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Healthcare Sector Biopharmaceutical Industry

NASDAQ Stock Market

Gilead Sciences Inc.

Date: 2/23/2015 Current Price: $102.61 Recommendation: HOLD Ticker: GILD (NASDAQ) Target Price: $104.64

Source: Factset

Source: Factset

￭ We are issuing a HOLD rating where we will sell call options on the shares to collect the recently issued dividends and the rent from the options.

Highlights ￭ Gilead showed very strong revenue growth in their revenues over 2014, with year-over-year (YOY) growth at 122%. This is a direct result of the launch of their two new HCV drugs, Sovaldi and Harvoni, with releases in December 2013 and October 2014, respectively. ￭ Gilead recently announced that it will be paying a quarterly dividend of $0.44 starting in March of 2015. They also plan to repurchase another $15 billion in shares once their current $5 billion buyback schedule is completed. Both demonstrate that Gilead is confident in their abilities to produce large levels of cash. ￭ P/E of $12.82 at the end of 2014 has dropped below the level of their competitors due to very strong earnings growth and a steady but slower growth in their share price, and we believe that it will remain below the industry levels going forward. ￭ Acquisition of Phenex Pharmaceuticals AG allowed Gilead to acquire the development program for Non-Alcoholic Steatohepatitis (NASH) and Other Liver Diseases; there is currently no approved therapies to treat NASH and Glead will receive their patient testing results by the start of the third or fourth quarter of 2015. ￭ Gilead was able to produce an EPS of $7.35 in 2014, a 306% increase from their 2013 EPS of $1.81. With very small increases in their costs, Gilead was able to produce a higher net margin than in previous years.

Closing Price 102.73

52-Week Range 63.5 - 116.83

Shares Outstanding 1,499,000,000

Market Cap 153,992,270,000

EPS 7.35

P/E 14x

EV/EBITDA 11.96

Company Profile

Business Description

Gilead is a research-based pharmaceutical company that develops, manufactures and markets new drugs to the

market, bringing innovative solutions to severe diseases and medical conditions that affect millions across the

globe. Gilead emerged at the turn of the millennium as revolutionary in the HIV drug market, launching several

different HIV combination therapies and drugs treating fungal infection. Gilead’s business structure focuses in the

following areas of medicinal research and development:

￭ human immunodeficiency virus (HIV),

￭ liver diseases such as chronic

￭ hepatitis B and C viruses and infections (HBV & HCV) infection and chronic hepatitis C virus (HCV)

oncology

￭ serious cardiovascular and respiratory conditions

Gilead’s primary driver of annual revenues has been its HIV drug line. Two of its HIV drugs, Atripla and Truvada, accounted for over 80 percent of product revenues just three years ago. After the acquisition of Pharmasset in 2012, Gilead acquired intellectual property rights to sofosbuvir, the primary ingredient in the Hepatitis C drug, Sovaldi. Gilead’s Sovaldi immediately made the company a major player in the HCV market and has been one of the most successful drug launches in recent pharmaceutical history. Gilead continues to expand and diversify its product line, continuing to support and strengthen its primary drug medicines with newer and more innovative solutions while expanding into oncology and antihypertensive markets.

Source: Factset

Product Line Overview: ￭ Sovaldi and Harvoni are used for the treatment of the

Hepatitis C Virus (HCV). Sovaldi was approved in the United States in December 2013 and in Europe in January 2014, Harvoni in the United States in October 2014. It is intended to be used alongside other HCV medications. During phase 3 clinical trials Sovaldi exhibited high cure rates for HCV, between 94-99%. Sales in 2014 were $12.41 billion. The current cost of a prescription of Sovaldi is $29,754 for 28 tablets1. ￭ Atripla is used for the treatment of HIV infection. The drug is intended to be used on its own or in combination with other HIV treating medication. It was approved July 2006. Sales in 2014 were $3.47 billion. The most recent cost of a prescription is $2,264 per 30 tablets2.

￭ Truvada is used for the treatment of HIV infection alongside other HIV infection medications. The drug was first approved by the US in August of 2004. In July 2012, the US also approved the drug for use as a preventative measure for high-risk HIV infection patients when used alongside other safe sex actions. Sales in 2014 were $3.34 billion. The current cost of a prescription is $1,368 for 30 tablets3.

￭ Complera is used for the treatment of HIV infection. The drug is a combination of other HIV infection treatment drugs. It is intended for patients who have never taken HIV medications before. The drug was approved in December 2013. Sales in 2014 were $1.228 billion. The current cost of a prescription is $2,185 per 30 tablets4. ￭ Stribild is used for the treatment of HIV infection. Like Complera, the drug is a combination of several HIV treatment drugs and is intended for patients who have never taken HIV medications before. The drug was approved in August 2012. Sales in 2014 were $1.197 billion. The current cost of a prescription is $2,615 per 30 tablets5. ￭ Viread is used for the treatment of HIV infection alongside other HIV infection medications. The FDA later approved the drug for the treatment of Hepatitis B Virus (HBV) infections. The drug was approved in October 2001 for HIV treatment and August 2008 for HBV treatment6. Sales in 2014 were $1.058 billion. The cost for a prescription of Viread is $996 for 30 tablets of 300 mgs7.

￭ Prospective: Non-Alcoholic Steatohepatitis (NASH) is a common type of liver disease and may lead to liver failure. On January 6, 2015, Gilead announced the acquisition of Phenex Pharmaceuticals’ development program that is focused on the treatment of NASH8. The acquisition allows Gilead to have a strong position in the race for creating a drug to treat NASH9. The Wall Street Journal reported that the deal may cost as much as $470 million. Gilead believes that NASH may affect an estimated ten to twenty percent of the developed world and will therefore have a large return on investment if an effective drug treatment can be created.

Industry Overview and Competitive Positioning

￭ The Biopharmaceutical industry is a leader in scientific and medical innovation, bringing innovative new medical solutions to the market on a yearly basis. Industry leaders are now rivaling Big Pharma in output of new molecular entities, or “first-in-class” drugs or chemicals that bring unprecedented medicinal solutions. Spending on medicines globally is expected to grow to $1.3 trillion by 201810. ￭ Today the biopharmaceutical industry generates more than $790 billion on an annual basis, and accounts for 3.4 million jobs across the U.S. About 1 in every 5 dollars spent on R&D in the U.S. is attributable to biopharmaceutical development11. There are several reasons for the rapid rise of biopharmaceuticals in the past 20 years. The most obvious is the breakthroughs that have occurred in molecular biology, genetics and genomics, which have revolutionized and redefined research and development. The industry has benefited by technological innovation by making molecular research and clinical testing more efficient and viable. The rise in the venture capital market, especially in the San Francisco Bay Area, has created a steady funding source for startup biotech companies and has helped financed a business that is incredibly capital intensive on the front side. The market capitalization of big biotech companies has risen 57% from 2009 to 2012, and such growth is anticipated to continue over the next five years as companies vie for position in specialty drug markets12. ￭ The U.S. market spent over $17.9 billion on autoimmune medications in 2013, and 18% growth from the year before and had yielded a 13 percent CAGR over the past five years13. In order to stay ahead of the Hepatitis C drug battle, Gilead has had to offer discounts on Sovaldi and Harvoni in order to close deals with CVS Health and UnitedHealth. Gilead has won favor due to a simpler pill regimen compared to Abbvie’s Viekira Pak, but it is evident that profit margins on its new blockbuster drugs will be cut down significantly. EVP of Commercial Communications Paul Carter stated on the February 3rd earnings call that in 2015, Gilead would be making a “gross to net adjustments for (its) HCV products in the United States to be approximately 46 percent”. While analyst consensus estimates combined revenue of $15.2 billion from these drugs in 2015, sales from Sovaldi revenues are expected to drop by half. ￭ Another major concern for Gilead is the plethora of HCV drugs in Big Biopharm’s pipeline that will be launched over the next three years. Gilead will attempt to maintain its market share with several NS5A inhibitors currently in its pipeline, but it will be a race to market launch. Bristol-Meyers expects to launch its new Hepatitis C drug Declatasvir sometime in 2016, but research supports that it is most effective when used with Sovaldi, which could help support Gilead’s sales down the road. However, Abbvie and Merck both have drugs in Phase III or pending status that could further crowd the market. Abbvie’s new “3d combination” drug Exveira is awaiting drug approval in Europe and the U.S. The drug has shown a Sustained Virological Response14 (SVR) rate as high as 99 percent over 12 months15. Merck has four separate protease inhibitor drugs in Phase III or later. New drugs that have treatment lengths and effectiveness similar or more favorable than Sovaldi and Harvoni will make it harder for Gilead to justify high sticker prices on these drugs. We believe that Gilead has not seen the end of these contract discounts and it is unlikely that Gilead will be able expand its patient treatment base enough to significantly compensate for these price adjustments. Improvement in the Drug Approval Process

The industry has benefited from improvement in the FDA’s drug review process in recent years. However, this poses as a threat for drugs currently in the market, as the quickening approval process could threaten their market share and shorten the high revenue growth period for new drugs. In 2009, the FDA expanded the CDER (Center for Drug Evaluation and Research), which reviews and approves all submissions for new drug development and monitors drug currently in the market. A recent innovation introduced in the FDA Safety & Innovation Act of 2012 is the “breakthrough therapy” clause, which expedites the review process for drugs that pose significant treatment advances in medical areas that have high demand for it16. Drug approvals in of a company’s first NDA submission have increased in recent years, as the approval rating has increased every year from 2010 to 2013. According to

the FDA, 74 percent of new drug approvals were approved in the U.S. before they were approved in a foreign drug market17. This is very beneficial for patients wanting newer innovation but greater price competition in oligarchic markets such as the HCV market.

Source: Center for Drug Evaluation and Research: New Novel Drugs 2015

Clinical Trials

The drug development process can endure 10 to 15 years in a successful drug approval. The grueling process serves as a huge barrier for smaller players in the market. The expensive NDA process is the reason that smaller biotech firms often get bought up by large cap biopharmaceuticals. The drug development process can be divided into three major stages: discovery, clinical development, and regulatory review. The discovery process fluctuates based on the indication and uniqueness of the drug. Clinical Development, which is divided into three phases, may take as long as six to seven years by most measures or at least 1-2 years per phase18. Stage I uses a small group of volunteers to test the safety of the drug and determine dosage levels and common side effects. Phase II tests a larger patient group and tests candidates who are infected with the disease or medical condition and collect data on the safety and efficacy of the drug. Phase III, where the patient volunteer pool expands from a couple hundred in Phase II to one to three thousand (dependent on the drug type), the company monitors the drug efficacy and any determines net benefit of the treatment19. In the months leading up to the final NDA submission, the firm prepares for market launch, constructing its salesforce, and makes all final revisions required by the Center of Drug evaluation and Research, the agency that reviews all NDA applications.. Phase III is the most capital intensive. PhRMA (Pharmaceutical Research and Manufacturers of America), which includes most Big Pharma and Biopharma companies, conducted a study on the total R&D costs of its members realized in 2012. The study

showed that on average Phase III R&D costs account for almost one third of the drug development process. The complexity of clinical trials has increased, adding to time, resources, and costs. The median number of trial procedures per trial protocol (i.e. routine exams, bloodwork) have increased 57% from 2003 through 2011, and the clinical trial period has increased 25% over that same timeframe20. The costs of the three clinical trial phases have increased over time as well. Today only 2 out of 10 marketed drugs yield revenues that match or exceed its R&D costs21. The reality for many smaller biopharmaceuticals in today’s industry is to a create new, innovative molecular entity that shows enough hope for a large cap firm to acquire the company along with rights to the entity. The larger cap biopharmaceuticals will have the resources and capital to push the NME on through FDA approval and a hopefully successful launch thereafter.

Function Dollars Share

Prehuman/Preclinical 11,816.30$ 24%

Phase I 3,823.30$ 8%

Phase II 5,756.20$ 12%

Phase III 15,926.80$ 32%

Approval 3,834.60$ 8%

Phase IV 6,776.50$ 14%

Uncategorized 1,653.80$ 3%

Total R&D 49,587.50$ 100%

R&D by Function, PhRMA Member Companies:

2012 (figures in $ millions)

Source: Pharmaceutical Research and

Manufacturers of America, PhRMA Annual

M&A Activity on the Rise

In recent years, the large biopharmaceuticals have begun to challenge Big Pharma in the M&A market. According to Ernst & Young, Big Pharma has slowly lost its ability to make acquisitions at will and is ceding much of this “firepower” to Big Biotech. In 2006, big pharmaceuticals accounted for 85% of the M&A capacity, but has watched its market share fall to 70% in 201322. This trend may continue as biopharmaceuticals continue to launch more “blockbuster” drugs, but will eventually subside as companies like Gilead and Biogen enter into mature growth stages. Ten years ago, Gilead may have appeared as an attractive takeover target for any Big Pharma wanting to enter the HIV market, but today the company’s market cap is the largest in the biotech industry and even rivals that of Merck. With the size to which Gilead has grown, it is unlikely that Gilead could be a realistic takeover target for any major pharmaceutical firm. As a result, there was no justifiable reason for us to consider Gilead as a takeover target in our valuation. Large cap biopharmaceuticals are here to stay and will continue challenge Big Pharma in bringing innovation in all fields of medicine.

HIV & HCV: Prevalence, Diagnosis & Treatment HIV Market ￭ According to the World Health Organization, there is believed to be 35 million people globally that are infected with some form of HIV, of which 37 percent are receiving treatment. The number of adults and children infected annually was approximately $2.1 million people globally in 2013, a number that has fallen 15% from $2.5 million in 200923. Treatment coverage of the disease for mid- and lower-income families has seen greater advancement in the last decade than ever before. About 12.9 million people received antiretroviral therapy (ART) in 2013, 11.7 million of them were in low or middle income countries24. This is figure has more than doubled since 2009. Large biopharmaceuticals have been successful in collaborating with foreign governments and generic manufacturers and other pharmaceuticals in bringing affordable ART drugs to patients in economically impoverished regions. Back in 2006, Gilead worked with a Merck Co. affiliate to provide Atripla to infected patients in developing countries in Africa and South America. ￭ According to UNAIDS 2013 Regional Factsheet, there are 2.3 million people in Western and Central Europe and North America that are living with HIV, with about 90,000 new infections that year. Roughly 56% of the infected are diagnosed and receiving ART treatment. These are the primary revenue-producing markets for all HIV drugs, as the countries in these regions have the highest percentage of middle and upper class patients that can afford to pay full price for the treatment regimens. ￭ While the growth of new infections marginally decreases year-to-year, increase in the effectiveness of diagnosing HIV in combination with a lower rate of HIV cases progressing to AIDS, the U.S. and European patient market has remained relatively stable. The Patient Protection and Affordable Care Act (PPACA) has enabled expansion of treatment accessibility for HIV patients in many states across the U.S. From 2009 to 2011, the percentage of persons diagnosed with HIV that were receiving prescribed ART treatment rose 4.6%25. Further innovation will continue in this market. According to PhRMA’s 2014 Profile on the drug market, 69% of pipeline drugs for HIV/AIDS indication are first-in-class medicines. HCV Market ￭ The World Health Organized estimates that 150 million people are living with Hepatitis C worldwide. There are an estimated 3 to 4 million cases in the United States. The most recent data shows the new infection rate in an upward trend. There is now a race to create an effective drug for the recent breakout of NASH, or Nonalcoholic steatohepatitis, a non-alcoholic liver disease often found in obese adults. Nash is believed to affect as much as 5% of the American population26. ￭ The industry has seen a revolution in terms of the way medicines attack the infection. In the last few years, direct-acting antiviral (DAA) agents, an antiviral therapy that targets and inhibits the entire viral lifecycle27. Merck & Co.’s Victrelis that launched in 2011 was the first of the “protease triple play” therapy drugs, used in combination with interferon and ribavirin28. Since then, many big players have submitted NDA applications with new drugs to treat HCV genotype I, many of them not requiring ribavirin in the treatment regimen, which helps cut down on the more unfavorable side effects (e.g. fatigue, nausea).

Investment Summary: ￭ We are issuing a specified HOLD recommendation based upon our analysis. Although we see Gilead as a strong company with high market share in the HIV and HCV drug sectors, the valuation indicates that their stock price has plateaued. We believe that Gilead is currently transitioning from a growth stock to a value stock, and the constant churning in their price over the next few years will not be successful in producing positive returns. Our strategy going forward is to hold the stock and sell call options in order to collect the dividends and rent, which will provide a more stable return. Based on a January 2015 call option currently available on the NASDAQ, the bid is $10.55, and the announced dividend is paying $1.96 annually, these two incomes would provide a return of 12.2% over the last closing price. Biotech Industry is Maturing

Global spending on medicine is believed to have peaked in 2014 at 7%, driven by roughly 12% growth in the U.S. market, and the compound annual growth rate is expected to fall to as low as 4% over the next 4 years. In addition, there are several big revenue drugs that face patent expiration over the next couple years. A total of $84 billion in pharmaceutical sales are at risk over the next two years due to patent expirations, of which $30 billion are expected to be lost over that time period. Amgen was the first large-cap biotech company to announce a dividend policy, paying a $0.28 dividend back in third quarter of 2011. Gilead will join the rank of dividend-paying biotech companies, and is anticipated to pay a $0.43 per share dividend in second quarter of 2015. Gilead has also repurchased $3.35 billion or 40.0 million shares of common stock through the third quarter of 2014 as a part of a three year $5 billion stock repurchase program beginning last year. While these actions may appease shareholders in the short term and reflect the company’s confidence in maintaining strong cash flows, it could also be an indication that a firm has not identified any projects that will yield greater return to investors than the stock repurchasing program will. While this indicates stability, it also suggests that rapid growth in the large biotech firms may begin to plateau. HIV Competition

Gilead appears to have a firm control over the HIV market. Atripla and Truvada rank 14th and 22nd on the list of non-discounted spending in the United States29. Gilead is awaiting response for approval of its new combination single-tablet drug abbreviated E/C/F/TAF. TAF is anticipated to effectively replace sales revenues that will be lost from the patent expiration of Viread in 2017. While Bristol Meyers and Johnson & Johnson have recently had new HIV drugs approved, these drugs will be used in combination with cobicistat, an active ingredient in Stribild. We believe that Gilead will continue to maintain revenue streams from its HIV drugs through internal drug development and collaborations with other large-cap biopharmaceuticals.

Wide Moat Morningstar currently perceives that Gilead as having a wide economic moat due its strong patent protection on key drug products. These patents have a long life and should ensure Gilead’s products are protected from competition at least for the next decade. Some older patents on drugs are set to expire in 2018. Gilead also boasts strong intangible assets such as expertise in infectious diseases, mainly HIV and HCV, and single-pill drug regimen formulas. Single-pill drug regiments are easier for patients to use and therefore tend to have more effective treatment and cure rates compared to multi-pill regimen. Large market share in Gilead’s key products will also ensure the company’s future stability. Currently, Gilead serves 85% of the HIV infected patient market in the United States. There are no threats that are expected to erode this market share currently, however they may face

pressure in the near future. The combination of these factors will help ensure that Gilead will be protected from competitors in the market. Flexibility in Financing Mergers and Acquisitions

Gilead has the ability to finance future mergers and acquisitions either through its cash reserves or borrowing funds. Our current cash flow estimates predict Gilead will earn about $12.5 billion in free cash flow for 2015. Even with the company’s plan of starting to pay a dividend and continuing its share buy-back program, Gilead is able to finance mergers and acquisitions with funds generated internally. Furthermore, the steep decline in the company’s leverage over the past two years, from 1.29 in 2012 to 0.69 will allow the company to take on additional debt and still remain competitive in the industry30. These factors will allow Gilead to remain flexible in future years in its approach to merging and acquiring promising new drugs in development. Pharmasset, Inc. In 2012, Gilead completed their $11.05 billion acquisition of Pharmasset, Inc. and in doing so acquired the lead compound now named sofosbuvir, which has led to the develop the first all-oral HCV regimen, Sovaldi and Harvoni. Sovaldi has had huge success since becoming available in December of 2013. An adverse decision on litigation relating to the patents of sofosbuvir could have a huge negative impact on revenues going forward; however, Gilead is the primary owner of the patents and is confident that they will be able to withstand any further litigation. In order to fund this purchase, it was financed with approximately $5.20 billion in cash on hand, $3.70 billion in senior unsecured notes issued in December 2011 and $2.15 billion in bank debt issued in January 2012. Phenex Pharmaceuticals AG

Gilead will be acquiring the Phenex Farnesoid X Receptor (FXR) program comprising small molecule FXR agonists for the treatment of liver diseases including nonalcoholic steatohepatitis (NASH). Under the terms of the agreement, Gilead will pay Phenex an upfront payment plus additional payments based upon achievement of certain development milestones that may potentially be worth up to $470 million. NASH is estimated to affect 10 to 20 percent of people in the developed world. There are currently no approved therapies to treat NASH31.

Valuation

Discounted Cash Flow (DCF) Analysis

Source: Team Estimates

￭ The DCF Analysis was very useful in determining a fair value estimate for the company. It uses forecasted values, based on set drivers and analyst predictions, to determine the free cash flows and the terminal value, which are all discounted by the weighted average cost of capital (WACC) to find the total value of the firm.

￭ Scenario Analysis of Revenues: For our DCF model, we

decided to look at three separate scenarios: a best case, base case, and a weak case for their revenues. The estimates were generated using a consensus of analyst predictions about the individual drug sales within Gilead’s drug pipeline. The revenues used within the model were calculated with a weighted average of the three different scenarios.

￭ Best Case – 30%: This could be caused by strong Harvoni sales expected in 2015, as well as strong growth in their mainline product sales, with Sovaldi sales dropping as Harvoni becomes more popular. ￭ Base Case – 50%: This is the most likely outcome for the projected revenues, utilizing the averages of the consensus analyst predictions. ￭ Weak Case – 20%: Least likely scenario that could be caused by weak international sales, specifically in Japan and Europe for HCV products, paired with higher discounting going forward and no approved new drug applications (NDAs). ￭ Model Drivers: Gilead’s cost structure has remained relatively constant over the last few years, with 2014 showing a large increase in revenues with almost no increases in their cost of goods sold. We believe that their

Target EV/EBITDA Price

9.5 109.99$

9.53 110.31$

11.20 130.08$

EBITDA and EBIT margins will remain constant at 65% and 63.5% respectively. The only forecasted percentage decrease is their cash levels for the next few years, this is due to the announcement that there will be a quarterly dividend paid along with larger stock buybacks as soon as the current round has ended. ￭ WACC: Using a cost of equity found using the CAPM paired with their cost of debt from currently outstanding notes, along with a five year adjusted beta acquired from the data source Factset, the WACC for Gilead was found to be 11%, and this led to a valuation of $101.67 per share, which signifies that the stock is currently undervalued by 3.06% at its current price.

EV-EBITDA Analysis

￭ The Enterprise Value/ Earnings Before Interest Taxes Depreciation Amortization (EV/EBITDA) analysis of a

company provides a view on the value of the company with the debt of the company included. For the first part of 2014 Gilead’s EV/EBITDA was in the 14 to 15 range. This at the time was much higher than the similar companies of JNJ, ABBV, PFE, MRK, and AMGN.

￭ In March Gilead’s EV/EBITDA began to decrease to be closer to similar companies. On April 23rd the EV/EBITDA plummeted well below that of the similar companies and has remained there. This large decrease is most likely tied with their release of the sales numbers related to Sovaldi and the large increase of earnings it brought in. ￭ Based on a weighted average of the similar companies, giving

ABBV a slightly higher weight in the model, we concluded that a range for the forward looking EV/EBITDA of similar companies was between 9.50 and 11.20. Based on this range for the forward looking EV/EBITDA the expected price of Gilead should fall between $109.99 and $130.08. ￭ Currently Gilead’s forward looking EV/EBITDA is at 8.81; well below of what the similar companies are at, and not within what we view as the acceptable range. We have concluded that Gilead’s forward looking EV/EBITDA is below where it should be and set a target EV/EBITDA value of 9.53, based on the average of the weighted average of the competitors and of Gilead. This EV/EBITDA value gives the Gilead a price of $110.31. P/E Analysis

￭ The Price to Earnings Ratio for Gilead started 2014 higher than the similar companies of JNJ, ABBV, PFE, MRK, and AMGN in the range of 20 to 23 compared against their range of 13.5 to 16. Beginning in March these ratios and the similar company’s ratios began to converge, as Gilead’s P/E ratio dropped to an average of 18.21 for the

month of March, still above the similar companies range but much closer than it was previously. In April Gilead’s P/E ratio was in line with that of the similar companies but then plummeted below that of the similar companies on April 23rd, and has remained consistently lower since then. ￭ Based on the similar companies we have come to a conclusion that a target P/E ratio between 14 and 16.5 is acceptable. Based on our forecasted

earnings this would give Gilead a price range of $116.20 $136.95. For Gilead however, given the downward trend of Gilead’s P/E, it’s recently constant lower P/E and the similar company ABBV below the similar company range as well, we have given a target P/E of 12.9. This P/E results in a target price of $107.09.

Final Weighted Price ￭ The final fair value price was determined by weighting the three model prices together. The DCF model received the highest weight due to the extent of the valuation, whereas the EV/EBITDA and P/E models were given less weight for the overall calculated price.

After-tax Cost of Debt 3.11%

Cost of Equity 11.56%

Debt Weight 6.55%

Equity Weight 93.45%

Market Risk Premium 10.03%

Beta 0.9529

Risk Free Rate 2.00%

WACC 11.00%

WACC Calculation

Financial Analysis: Financial Statements

￭ The key figure within the income statement is the revenues, which were estimated beyond 2014 using a scenario analysis of the individual drug revenues. For the years prior to 2014, Gilead has had strong revenue growth, 16% in 2013 and 15% in 2012, with their gross margin remaining stable for the last three years (2014 figures represent abnormal growth). The 2014 surge in U.S. sales of Sovaldi has decreased Gilead’s international exposure by almost 14%, from 40% to about 26%. The operating and net margins have both been declining over the last 5 years; however, 2014 has shown a huge amount of growth with the success of their emerging HCV market. The increased revenues for Harvoni are expected to cause a subsequent decrease in Sovaldi sales, and with these two drugs producing almost half of Gilead’s revenues, the future growth in the HCV market is critical to predicting their earnings levels. These declining revenues through 2019 causes for a subsequent decline in their net income, but at a much slower rate. The forecasted net margins will remain in a range between 42% and 48%. ￭ Gilead has shown wild fluctuations in their levels of cash throughout the last few years, with the large decreases coming from the many acquisitions they have undertaken to expand their drug pipeline, and more recent cash increases being fueled by massive increases in sales for Sovaldi along with the issuance of senior notes. In 2012, there was a $10 billion increase to intangible assets from the acquisition of Pharmasset and the new drug sofosbuvir. ￭ There have been increases in long-term debt since 2011; however, the subsequent increases to their equity value and assets has kept their capital structure relatively constant. In 2014, the doubling of their annual revenues has had a positive influence on the market value added to equity. Ratio Analysis

All 2014 ratios reflect trailing twelve month (TTM) values as of September 2014, unless otherwise stated. ￭ Profitability: For year-end 2014, Gilead leads the industry in profitability. Among major biopharmaceuticals, Gilead has lead the industry in net margin 3 of the last 4 years. Gilead’s trailing twelve month (TTM) net margin as of September 2014 is 45.31% in 2014 is unrivaled among its closest competitors, nearly doubling Biogen’s and Abbvie’s net margin over the same period. Strong bottom-line growth was driven by high revenues of Sovaldi sales and the Harvoni launch in Q4, which combined for just over 50% of product sales in 2014. ￭ Valuation: Gilead’s P/E is relatively in line with its large cap competitors and is very favorable to the ProShares Ultra NASDAQ Biotechnology ETF average of 69.40. Note however, that unsustainable revenue growth has artificially pushed this number lower. We project the forward P/E to rise to 12.9 from the 10.2 mark where it stands currently. Gilead’s 2014 price-to- free cash flow is the most attractive in the industry next to Amgen, who also experienced strong stock price appreciation of 41% last year. ￭ Per Share: Gilead’s Sales and Earnings per share have generally been inferior to competitors such as Amgen, Biogen and Merck. An equal weighting of these three companies’ annual EPS has averaged $6.35 from 2012 through 2014 compared to Gilead’s average of $4.12. This statistic certainly justifies Gilead’s $5 billion stock repurchase program, as a means to boost per share values to match or exceed competitors. Abbvie has watched its EPS value fall over the same time as its Viekira Pak has lost ground in the battle for healthcare providers and retail pharmacies such has UnitedHealth Group and CVS Health. Gilead’s TTM EV/EBITDA of 10.94 looks strong compared to Amgen and Abbvie, who were 13.23 and 13.37 respectively. ￭ Efficiency: Gilead has the strongest revenue per employee of all public biopharmaceutical companies, one

reason being that it outsources a major portion of their research and development to outside labs instead of producing it in-house. Gilead also has a very high operating cycle due to some net inventory build of Harvoni following its launch as noted by Paul Carter in the latest earnings call; however, due to a large days of payables outstanding, the final net operating cycle falls in line with their competitors.

Investment Risks: Market Risk: Raw Material Shortages

The pharmaceutical industry relies on high quality raw materials in order to ensure manufactured drugs have the desired results without unintended side effects. Occasionally lapses or blind sights in safety controls pose a threat to consumers. Gilead must work diligently to ensure its materials and suppliers maintain a high standard of quality in order to protect consumers and Gilead's image.

Market Risk: Generic Drug Pricing

Gilead has a history of developing market leading drugs and is able to sell these drugs for a premium. As patents expire however, cheaper alternatives force Gilead to cut its pricing in order to remain competitive. Gilead is therefore under pressure to continue to develop new market leading drugs in order to maintain a high profit margin. Market Risk: Discount Pricing on Products

Gilead's drug products are expected to take a price discount in the future in order to remain competitive and reach the broader market. Initially Gilead sells these market leading and innovative drugs at a premium but is later pressured into reducing the price in order to keep sales high. Therefore, Gilead is expected to generate reduced revenue in future years as the company lowers its profit margin. Sovaldi is expected to take a 46% price discount in the coming year, compared with 22% for 2014, and may see an additional price cut depending on future market conditions. Rising R&D Costs

The tightening of drug regulation and expansion of the NDA (New Drug Application) process has been a burdensome driver of rising R&D costs. Total R&D costs have soared over the last decade. In the late 1990s, the average cost to develop one new approved drug, including the cost of failures, totaled $800 million. That number grew to $1.2 billion in the early and mid-2000s, and today that cost now stands at roughly $2.6 billion, with approximately $1.4 billion of those expenses coming out-of-pocket and the rest capitalized32. In Tufts study of 10 pharmaceuticals drug pipelines over a nearly three decade period starting in 1995, it found that declining clinical success rates have contributed to the rising R&D costs. This among other factors has contributed to an inflation-adjusted annual growth rate of 9.3% for out-of-pocket R&D costs. With many larger biopharmaceuticals entering maturing growth stages, either more cash or higher leverage will be needed to acquire new intellectual property for patenting as a means to hedge the company from patent cliffs. As these companies exit their high-growth stages and their blockbuster drug revenues dissipate, these growing R&D costs will become more burdensome on margins. Political Reform

Health Care Reform has been an ongoing battle US political arena. Due to legislation passed in 2010, The Affordable Care Act, Gilead was required to further rebate or offer discount on products that were reimbursed or paid for by various public payers. As competitors patents expire, Gilead expects to have to pay an increasing amount of the Branded Prescription Drug (BPD) Fee. The BPD fee imposed on the pharmaceutical industry will be $3 billion for 2015 and 2016, $4 billion in 2017, 4.1 billion in 2018, and finally decrease to $2.8 billion for 201933. Comparative Effectiveness

A potential threat to biopharmaceuticals with pricy product lines is the comparative effectiveness studies on currently marketed products. The study was a $1.1 billion piece of the stimulus package the Obama Administration rolled out in 2009, with the initiative of finding evidence on “the effectiveness, benefits, and harms of different treatment options” across the drug industry34. The results of the study may result in unfavorable reimbursement decisions, and may pressure drug manufacturers to heavily discount their higher-priced drugs.

Source: Company Data

International Exposure

In the years prior to the release of Sovaldi and Harvoni, Gilead maintained their international exposure at about 40 percent. Sovaldi was released in the US before anywhere else, and the surge in sales throughout 2014 caused their international exposure to drop by about 14%. Sovaldi has been approved for sale in Europe, and they are currently awaiting approval in Japan, a major HCV market, and these two factors could help to balance out their exposure.

Appendix

Glossary Antiretroviral Therapy (ART) – the main treatment for HIV with the purpose of keeping the amount of HIV at a low

level and preventing it from progressing AIDS.

At Risk: revenues earned by drugs that are a year away from losing patent protection or market exclusivity.

Brand Prescription Drug (BPD) - (1) any prescription drug the application for which was submitted under section

505(b) of the Federal Food, Drug, and Cosmetic Act; or (ii) any biological product the license for which was

submitted under section 351(a) of the Public Health Service

Act. (http://www.irs.gov/Businesses/Corporations/Annual-Fee-on-Branded-Prescription-Drug-Manufacturers-and-

Importers).

E/C/F/TAF - an investigational, once-daily single tablet regimen containing elvitegravir 150 mg, cobicistat 150 mg,

emtricitabine 200 mg and tenofovir alafenamide (TAF) 10 mg currently in submission for NDA approval.

EV/EBITDA – Calculated taking the enterprise value, the market value of equity plus total outstanding debt, over

earnings before interest, taxes, depreciation, and amortization. The numerator essentially tells us the “takeover

value” of the business while the denominator show us the value remaining after the costs of simply running the

business are subtracted from the firm’s revenue.

New Drug Application (NDA) - vehicle through which drug manufacturers formally propose that the FDA approve a

new pharmaceutical for sale and marketing in the U.S.

New Molecular Entity (NME) - an active ingredient that has never before been marketed in the United States in

any form. (fda.gov)

Non-Alcoholic Steatohepatitis (NASH) – liver disease more often found in non-alcoholics caused by excessive fat in the liver resulting in inflammation and damage.

Porter’s Five Forces

Source: Team Estimates

Bargaining Power of Suppliers: Moderate

The risk in supply line comes from a low number of suppliers for raw materials necessary for the manufacturing of

Gilead’s products. Furthermore, there have been occasional supply disruptions and shortages of raw materials.

These factors pose enough of a risk that Gilead must be vigilant and ensure the quality of its supply line.

Fortunately, Gilead is able to earn a high profit margin on its products so the company is able to weather

unfavorable changes in supply prices.

Bargaining Power of Customers: Low

Given the low number of drugs available on the market to effectively treat HCV and HIV, consumers have little

option to switch between drug products. Furthermore, these drugs are highly important to patients who are often

suffering from life threatening infections. These factors allow Gilead to be able to initially generate a high margin

for their products.

Competitive Rivalry: Moderate

High profit margin and a limited consumer base have lead to high competition amongst a few major prescription

drug manufacturers. Fortunately for Gilead, strong patent protection laws in the Untied States allow Gilead to

enjoy a period where it can sell new products without threats from competitors. However once patent protection

expires, Gilead faces strong competition from competitors.

Threat of Substitutes: Low

Gilead offers market leading prescription drugs. As a result, there are few substitute drug products available on the

market that can successfully compete with Gilead. Even when a substitute product exists, Gilead tends to offer

premium products that require a relatively low treatment period. The development of substitute drugs is a long

and costly endeavor so Gilead will have adequate time to adapt to new products from competitors.

Threat of New Competitors: Insignificant

Gilead also has little to fear from new competitors in the industry given the high barriers to entry. The industry

requires companies to have a high level of technical expertise and strong financial backing. As a result, a relatively

few number of companies enter the industry. This allows Gilead to be protected from the threat of new

competition.

Forecasted Income Statement

Sources: Company Data and Team Estimates

Sources: Company Data and Team Estimates

Income Statement 2012A 2013A 2014A 2015E 2016E 2017E 2018E 2019E

Sales 9,613.71$ 11,221.35$ 24,890.00$ 29,477.42$ 27,543.04$ 26,116.26$ 25,084.96$ 24,420.18$

Cost of Goods Sold (COGS) incl. D&A 2,471.36$ 2,898.96$ 3,788.00$ 5,312.99$ 4,638.57$ 4,170.44$ 3,847.58$ 3,646.35$

Gross Income 7,142.35$ 8,322.39$ 21,102.00$ 24,164.43$ 22,904.47$ 21,945.82$ 21,237.39$ 20,773.83$

SG&A Expense 3,220.98$ 3,720.43$ 5,837.00$ 8,186.89$ 7,147.66$ 6,426.31$ 5,928.80$ 5,618.72$

EBIT (Operating Income) 3,921.37$ 4,601.96$ 15,265.00$ 15,977.54$ 15,756.82$ 15,519.50$ 15,308.59$ 15,155.11$

Nonoperating Income - Net 52.63$ (12.00)$ 3.00$ 3.00$ 3.00$ 3.00$ 3.00$ 3.00$

Interest Expense 360.92$ 306.89$ 412.00$ 412.00$ 412.00$ 412.00$ 412.00$ 412.00$

Pretax Income 3,611.98$ 4,208.22$ 14,856.00$ 15,562.54$ 15,341.82$ 15,104.50$ 14,893.59$ 14,740.11$

Income Taxes 1,038.38$ 1,150.93$ 2,797.00$ 3,112.51$ 3,068.36$ 3,020.90$ 2,978.72$ 2,948.02$

Net Income 2,591.57$ 3,074.81$ 12,101.00$ 12,450.03$ 12,273.45$ 12,083.60$ 11,914.87$ 11,792.09$

Income Statement - Common Size 2012A 2013A 2014A 2015E 2016E 2017E 2018E 2019E

Sales 100% 100% 100% 100% 100% 100% 100% 100%

Cost of Goods Sold (COGS) incl. D&A 26% 26% 15% 18% 17% 16% 15% 15%

Gross Income 74% 74% 85% 82% 83% 84% 85% 85%

SG&A Expense 34% 33% 23% 28% 26% 25% 24% 23%

EBIT (Operating Income) 41% 41% 61% 54% 57% 59% 61% 62%

Nonoperating Income - Net 1% 0% 0% 0% 0% 0% 0% 0%

Interest Expense 4% 3% 2% 1% 1% 2% 2% 2%

Pretax Income 38% 38% 60% 53% 56% 58% 59% 60%

Income Taxes 11% 10% 11% 11% 11% 12% 12% 12%

Net Income 27% 27% 49% 42% 45% 46% 47% 48%

Price to Earnings for Gilead and Major Competitors

EV/EBITDA for Gilead and Major Competitors

References 1 Drugs.com Sovaldi Drug Pricing 2 Drugs.com: Atripla Drug Pricing 3 Drugs.com: Truvada Drug Pricing 4 Drugs.com: Complera Drug Pricing 5 Drugs.com: Stribild Drug Pricing 6 WSJ: FDA Clears Viread for Hepatitis B, August 2008 7 Drugs.com: Viread Drug Pricing 8 Gilead Press Release: Gilead Sciences Announces Acquisition of Phenex Pharmaceuticals’ Development Program for Non-Alcoholic

Steatohepatitis (NASH) and Other Liver Diseases, January 6, 2015 9 Reuters: After hepatitis C cure, companies target next big liver disease market, November 2014 10 MS Market Prognosis, September 2014 11 PhRMA, The U.S. Biopharmaceutical Industry: Perspectives on Future Growth and The Factors That Will Drive It, 2014 12 S&P Capital IQ: Industry Surveys, Biotechnology, September 2014 13 IMS Health, National Sales Perspectives, Jan 2014 14 SVR indicates the a period of time over which the virus is undetected 15 The Pipeline Report 2015. Retrieved from http://media.mmm-online.com/ 16 S&P Capital IQ: Industry Surveys, Biotechnology, September 2014 17 S&P Capital IQ: Industry Surveys, Biotechnology, September 2014 18 PhRMA Profile 2014 19 PhRMA Profile 2014 20 K.A. Getz, R.A. Campo, and K.I. Kaitin. “Variability in Protocol Design Complexity by Phase and Therapeutic Area.” Drug Information

Journal 2011; 45(4): 413–420 21 J.A. Vernon, J.H. Golec, and J.A. DiMasi. “Drug Development Costs When Financial Risk Is Measured Using the Fama-French Three Factor Model.” Health Economics 2010; 19(8): 1002–1005. 22 Ernst & Young, In recent years, Biopharma M&A in an Era of Elusive Growth 23 World Health Organization, Global Update on the Health Sector Response to HIV 2014 24 World Health Organization, Global Update on the Health Sector Response to HIV 2014 25 National HIV Surveillance System 26 National Institute of Diabetes and Digestive Kidney Diseases 27 PhRMA Profile 2014 28 HCSP Fact Sheet. Retrieved from Hcvadvocate.org 29 IMS Health, National Sales Perspectives, Jan 2014 30 Morningstar Credit Research Highlights, February 9, 2015, Page 34 31 Gilead Press Release: Gilead Sciences Announces Acquisition of Phenex Pharmaceuticals’ Development Program for Non-Alcoholic

Steatohepatitis (NASH) and Other Liver Diseases, January 6, 2015 32 Cost of Developing a New Drug. Tufts Center for the Study of Drug Development. November 18, 2014. 33 Gilead 10-k report: September 2014, Page 44 34 What is Comparative Effectiveness Research? Retrieved from effectivehealthcare.ahrq.gov

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