Did Gilead Sciences Just Commit a Cardinal Sin?

Source: U.S. Food and Drug Administration.

Blue-chip biotech stock Gilead Sciences is the company that practically every peer wants to imitate.

Gilead stepped into a great situation in 2011 when it scooped up Pharmasset for $11 billion. The drug it acquired, sofosbuvir, went on to help yield two revolutionary hepatitis C therapies (Sovaldi and Harvoni) that will likely bring in more than $10 billion in revenue alone for Gilead this year.

Yet, in addition to growing by acquisition, Gilead also managed to develop blockbusters internally, including a four-in-one HIV therapy known as Stribild, which based on its six-months sales totals is on pace for $1.6 billion or more in sales in 2015. As icing on the cake, Gilead's $17.8 billion in free cash flow over the trailing-12-month period has allowed it to establish a dividend and repurchase its common stock to the benefit of investors.

However, last week Gilead Sciences may have committed a cardinal sin.

Gilead prices a huge debt offering On Sept. 9, 2015 Gilead announced that it was selling $10 billion worth of senior unsecured notes with maturity dates ranging from 2018 through 2046 in six separate tranches. In the words of Gilead's press release:

Source; MyFuture.com via Flickr.

There are a lot of potential positives about this debt offering that got Wall Street and investors excited. Primarily, the idea of floating $10 billion in debt could signify that Gilead is planning for a substantial acquisition. Gilead ended its latest quarter with $14.7 billion in cash and cash equivalents, up $200 million from the sequential first quarter, so it's not as if Gilead is hurting for cash. But the added cash from its debt offering, inclusive of its third-quarter cash flow, could push its cash pile north of $25 billion.

Also, it's just a generally smart time to consider floating debt given our historically low interest rates. With the Federal Reserve tinkering with the idea of boosting the federal funds target rate at some point in the near or intermediate future, Gilead is locking in plenty of capital now at presumably the lowest lending rate imaginable.

But there could be hidden dangers here as well.

Gilead's potential cardinal sin As Gilead notes in its filing, it could use the company's debt offering to fund its dividend, which works out to $2.57 billion in cash outflow each year, or its share buyback program, which was initially approved for $15 billion worth of the company's common stock. While paying a dividend and buying back stock does indeed help investors, financing these activities with debt is a major no-no in this investor's opinion.

Source: StockMonkeys.com via Flickr.

Borrowing money isn't free, which means that Gilead's possible use of these funds (remember, there are no guarantees Gilead will actually use these funds for its dividend or share buybacks) for a dividend or stock repurchase could cost the company quite a bit in profit and ultimately have a negative effect on shareholder value.

The move will also push Gilead's net debt levels from $13.6 billion to a whopping $23.6 billion. Think about the extra interest payments that $10 billion in new debt could generate each year for Gilead and the billions it's already funneling to shareholders via dividends and buybacks.

For the time being, Gilead's free cash flow looks healthy, but what happens when competing once-daily hepatitis C therapies hit the market? We've already witnessed Harvoni prescriptions tapering off in recent months, and it's possible that Gilead's cash flow could shrink a bit as new entrants, such as Merckor Bristol-Myers Squibb, enter the HCV space and put additional pressure on Harvoni's pricing.

We also have a real-world example of what can happen if a company uses a debt offering for the wrong reasons. Theravance priced $450 million in debt in April 2014 and planned, among other things, to use its offering to fund a $0.25-per-share quarterly dividend to shareholders. The plan had been that Theravance's long-term COPD and asthma products would launch successfully and cover the cost of the interest payments with ease. Two years following the launch of Breo Ellipta, Theravance is still losing money because it hasn't come close to covering its interest expenses.

Source: Federal Reserve Bank of New York.

What this investors thinks To be clear, comparing Theravance to Gilead is like comparing a Big Mac to a filet mignon, but the point is to demonstrate that debt used for the wrong reasons can come back to haunt investors. Even if a debt offering might look like a good idea at the time of the pricing, unforeseen factors can change investors' perceptions in a hurry.

My personal opinion remains the same that Gilead is still an inexpensive company that could see additional upside over the long term thanks to its successful HCV pipeline and growing product diversity. However, with increasing competition on the horizon for HCV and fresh debt being added to the balance sheet without any genuine clarity as to where it will be used, I'd certainly urge investors to be a bit more skeptical and inquisitive than normal with Gilead when deciding whether to invest in this blue-chip biotech stock.

The article Did Gilead Sciences Just Commit a Cardinal Sin? originally appeared on Fool.com.

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool owns and recommends Gilead Sciences. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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