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When Growth Becomes Value

When a growth stock with a high P/E Ratio drops in price yet their EPS growth is up significantly from just six years ago, you get a Growth Stock at a Value price!

GILDDouble click on any image for a full sized view

Gilead Sciences is a top notch Biotech company that has seen its stock price tumble more than 30% over the last year along with most of its competitors.  The biotech industry had the unfortunate luck to be painted with the same brush as the drug company that overnight raised the price on one of its drugs 5000% when a new owner took over.  The political establishment jumped on this and made statements about punishing the industry when it was really just one bad owner who needed to be corrected.

At the current price, Gilead trades at a 6.75 P/E ratio when the stock market is trading at a 25 P/E ratio.  It projects that it will earn $30 Billion this year.

It has two bread and butter franchises:  one is an HIV franchise that has been revitalized with a new drug that is out performing expectations (according to analyst David Katz) and the other is a Hepatitis C cure (not just a treatment but an actual cure) that has been so successful for so long that the market for this drug is shrinking, albeit slowly.

This last issue, the shrinking market for its Hep C cure has the market up in arms and when earnings were released today investors sold off Gilead for a > 6% loss on the day because it lowered its revenue guidance from $30.5 Billion to $30 Billion.

I was one of the buyers today and made a bit under 1% for our clients in our growth strategy, doubling down on our current position – unfortunately, I was also a buyer when the stock was down a bit more than 25% but the fundamentals justify the purchase decision.

So I thought I’d give you some insight into the sort of analysis we do on a company like this that leads me to buy it.

1.  GILD has 61 products in Phase III trials per CMLviz (the last step before the FDA can approve a drug).  Investors should not be overly concerned about the Hep C market shrinking when somewhere in these 61 new drugs there could be one or more that will be block busters like the two principal franchise it currently has.  Having this number of drugs in Phase III trials is a catalyst for future earnings growth many company’s could only wish to have.

2.  We are buying this classic growth stock at a significant discount to the market (6.75 P/E ratio).  Normally, you only get to buy deep cyclicals at this sort of valuation, not a company earning $30 Billion this year with 61 potentially significant catalysts to earnings on the horizon.

3.  Investors get a > 2% dividend yield on a biotech stock.  In all the years I’ve been a growth stock investors, it has been tough to find companies that are growing their earnings faster than the market and the economy while paying a dividend yield  greater than the yield on the S&P 500 or the yield on fixed income investments.

4.  Check out this graph of productivity (Revenue per Employee):

GILD rev empGilead is off the charts compared to its competitors (graph courtesy of CMLviz)

5.  Check out this graph of efficiency (Revenue per $1 of Expense):

GILD rev expAgain, Gilead is off the charts compared to its competitors (graph courtesy of CMLviz)

6. Check out this graph of Revenue Growth (you can see why its a growth company):

GILD rev growthNormally, the earnings multiple valuation for a company like this is higher than the market multiple – because of the political impact, you are getting a growth stock for a value stock multiple.

7.  When I calculate the target price for GILD using our multi-factor valuation methodology, I come up with $148 or 80% potential upside.  Gilead is currently trading at the bottom of its 52 week price range.  The risk to reward ratio is clearly favorable.

8.  The Morningstar Fair Value price for GILD is $124 (making it 34% undervalued today) and their Sale Target is $168 (or 100%+ potential upside).  The risk to reward ratio is clearly favorable.

9.  When I perform our standard calculation for under-valued Vs over-valued, I come up with a fair value today of $126, making it currently 35% undervalued.  This is based upon an extrapolation of next year’s earnings estimates, book value, estimated sales, and estimated cash flow using a ten-year weighted-average of the Price to Earnings ratio, Price to Book Value Ratio, Price to Sales Ratio and Price to Cash Flow Ratio.

Given the superior operating performance of Gilead Sciences, Inc., its potential earnings growth catalysts, its above average dividend yield, its current undervaluation and the potential upside leading to a superior risk to reward scenario, Gilead is a buy in my estimation.

One thing to remember – even though a stock is cheap, it can always get cheaper.  If Gilead drops in price some more, I will be a buyer – investing is a long-term activity that cannot be constrained by a calendar.  Yes, I might not be a winner on this one stock by 12/31 when clients get their annual statements.  However, buying good companies with strong earnings power at cheap prices is the hallmark of how you make money investing in stocks.  You don’t always see the results tomorrow, but you will see the results with patience and conviction.

Mark