Valeant and Gilead: Beaten Down Bargains or Truly Terrible?

By Todd Campbell and Kristine Harjes Markets Fool.com

Valeant Pharmaceuticals(NYSE: VRX) andGilead Sciences(NASDAQ: GILD) are in the bargain bin, but first quarter financial results show that sales continue to decline at both companies. Are these companies making enough progress to make them worth owning in portfolios?

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In this episode of the Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes and contributor Todd Campbell search Valeant Pharmaceuticals and Gilead Sciences first-quarter financials for clues to determine if now is a good time to buy.

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A full transcript follows the video.

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This video was recorded on May 17, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It isMay 17, and I'm your Healthcare show host, Kristine Harjes.I'm on the phone with Todd Campbell, a Fool.comhealthcare writer. Todd, welcome to the show, as usual!

Todd Campbell: Hi, Kristine! How are you today?

Harjes: I'm doing all right,I'm getting ready for a trip to Toronto tomorrow, sopretty wiredthat it's basically my Friday.

Campbell: Oh,excellent, I hope you have a great time.I've always wanted to go up there,I've yet to travel up there.

Harjes: Yeah,I haven't been either. Listeners, if you listen to this before I actually go, which is tomorrow the 18th,please shoot me a note at industryfocus@fool.com.I'll take all the recommendations that you guys have forrestaurants, and I hear there's a good music scene, andanything else that comes to mind.I'll be in Toronto and also Niagara Falls. So,that should be fun. Before I go, we aretalking on the show today about twocompanies that have been incredibly beaten up by tradersover the past couple years, and are botharguably value stocks right now. We'regoing to be talking about bothValeant PharmaceuticalsandGilead Sciences. Todd,which one do you want to start with?

Campbell: Let's start with Valeant,because of the two, that's the one that's been beaten up most. If you've been an investor in Valeant,you're probably looking at this stock and going, "Oh boy,what's he going to say next?" The stock hasgone from about $260 to around $13 per share. But,it dropped below $10 or something like that. It's been tough sledding for the stock, and there's a lot of reasons, we covered it before, Kristine, on the show. As arefresher, there was a lot of pushbackregarding pricing decisions that they had made in the past thatled to scrutiny thatled to the closure of their specialtydistributor, pushbackas a result of that anddeclining sales volumes has caused income to drop,and as a result, there has been a lot of fear that theymight have a hard time paying off their debt load. So,heading into the first-quarter earnings results, a lotpeople were watching to see what management would say, and see if theyprovide some indication that the corner is turning.

Harjes: Bythe reaction the market had, it seemed like people werepretty happy with their earnings, whichthey released on May 9. The stock is up 40% since they released those earnings. Onthe surface, the headline waspretty good. They had their first profit that they posted in six whole quarters,but there's kind of an asterisk there wherethey reported a GAAP net income of $628 million,but that was almost entirely due to this one-time taxbenefit of $908 million, which wasattributed to non-cashinternal restructuring. So, they'refudging the numbers a little bit,not in a nefarious way, butthere's a huge difference for this companybetween their GAAP numbers and non-GAAP numbers.

Campbell: Right. Youalmost have to be a CPAto be able to dig in here andfigure out what's going on behind the scenes, tohave to reconcile the GAAP versus non-GAAP and figure, quarter for quarter,what is going on with the company. You mentioned that they'd reported top-line GAAPprofitability. As you've said, that was all due to this one-time benefit from this tax item, sodon't count on that going forward, you have to X that out. Revenue, the top line, did fall again,it was down 11% to $2.11 billion. So, you still have deterioration in the top line, and we'll get into why in a minute. But, without a doubt, Kristine, if you were a shareholder going into earnings last week, right now you're smiling a lot bigger than you were last week,especially if you were one of the fortunate onesto have been able to pick this thing up at the low.

Harjes: Right,indeed. This is something where,I guess, if you timed it correctly, youcould have made quite a profit. But I doimagine that the vast majority of shareholders are still sitting on a pretty big loss here.

Campbell: I think that's probably true. Unfortunately for those long-terminvestors who have ridden the stock down, when I duginto the numbers and started reallygoing through the puts and the takes here on balance,I had to walk away a little bitunimpressed. Theircrown jewel is Bausch + Lomb. That's their biggest segment, it does $1.1 billion roughly inquarterly sales. But that crown jewel gained no ground year over year. Sales were essentially flat on a reported basis. Sure, if you back out currency, operational growth was 4%. But currency is something that these international companies deal with quarter after quarter. The reality is, sales for Bausch + Lomb were flat. Andif you dig a little bit deeper, U.S. volume for Bausch + Lomb declined, and was offset by some emerging markets, overseas growth. So, Bausch + Lomb, we'llcall it a push for the quarter. Branded Rx,sales continued to drop there, fell9% to $604 million. Then,because of generic competition and some pricing woes, their U.S.diversified business gotabsolutelyclobbered. Sales fell 37% year-over-year to $355 million. Unfortunately, the threat ofgenerics is not going away -- this isgoing to remain a headwind for this company over the coming year.

Harjes: Right,pricing is going to be a huge issue for them,because of all the bad publicity that they gotway back in 2015when this whole controversy startedabout their cardiovascular drugs that theyboosted the prices onby hundreds and hundreds of percents. Theykind of can't do that anymore, andthat was a big part of how they were making money. So,now, when you look at their portfolio, a lot ofdrugs are either hit or about to be hit bypatent expirations, and theydon't really have the option anymore ofraising prices to compensate for lower volume.

Campbell: Yeah. So,we have a situation where we have a company that'sstill seeing a lot of pressure on its top line. There wasa little bit of evidence of some price stability in Branded Rx, to be fair. So, that's somewhat good news. But,on balance, you look at this, and it's like, this wasn't that great of a quarter. Why on earth is the stock up 40-50% since the report?

Harjes: Yeah,and I know you have an interesting theory about this.

Campbell: Yeah. It'sreally all tied to the size of the short position, in my view, and a $50 million bump-up in its guidance for the year in EBITDA.

Harjes: Right. Let me take the latter thingyou just said and expand on that a little bit. People are very concerned that Valeant isgoing to default on its debt. It has ahumongous debt load, andfor a long time, it's been kind ofunclear whether or not they would be able to meet this debt. So,when they say they are going to up their EBITDA guidance,that is a great thing forpeople that are concerned about the debt. So,when you trace thatback to the first thing you said, which was the short position, that is whereyou start to get people potentially exiting their shorts.

Campbell: Yeah. Again,as a refresher,if you're going to short a stock, you'reborrowing from your broker, you'llselling it with the hope of buying it back cheaperand then replacing the shares that you borrowed. So, as a stock rallies andpeople who have sold it short see that happening,you end up getting a domino effect where, "Oh,it's rallying, I have to cover, nowI have to cover, and I have to cover." Ifyou look at the short ratio, which issimply the percentage of shares that are sold short toward the shares that are out there that can trade,it was at a record high leading up to the earnings. A record high.

Harjes: Right,15%.

Campbell: Yeah. So,it wouldn't take a lot to move the needle here. And it really didn't. The bump up in EBITDA guidance was $50 million. They went from basically guidance of 3.5%-3.65% to 3.6%-3.75%, a $50 million improvement. But, again,the big thing here is the debt. They haveover$30 billion in debt. They've knocked about$3 billion off of that. That's good news,because what that does it is it,theoretically, improves their interest coverage ratio. Andnow we're getting really wonky.

Harjes: It's a wonky company.

Campbell: Yeah. When you have all these creditors, theywant to know they're going to be paid back. Andone of the ways they do that iscalculate your interest coverage ratio, which is simply EBITDA divided byinterest expense. So, you have debt,you're paying interest expense on it. Are yougenerating enough EBITDA to cover that interest expense? Typically speaking, if you getbelow 2:1, itstarts to get you a little bit nervous.

Harjes: Right. At the end of Q1, they were at 1.83, which is below that 2 threshold, but it is above what their newlyrenegotiated level is,which is 1.5, which is what theirlenders need to see.

Campbell: Wow. There areso many rabbit holes we could chase here. Theyhad to renegotiate a lot of thesecovenants lower because they were going to run into a risk of default,because they weren't going to make the 2:1 ratio. So, you had various ratios that range from 3:1 and 2:1. They've knocked those ratios down to 1.5:1, so they're still OK. And bybumping up the EBITDA guidance, that led people to believe, if EBITDA improves, then it's less likely that creditors are going to end up knocking at the doordemanding payment,because that interest coverage ratio falls belowthe threshold. It getseven more complex than that, though, Kristine,because you have to look at where that EBITDAimprovement is coming from. And frankly, I'm not convinced that'sit's coming from a material improvement in the business.

Harjes: Right,and that's really what it comes out here, tobring it back to a little bit of a higher level --this is a company that needs to find a way to come up with money. Theyneed to service their debt. They can do that by having a better top line. We'vealready dug into the different business segments, andit's questionable whether or not they'll be able to do that in any significant way. Or, their other option is,they can sell some of their assets. Buteverybody else out there that could be a potential buyer for these assets knowsexactly the situation that Valeant is in,so they're not going to pay a premium for some of these assets. Then,you get hit with a double whammy, if you're Valeant, of, I'mtrying to get a good price forsome of my portfolio. In order to get a good price,you need to sell the best stuff, andthat's exactly the stuff that's going to bolster your top line.

Campbell: Right. And Kristine,just to make things even worse for them, that has a negative impact on EBITDA. So,you have to make sure you're paying off enough debt to lower your interest expense,at the same time you're selling these things that are generating outearnings. And one of the concerns I have going forward here is, they're sellingone of their prized assets,Dendreon,which makes a prostate cancer drug called Provenge, they'reselling that later this year, and their EBITDA guidance, it saysright in the report that it doesn't include that sale in itscalculation.

Harjes: Right. So, take out the sales from Provenge, andall of the sudden you get EBITDA lower.

Campbell: Right. You say, they paid down $3 billion in debt, so theirinterest expense has to befalling. But, because they had to renegotiate all of these deals,they're ending up having to pay more in interest. So, you shaved$3 off your debt, butat the same time, your interest expense actually went up year over year. Now, eventually,hopefully, if you look at the maturities on the debt, they'repretty manageable until about 2020. But,you have a lot of issues here, andI think it's maybe a little bit premature forinvestors to look through that report, see shares running, and say, "Oh,OK, the corner has turned and the stock is going to go back to $100."

Harjes: Andit would be easy to do so, too,because by almost every metric, this is a very cheap stock. It's really just gotten clobbered by the market. Butafter having this discussion,hopefully it's pretty clear to our listeners thatit's kind of for good reason. Thiscould be a turnaround story, butpersonally, I don't think I would sleep at night if I bought shares of this company.

Campbell: Yeah,it's almost like skydivingwithout a parachute and hoping someone throws you a parachute and that you'll be able to catch it andopen it before you hit the ground.

Harjes: [laughs] Yes,that's accurate imagery.I was trying to come up with something like a treadmill, but I like yours better,let's go with that.

OK, we said we were going to talk about Gilead Sciences, and that was not a lie. It is now time to dive into Gilead.

Campbell: This one hits a little bit close to home for me, Kristine, and I think maybe it does for you too?

Harjes: As a shareholder? Yeah.

Campbell: Yeah. This is a stock that is a behemoth in biotech. And unfortunately, its shares have fallen from $120 to about $65 since the summer of 2015, making thecomparison even worse when you look atthe fact that the S&P 500 has rallied andhas been flirting with new highs. This stockhas gotten clobbered. And it's been a tough run for shareholders like me, and I have to --can we do a little confessional here?

Harjes: Let's hear it.

Campbell: I confess, I made a grave error in the way Inormally approach stocks.I usually buy stocks --we talked about this last week --based on a particular catalyst, and thenwhen I'm evaluatingwhether or not to hold the stock,I see if anything's changed that catalyst. Now,normally, if the catalyst has failed to pan out or change, that'sa signal to me that I should sell or exit the stock. Mycatalyst did, indeed, change for Gilead, and I did not sell the stock. My cost is somewhere in the $90s, I'm down 20%-25%.

Harjes: Whatwas the catalyst that you were looking for?

Campbell: I really thought theirleadership in developinghepatitis C drugs was going toallow them to continue to innovate anddominate the market, which they have. ButI also felt they would be able to innovate shorter andshorter treatment duration,getting it down to as little as four weeks over time from the 12 weeks it is currently. And it does look likethat's not in the cards. It'slooks like they're slowing down theirefforts to continue to move the needle in developing newproducts for hepatitis C.I also underestimated the negative drag and impact of price concessions they would be forced to make to stay ahead of competitors likeAbbVie. And, I also had bought it originally because I had somegood thoughts that they would do well with their push into cancer drugs, andunfortunately that was a bust. YetI looked at it and said,this is still a very profitable company, andnow they're paying a dividend, andthey have a ton of cash on the balance sheet, soI guess I'll stick around. Obviously, so far, that's been the wrong choice.

Harjes: The thing is,you talked a lot about hepatitis C, and I think that is whatmost people focus on with this company. But, if you look at what has happenedto the company over the course of its HCV life cycle, its firsthepatitis C drug, Sovaldi, wasapproved in December 2013. At the time ofapproval, Gilead's market cap was $114 billion. Today's market cap of $86 billion is 25% lower than that. For me, I look at this company andI just can't help but think that the market has overreacted to itshepatitis C woes. Andyou're totally right about cancer not quite panning out,but I don't think there is as high hope and drama andexpectation tied into its oncology efforts,necessarily, as it was for HCV sales.

Campbell: Yeah. I agree with you, insome respects. Buthere's the problem: We have yet to find a floor on thosehepatitis C sales. In Q1, revenue came in a $2.6 billionacross their hepatitis C franchise. That was down from $4.3 billion the year before.

Harjes: Yeah,that's a 40% decline.

Campbell: Yeah,massive drag. As a result, Q1 total sales were $6.5 billion. That was down 16.5%. EPS fell from$3.03 last year to $2.23 this year, ouch.

Harjes: Yeah,and I totally agree that that does hurt. But,I think with this company, it'simportant to remember thatthey have other things going on. Inparticular, their HIV products werevery good in the last quarter. And that was how this company really made its name. Its HIV and HBVproduct sales were up year over yearin the first quarter13% to $3.3 billion. That's a good thing. Sales fell forsome of the older products, but it was made up for by the newerones like Genvoya and Descovy and Odefsey.

Campbell: Right. They'veenjoyed a lot of growth,and that's because they reformulated Viread. They made it safer, and now they've beenrolling out combination therapies that replace Viread in those combinations with TAF, this new formulation. I imagine that we'llprobably see a leveling off in sales growth thereonce all the combination therapies have been launched. But, yes,they remain a dynamoin that business. It's a great business for them,and it's been a growing business for them,it just hasn't been growing fast enough to offset the slide in sales inhepatitis C. So, youlook at it from an investment standpoint now, and you say, OK, well,we know that HIV is going to be stable to growing. That's good. And we know thathepatitis C is declining, andwe don't know where the floor is.

Harjes: And that's bad.

Campbell: Yeah, that's bad. So, we say, what'sthe catalyst, what's going to cause this stock to get back to growth? Because,ultimately, we want to see sales grow, earnings grow. Shares will follow earnings over time. So, we look at it and say, they have, first of all,a lot of money on the balance sheet, isn't itsomething like $32 billion?

Harjes: I have this right here,$14.7 billion in cash. That's without their short-term investments.

Campbell: Yeah, andsecurities that they can sell, as well. And they spend a ton on research and development. I think their run rate now onresearch and development is something like $3.6 billion. So,they have a pipeline and they'reworking on that pipeline. So, you say, maybe new drugscoming out of that pipeline, oracquisitions,because of all this cash, can spark growth, right?

Harjes: Yeah. So,you have the organic side and you have theinorganic side. Andwhen you look at the organic side, what are they actually developing themselves, they do have some exciting things going on. But it's going to be a while before we hear about any of them. And so, that's when you get this pressure for the inorganic growth. And there has beenso much speculation about,who is Gilead going to buy, when are theyfinally going to pull the trigger? I do think,at least in the short term, that's the catalyst to watch. What are theygoing to do with that money? Whoare they going to buy? Whenwill they actually make a move totry to bolster theirportfolio and get some moreinternal catalysts to getrevenue moving in the right direction before, say, 2020, when they startgetting data for all of the really awesome drugs in theirpipeline that are not quite ready for market yet.

Campbell: Yeah. If you look at the lead candidates in the pipeline, you have filgotinib, which is theautoimmune disease drug they'reworking withGalapagoson. Data for that should start rolling in, I think,as early as next year,stretching through 2020,depending on the indication and the trial we're talking about. Then,there's another one for something called NASH,which is another liver disease, but,again, we won't see data from that until the 2020s as well. So,you look at that and say, OK, there's not a whole heck of a lot that's going to, as far asdrugs that are going to hit the market that could really make a big deal here. So, what would be the M&A target? Can they buy something? Then, assuming they can cut a lot of overlapping expenses, maybe they can getoperating margin moving in the right direction again. Butonly time will tell. We have to see how that plays out. And Gilead is being patient. They have the war chest, and they have the money,but they look at it from an operational standpoint, saying, "I don't want to paytoo much for this company when three years from now, I could get it for a bargain."

Harjes: Well, that, and they look at their own company and they say, "Holy moly this is cheap." Gilead spent $14.8 billion on shareholder rewards in the last 16 months. $12 billion of that was on share repurchases. So, this companyis not interested in buying otheroverpriced assets when it could just buy back its own stock atpretty low valuations.

Campbell: Yeah. Although,you take the other end of that coin and say,from a shareholder standpoint,is that the best use of your dollars? So farit has not been, because shares have still declined. So,you brought back a lot of shares at a lot higher prices. Has that been the best use of your money, whereif you had gone out and boughtsomething likeMedivation or something, tokick-start growth that way,would that have been a better reward for shareholders? Who knows. We don't know. The reality is, this remains a biotech behemoth. They're not going away. At some point, somewhere down the line, they'regoing to do something that will restart growth. The question will be, where will shares be at that point? Is this the low? Was $80 the low? Was $90 the low? I don't know.

Harjes: Right. Andwhen they do it, we will absolutely have you covered here on Industry Focus. Thank you so much, Todd, for all of your thoughts today, and I'll talk to you next week. As always, people on the program may have interests in the stocks they talk about, andThe Motley Fool may have formal recommendations for or against, sodon't buy or sell stocks based solely on what you hear. For Todd Campbell, I'm Kristine Harjes, thanks for listening and Fool on!

Kristine Harjes owns shares of Gilead Sciences. Todd Campbell owns shares of Gilead Sciences. The Motley Fool owns shares of and recommends Gilead Sciences and Valeant Pharmaceuticals. The Motley Fool has the following options: short June 2017 $70 calls on Gilead Sciences. The Motley Fool has a disclosure policy.