you have to look at where that EBITDA improvement is coming from. And frankly, I'm not convinced that's it's coming from a material improvement in the business.

Harjes: Right, and that's really what it comes out here, to bring it back to a little bit of a higher level -- this is a company that needs to find a way to come up with money. They need to service their debt. They can do that by having a better top line. We've already dug into the different business segments, and it's questionable whether or not they'll be able to do that in any significant way. Or, their other option is, they can sell some of their assets. But everybody else out there that could be a potential buyer for these assets knows exactly the situation that Valeant is in, so they're not going to pay a premium for some of these assets. Then, you get hit with a double whammy, if you're Valeant, of, I'm trying to get a good price for some of my portfolio. In order to get a good price, you need to sell the best stuff, and that's exactly the stuff that's going to bolster your top line.

Campbell: Right. And Kristine, just to make things even worse for them, that has a negative impact on EBITDA. So, you have to make sure you're paying off enough debt to lower your interest expense, at the same time you're selling these things that are generating out earnings. And one of the concerns I have going forward here is, they're selling one of their prized assets, Dendreon, which makes a prostate cancer drug called Provenge, they're selling that later this year, and their EBITDA guidance, it says right in the report that it doesn't include that sale in its calculation.

Harjes: Right. So, take out the sales from Provenge, and all of the sudden you get EBITDA lower.

Campbell: Right. You say, they paid down $3 billion in debt, so their interest expense has to be falling. But, because they had to renegotiate all of these deals, they're ending up having to pay more in interest. So, you shaved $3 off your debt, but at the same time, your interest expense actually went up year over year. Now, eventually, hopefully, if you look at the maturities on the debt, they're pretty manageable until about 2020. But, you have a lot of issues here, and I think it's maybe a little bit premature for investors to look through that report, see shares running, and say, "Oh, OK, the corner has turned and the stock is going to go back to $100."

Harjes: And it would be easy to do so, too, because by almost every metric, this is a very cheap stock. It's really just gotten clobbered by the market. But after having this discussion, hopefully it's pretty clear to our listeners that it's kind of for good reason. This could be a turnaround story, but personally, I don't think I would sleep at night if I bought shares of this company.

Campbell: Yeah, it's almost like skydiving without a parachute and hoping someone throws you a parachute and that you'll be able to catch it and open it before you hit the ground.

Harjes: [laughs] Yes, that's accurate imagery. I was trying to come up with something like a treadmill, but I like yours better, let's go with that.

OK, we said we were going to talk about Gilead Sciences, and that was not a lie. It is now time to dive into Gilead.

Campbell: This one hits a little bit close to home for me, Kristine, and I think maybe it does for you too?

Harjes: As a shareholder? Yeah.

Campbell: Yeah. This is a stock that is a behemoth in biotech. And unfortunately, its shares have fallen from $120 to about $65 since the summer of 2015, making the comparison even worse when you look at the fact that the S&P 500 has rallied and has been flirting with new highs. This stock has gotten clobbered. And it's been a tough run for shareholders like me, and I have to -- can we do a little confessional here?

Harjes: Let's hear it.

Campbell: I confess, I made a grave error in the way I normally approach stocks. I usually buy stocks -- we talked about this last week -- based on a particular catalyst, and then when I'm evaluating whether or not to hold the stock, I see if anything's changed that catalyst. Now, normally, if the catalyst has failed to pan out or change, that's a signal to me that I should sell or exit the stock. My catalyst did, indeed, change for Gilead, and I did not sell the stock. My cost is somewhere in the $90s, I'm down 20%-25%.

Harjes: What was the catalyst that you were looking for?

Campbell: I really thought their leadership in developing hepatitis C drugs was going to allow them to continue to innovate and dominate the market, which they have. But I also felt they would be able to innovate shorter and shorter treatment duration, getting it down to as little as four weeks over time from the 12 weeks it is currently. And it does look like that's not in the cards. It's looks like they're slowing down their efforts to continue to move the needle in developing new products for hepatitis C. I also underestimated the negative drag and impact of price concessions they would be forced to make to stay ahead of competitors like AbbVie. And, I also had bought it originally because I had some good thoughts that they would do well with their push into cancer drugs, and unfortunately that was a bust. Yet I looked at it and said, this is still a very profitable company, and now they're paying a dividend, and they have a ton of cash on the balance sheet, so I guess I'll stick around. Obviously, so far, that's been the wrong choice.

Harjes: The thing is, you talked a lot about hepatitis C, and I think that is what most people focus on with this company. But, if you look at what has happened to the company over the course of its HCV life cycle, its first hepatitis C drug, Sovaldi, was approved in December 2013. At the time of approval, Gilead's market cap was $114 billion. Today's market cap of $86 billion is 25% lower than that. For me, I look at this company and I just can't help but think that the market has overreacted to its hepatitis C woes. And you're totally right about cancer not quite panning out, but I don't think there is as high hope and drama and expectation tied into its oncology efforts, necessarily, as it was for HCV sales.

Campbell: Yeah. I agree with you, in some respects. But here's the problem: We have yet to find a floor on those hepatitis C sales. In Q1, revenue came in a $2.6 billion across their hepatitis C franchise. That was down from $4.3 billion the year before.

Harjes: Yeah, that's a 40% decline.

Campbell: Yeah, massive drag. As a result, Q1 total sales were $6.5 billion. That was down 16.5%. EPS fell from $3.03 last year to $2.23 this year, ouch.

Harjes: Yeah, and I totally agree that that does hurt. But, I think with this company, it's important to remember that they have other things going on. In particular, their HIV products were very good in the last quarter. And that was how this company really made its name. Its HIV and HBV product sales were up year over year in the first quarter 13% to $3.3 billion. That's a good thing. Sales fell for some of the older products, but it was made up for by the newer ones like Genvoya and Descovy and Odefsey.

Campbell: Right. They've enjoyed a lot of growth, and that's because they reformulated Viread. They made it safer, and now they've been rolling out combination therapies that replace Viread in those combinations with TAF, this new formulation. I imagine that we'll probably see a leveling off in sales growth there once all the combination therapies have been launched. But, yes, they remain a dynamo in that business. It's a great business for them, and it's been a growing business for them, it just hasn't been growing fast enough to offset the slide in sales in hepatitis C. So, you look at it from an investment standpoint now, and you say, OK, well, we know that HIV is going to be stable to growing. That's good. And we know that hepatitis C is declining, and we don't know where the floor is.

Harjes: And that's bad.

Campbell: Yeah, that's bad. So, we say, what's the catalyst, what's going to cause this stock to get back to growth? Because, ultimately, we want to see sales grow, earnings grow. Shares will follow earnings over time. So, we look at it and say, they have, first of all, a lot of money on the balance sheet, isn't it something like $32 billion?

Harjes: I have this right here, $14.7 billion in cash. That's without their short-term investments.

Campbell: Yeah, and securities that they can sell, as well. And they spend a ton on research and development. I think their run rate now on research and development is something like $3.6 billion. So, they have a pipeline and they're working on that pipeline. So, you say, maybe new drugs coming out of that pipeline, or acquisitions, because of all this cash, can spark growth, right?

Harjes: Yeah. So, you have the organic side and you have the inorganic side. And when you look at the organic side, what are they actually developing themselves, they do have some exciting things going on. But it's going to be a while before we hear about any of them. And so, that's when you get this pressure for the inorganic growth. And there has been so much speculation about, who is Gilead going to buy, when are they finally going to pull the trigger? I do think, at least in the short term, that's the catalyst to watch. What are they going to do with that money? Who are they going to buy? When will they actually make a move to try to bolster their portfolio and get some more internal catalysts to get revenue moving in the right direction before, say, 2020, when they start getting data for all of the really awesome drugs in their pipeline that are not quite ready for market yet.

Campbell: Yeah. If you look at the lead candidates in the pipeline, you have filgotinib, which is the autoimmune disease drug they're working with Galapagos on. Data for that should start rolling in, I think, as early as next year, stretching through 2020, depending on the indication and the trial we're talking about. Then, there's another one for something called NASH, which is another liver disease, but, again, we won't see data from that until the 2020s as well. So, you look at that and say, OK, there's not a whole heck of a lot that's going to, as far as drugs that are going to hit the market that could really make a big deal here. So, what would be the M&A target? Can they buy something? Then, assuming they can cut a lot of overlapping expenses, maybe they can get operating margin moving in the right direction again. But only time will tell. We have to see how that plays out. And Gilead is being patient. They have the war chest, and they have the money, but they look at it from an operational standpoint, saying, "I don't want to pay too much for this company when three years from now, I could get it for a bargain."

Harjes: Well, that, and they look at their own company and they say, "Holy moly this is cheap." Gilead spent $14.8 billion on shareholder rewards in the last 16 months. $12 billion of that was on share repurchases. So, this company is not interested in buying other overpriced assets when it could just buy back its own stock at pretty low valuations.

Campbell: Yeah. Although, you take the other end of that coin and say, from a shareholder standpoint, is that the best use of your dollars? So far it has not been, because shares have still declined. So, you brought back a lot of shares at a lot higher prices. Has that been the best use of your money, where if you had gone out and bought something like Medivation or something, to kick-start growth that way, would that have been a better reward for shareholders? Who knows. We don't know. The reality is, this remains a biotech behemoth. They're not going away. At some point, somewhere down the line, they're going to do something that will restart growth. The question will be, where will shares be at that point? Is this the low? Was $80 the low? Was $90 the low? I don't know.

Harjes: Right. And when they do it, we will absolutely have you covered here on Industry Focus. Thank you so much, Todd, for all of your thoughts today, and I'll talk to you next week. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. For Todd Campbell, I'm Kristine Harjes, thanks for listening and Fool on!