I Was Wrong About Gilead Sciences

When Gilead Sciences (GILD -1.64%) reported earnings earlier this month, I was stunned. Management guided for 2017 Hepatitis C revenue of $7.5 billion to $9.0 billion, down almost 50% from its full-year 2016 Hepatitis C revenue of $14.8 billion.

I had thought Gilead Sciences' Hepatitis C franchise was pretty close to the bottom.

I was wrong.

Breaking it down

In healthcare, revenue boils down to two components: price and number of patients treated. Gilead has been getting hammered on both, although management expects Hep C drug Harvoni's U.S. prices to stabilize at roughly $15,000 per bottle in 2017, down from an initial list price of $94,500. Unfortunately for investors, patient volume is expected to continue declining as healthier patients come into treatment. Since Hepatitis C is a slow-moving disease, these patients have years before they're in serious danger -- years during which many insurers will likely delay getting them a cure in the hopes that prices will come down in the future.

Now, in all fairness to me (and other investors who felt similarly), we were in uncharted waters -- Gilead is selling a wonder drug that, in over 90% of cases, provides a cure for a disease that infects as many as 150 million people worldwide, according to the World Health Organization (WHO). This was the first time a really expensive drug was marketed for a common disease. Predicting the market dynamics was tough.

Nonetheless, I pretty clearly made a mistake: I didn't seriously consider what a significant erosion in the Hepatitis C space would look like. I figured that things might decline by 20%, or even 25%, but a nearly 50% decline in 2017 didn't really figure into my calculations.

And it should have. I should have analyzed different potential scenarios and what I thought the stock might be worth under those scenarios.

The upshot

I've decided to add a step to my investing process. From now on, I'll do a base/bull/bear framework. I'll make my best guess as to what a 'reasonable' level of growth -- likely heavily anchored to past performance -- for a company will be over the next five years. And then I'll do predictions skewed heavily toward optimism and pessimism. For each of those three, I'll apply a valuation multiple based on what companies in similar circumstances have historically traded at -- and then consider the range of potential outcomes based on that.

Here's an example of what that might look like. (And while it's tangential to the point of this article, I'm happy to own Gilead stock at current prices with the framework I'm about to lay out.)

In the bear case, I assume that Hepatitis C revenue goes to zero, HIV revenue declines by 20% from last year (reflecting market-share losses to competitors, most notably GlaxoSmithKline's VIIV Healthcare), and that Gilead fails to get a single drug through its pipeline and do anything with its cash hoard (currently $32 billion). It freezes the dividend where it is, largely directing future cash flow to maintaining its dividend. The market assigns it a valuation of seven times earnings, and largely leaves the company for dead.

In the base case, I assume that Hepatitis C revenue declines by more than 50% from where it's forecasted to be next year, as price concessions and market-share losses continue to undermine the business. HIV revenue increases by 5% annually as market-share gains by new drugs Genvoya, Odefsey, and Descovy are partially offset by lapsed patents,and lost revenue on some of Gilead's older HIV drugs.

Gilead uses its cash to make an acquisition, which boosts its non-HCV/non-HIV revenue appreciably, enough to get it back to nearly its current annual revenue and earnings-per-share (EPS) generation. The dividend continues to grow by 10% annually, and the market continues to value the company as a large value stock instead of a growth stock.

In the bull case, I assume that HCV revenue stabilizes next year, or shortly thereafter, HIV revenue improves more as Gilead's new HIV drugs actively seize market share and elbow out the competition, and that Gilead makes a transformative acquisition that broadens its pipeline. That, combined with some successes from internally sourced drugs, takes it to new highs. The company grows its dividend by 20% annually and the market treats it as a growing large-cap pharma stock, valuing it higher than the S&P 500.

It's never quite that simple

The answer, of course, is somewhere in between. Maybe HIV grows along the lines of the bull case, but Hep C goes fully to zero. Maybe both fail, but Gilead makes a transformative acquisition, or has some good news out of its NASH pipeline.

You get the idea. This isn't trying to predict the future, but rather trying to capture the range of possibilities and think through what could happen -- explicitly anchoring to past performance with the "base" case, and then throwing that out with the bull and bear cases.

Take it. Adjust it to your investments and learning style. Think through the different risks, what your investment might be worth in different scenarios, and whether you're willing to accept the pricing implied by those outcomes.

Most importantly, remember that you're still going to be surprised, and that the market won't do things to deliver nice, neat, precise prices that match your models. That's part of the fun of investing, after all.