Thursday, August 8, 2013

Gilead Sciences Carving Out a Wider Moat

Investment Commentary

Gilead Sciences Carving Out a Wider Moat

Stock Investor editor Matt Coffina and senior biotech analyst Karen Andersen discuss Gilead's growing competitive advantages.

By Matthew Coffina, CFA | 08-08-13 | 06:00 AM

I recently sat down with senior biotechnology analyst Karen Andersen to discuss  Gilead Sciences (GILD). A few weeks ago, we raised our fair value estimate for Gilead to $71 per share, based on positive clinical trial results and a lower cost of equity assumption. While Gilead has only a narrow moat, the moat trend is positive. If all goes well with its drug pipeline, Gilead could cross the threshold into wide-moat territory soon

Matt Coffina, editor of Morningstar StockInvestor: Gilead’s historical strength has been in HIV drugs. How has the company's portfolio of HIV drugs evolved, and where are we now in terms of growth potential and patent protection?

Karen Andersen, senior biotechnology analyst: Gilead started out with Viread, which has become the foundation of all of its marketed combination therapies. First, Gilead introduced a combination therapy, Truvada, that can be paired with treatments from other companies. Then Gilead partnered with other firms--  Bristol-Myers Squibb (BMY) and  Johnson & Johnson (JNJ)--to create single-tablet regimens Atripla and Complera. Each new drug has improved upon its predecessors. Atripla is a combination of Truvada and Bristol's Sustiva, but Sustiva causes psychiatric symptoms (depression, nervousness), rash, and elevated cholesterol, and can't be taken by pregnant women. Complera improves upon some of the neurological side effects.

Most recently, Gilead brought Stribild to market, which contains all-Gilead ingredients. Stribild combines Truvada with Gilead's integrase inhibitor, so it's like a more convenient version of Truvada plus  Merck's  (MRK) Isentress. Stribild, in my opinion, looks like a stronger regimen than Complera--it has fewer side effects than Atripla, but it might also be slightly more effective than Atripla, particularly among healthier patients. The better Stribild does, the better for Gilead, since the company doesn't have to share as much of its profit with partners and the Stribild patents go out to 2029.

Overall, Gilead now sees almost $8 billion in annual HIV drug sales. I think Gilead should continue to see high-single-digit sales growth from its HIV portfolio through 2017. These sales should flatten with the expiration of Viread patents in 2018 and begin a slow decline in 2022 as Atripla patents expire.

Matt: Everyone is excited about a variety of hepatitis C drugs in late-stage development. What is hepatitis C and how do you size the potential opportunity?

Karen: Hepatitis C is a viral infection of the liver. Patients left untreated over a period of decades usually develop chronic liver disease, such as cirrhosis, or in the most serious cases liver failure or liver cancer. Most patients in the U.S. today are baby boomers. New infection rates are quite low due to effective blood screening, so we think the market will plateau and then begin to decline as baby boomers age. However, in the meantime, the potential is enormous--there are more than 12 million patients with chronic hepatitis C in major developed markets and more than 3 million in the U.S. alone. Even if diagnosis and treatment rates only improve incrementally over the next few years, we think the global annual market will hit $20 billion by the end of our 10-year forecast.

Matt: Recent clinical trial data for Gilead’s hepatitis C drugs has been very promising. Can you summarize the efficacy and side-effect profile?

Karen: Gilead's strategy is to bring the foundation of its hepatitis C portfolio, sofosbuvir, to market in 2014, and a combination with another drug candidate, ledipasvir, to market in 2015. This oral combination therapy is particularly promising, and efficacy in a recent Phase II trial indicated that cure rates could be as high as 100% after 12 weeks of therapy, with few side effects. For perspective, the current standard of care (with drugs like  Vertex Pharmaceuticals(VRTX) Incivek) results in cure rates of around 70% for most previously untreated patients, treatment typically lasts for six months, and side effects--including flulike symptoms, depression, and anemia--prevent many patients from finishing or even initiating therapy. In addition, current treatment involves a complex regimen of once-weekly injections and around a dozen pills a day, while Gilead's regimen will be a once-daily pill.

Matt: How do Gilead’s drugs compare to those in development at competitors like  AbbVie (ABBV), Bristol, Johnson & Johnson, and Vertex?

Karen: Given the market potential I outlined, it is no surprise that several other firms are vying to enter this market. AbbVie is likely to bring its own all-oral combination regimen to market in 2015, but we expect this regimen to require ribavirin, which is part of the current standard of care but which causes anemia. It will also require several pills per day in order to achieve efficacy on par with Gilead's combination regimen. Bristol may be able to bring a ribavirin-free regimen to market with similar efficacy to Gilead's, but Bristol is just entering Phase III trials and also requires several pills per day. I'm most concerned about competition from Vertex, which has a drug that could be similar to Gilead's sofosbuvir. However, Vertex's key trials are only at the Phase II level, which will make the product late to market. Unless Gilead's regimen sees surprisingly weak efficacy in Phase III trials or Vertex is able to significantly shorten treatment times (Gilead is already testing its regimen as an eight-week treatment), we doubt it will be able to offer any improvements relative to Gilead's product.

Matt: Gilead built out its hepatitis C portfolio through the $11 billion acquisition of Pharmasset. Do you think the price it paid was low, high, or about right, given what we know now?

Karen: Given the data we have seen for sofosbuvir and competing products over the past year, we have gone from estimating Pharmasset was purchased at a fair price to estimating it was actually a bargain. For example, last year we conducted a net present value analysis of the acquisition, which implied that Gilead had paid a fair price for Pharmasset assuming a discount rate of 10.2% and $4.5 billion in annual sofosbuvir sales by 2020, followed by flat sales through patent expiration. Today, we assume less than an 8% cost of capital and sales of sofosbuvir flattening around $8 billion by 2020, and the acquisition now looks like it was worth at least twice what Gilead paid.

Matt: Gilead seems to have special expertise in infectious diseases and single-pill formulations that carry across drug classes. Would you agree, and what might this mean for future innovations?

Karen: I think we're starting to see that play out, as the firm's ability to recognize valuable molecules in HIV and strategically create the best combination regimens is clearly carrying over to the field of hepatitis C. I think this is one of the reasons why Gilead will be able to hang on to the high market share it will undoubtedly gain after the launch of sofosbuvir, despite emerging competition. Gilead has a large pipeline of hepatitis C drug candidates that could allow it to serve a broader group of patients with an even shorter duration of therapy. Gilead is also beginning to advance in the field of oncology, which might sound like a stretch. However, Gilead is focusing initially on hematological oncology, where progress looks like it will be heavily focused on combination regimens in niche markets, which is Gilead's specialty.

Matt: We assign Gilead only a narrow economic moat, but the moat trend is positive. What would it take for the company to cross the threshold into wide-moat territory, in your view?

Karen: Assuming clinical data continue to support our thesis that Gilead's hepatitis C pipeline is clearly superior to those of its key competitors, we expect to assign the firm a wide economic moat once sofosbuvir reaches the market (by early 2014). We think patent protection on newer HIV regimens as well as Gilead's lead in producing an all-oral hepatitis C cure will be enough to ensure strong returns for the next couple of decades, and we think visibility on profits is clearer at Gilead than at many of its large-cap biotech peers.

Final thought from Matt: Biotechnology can be a risky place to invest, full of high hopes and dashed dreams, where luck is often as important as skill in the hit-or-miss game of drug development. However, a small handful of biotechs have managed to carve out wide economic moats, based on patents, scale, and the ability to leverage unique expertise across a diversified portfolio of drugs. Gilead appears to be headed in this direction.

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