Many investors are almost addicted to the dividends that drug stocks pay. It’s easy to see why: Pfizer (PFE), Johnson & Johnson (JNJ) and Merck & Co. (MRK) all pay a secure 3%, thanks to the profits they reap from their pills.
But today’s dividends are merely a product of today’s cash flow. If you’re interested in the best long-term returns tomorrow and beyond, you need to dig deeper. Which is why my second-level assessment of any drug company starts with its R&D pipeline.
Few can boast bigger homeruns in that area than Gilead Sciences, Inc. (GILD). In December 2013, the FDA greenlighted its Sovaldi hepatitis C treatment. Ten months later, the next iteration, Harvoni, got the nod.
The result was a revolution in hep C treatment: with Sovaldi and Harvoni, patients take a pill a day for 12 weeks. After that, there’s a 90% chance their hep C will be gone—with few side effects.
With a cure rate like that, it’s easy to see how Gilead moved a combined $10.2 billion worth of Sovaldi and Harvoni in 2014, or 51% of its total revenue. Today, Gilead has a 90% stranglehold on the hep C market.
Investors also came away happy: since Sovaldi was approved on December 6, 2013, Gilead shares have surged 49%, blowing away the names I mentioned above and nearly tripling the S&P 500’s rise in that time.
An Unbeatable Bargain
After that type of jump, you might think you’ve missed the boat on this one. But Gilead is still cheap, with a forward P/E ratio of just 9.1—that’s a nice discount to rivals like Merck and Abbvie Inc. (ABBV), at 14.7 and 12.0, respectively. And Gilead has a more robust pipeline too—more on this in a bit.
But first, let’s review the company’s third-quarter earnings report from last Tuesday.
During the quarter, the drug maker’s sales jumped 37.3% from a year ago, to $8.3 billion—well ahead of the $7.8 billion analysts were expecting. Adjusted earnings gained 75%, to $3.22 a share, again eclipsing the consensus forecast of $2.89.
How did investors respond? They sent the stock down 3% after hours!
They didn’t like the 2% decline in Harvoni and Sovaldi sales compared to the second quarter—even though their total revenue of $4.8 billion was up 70.4% year-over-year and $300 million ahead of the Street’s expectations.
What the Herd Is Missing
The truth is, first-level investors have been wringing their hands over Sovaldi and Harvoni since they launched, worried a competitor might come along and snatch the crown away.
Those fears have been fanned by the heat the company is taking from veterans’ groups, insurers and others over the drugs’ prices: $95,000 for a 12-week treatment of Harvoni and $84,000 for the same period with Sovaldi.
That’s made insurers pickier about whom they’ll cover, creating a headwind for Gilead and, yes, an opening for competitors. Abbvie, for example, entered the market in December 2014 with its Viekira Pak treatment, which goes for around $83,000. Merck aims to get its own hep C drug out in 2016.
Still, Abbvie hasn’t had much luck reeling in Gilead, despite signing a deal with pharmacy benefits manager Express Scripts Holding (ESRX) at a substantial discount earlier this year. Gilead responded by offering average discounts of 46% in the US.
But here’s the key takeaway: competition or no, this is a huge and growing market for Gilead. Roughly 3 million Americans suffer from hepatitis C, with 150,000 new cases diagnosed annually. The global total is between 130 million and 150 million, according to the WHO.
More Hits to Come
Gilead isn’t resting on its laurels: on September 21, it reported positive results from a Phase 3 trial on a combination treatment consisting of Sovaldi and an experimental drug. The goal: an all-in-one treatment for all six genotypes of hep C. (Sovaldi is used for genotypes 1 to 4, while Harvoni is for genotype 1, the most common strain.) Gilead says it will file for US approval in the coming weeks.
Last week, the company reported positive test results for its new Genvoya HIV drug (another area it dominates, with 87% of the market). Genvoya is as effective as Gilead’s Stribild treatment but has milder side effects. An FDA decision is imminent.
Cash Pile Ready to Go to Work
Meantime, Gilead’s strong operating cash flow ($4.1 billion in Q3, up from $4.0 billion a year ago) and healthy balance sheet (more than $25 billion in cash) will let it keep developing new blockbuster drugs while shoveling cash back to shareholders. In February, it initiated a $0.43-a-share quarterly dividend (for a 1.6% yield).
It’s bolstering that payout with share buybacks, too. Also in February, it rolled out a $15-billion repurchase program (for almost 10% of outstanding shares) to go along with the $3 billion it had remaining on its previous authorization. Gilead bought back $3.1 billion of shares in Q3 and $900 million in Q2, so this plan still has lots of room to run.
These buybacks will likely kick off a virtuous cycle for shareholders. They’ll cut the number of shares outstanding, sending per-share earnings—and the share price—higher. They’ll also make it easier for Gilead to boost its dividend going forward, with fewer shares on which to pay out. With the stock as cheap as it is today, shareholders should see a lot of leverage from these repurchases.
Big Deal Could Send GILD Soaring
What would really light a fire under the stock is a transformative acquisition, something Wall Street has been waiting on for years. With several beaten-down names in the biotech sector and Gilead’s huge cash hoard, I’m betting we’ll hear more on that front soon.
As attractive as Gilead is, it’s not my favorite health care pick now. That honor goes to a little-known stock boasting a 7.3% yield—nearly five times as much as Gilead!
I call it “the safest 7.3% you’ll find right now” because it’s quietly cashing in as the number of Americans aged 65+ skyrockets.
I expect this hidden gem to double its payout in the next 10 years. Plus you’ll get a nice capital gains bonus, too: we’re banking on a 10% pop in the share price as more investors clue in to this recent spinoff.