Balm in Gilead?

Implications:

Audit Integrity believes that Gilead is at risk of both legal action and declining market performance.

Audit Integrity rated Gilead Sciences ‘Very Aggressive’ with an AGR® (Accounting & Governance Risk) score was 21 for the 2Q 2006, its lowest score over 12 quarters based on signs of financial engineering related to investment and acquisition accounting.

Audit Integrity believes that the Gilead’s compensation structure places it at risk of declining market performance, law suits and enforcement actions, centered on the high level of merger activity and overly aggressive accounting, manifested in Gilead’s low AGR® score.

Analysis:
The following discusses the validity of Audit Integrity’s evidence and conclusions offered in its study of Gilead Scientific.

Not being a customer, I do not know how they define the universe against which Gilead is judged. The Forbes peer group for Gilead is quite interesting appearing to contain several hundred companies traded on NASDAQ.

http://www.forbes.com/finance/mktguideapps/compinfo/CompaniesByIndustry.jhtml?ind=515&orderby=coname&sortorder=desc&fullind=Biotechnology&sector=Healthcare

Within that group there would have to be a very broad range of, size, financial health, and finally business models: some would be high growth, some low, some moribund. Knowing more about how the peer group was selected would add a great deal to product value in this case.

Whatever the validity of Audit Integrity’s views, institutional investors own about 90% of Gilead common, and Barclays Global Investors and Axa Financial, the two largest, hold 14.8%. Institutional investor routinely subject growth holdings like Gilead to intense scrutiny, but there have not been wide swings in the share price, or volume though share price has about doubled over the last two years. Further Gilead shows its beta to be .66, while the business risk index for the industry has been in the low 70’s, a better measure since the company has had almost no debt over the last five years. Beta is high enough to demonstrate that share price, is tied to the broader market, rather than being news-driven. If institutional investors believe that there were potential problems, the foregoing would not be true.

Audit Integrity stresses performance-based management compensation as a potential indica of fraud. As will be discussed later, Gilead has an important transaction orientation in its core business, with mergers being key to its future as a sources of new products. All such companies compensate key personnel on performance measures, like brokers or traders.

As for the fraud triangle, management has generated little pressure on itself. Press releases are relatively few, and only provide the information required. Management has not made any visible effort to hype its story, nor has it, despite its size, attracted significant press interest. See the Wall Street Journal for a list of companies currently under investigation for stock option manipulation: http://online.wsj.com/public/resources/documents/info-optionsscore06-full.html. Gilead is not on it.

Despite the above, Audit Integrity has serious misgivings about the Gilead’s level of merger activity. "We flagged the company for high merger activity as this elevates accounting risk and has been a contributing factor in many SEC Enforcement Actions." Merger activity however is part of their core strategy: "We discover, develop and commercialize Therapeutics to Advance Patient Care." There are three factors operating here:

• In this business a company has to merge to keep a pipeline of new drugs in development: in many instances mergers are the only solution. Gilead devotes a lot of space to drug development status on its website.

• Gilead has a market capitalization of roughly $30 billion. The largest of the merger mentioned, Myogen was recently closed at roughly $2.5 billion. The others are much smaller. Hardly a ‘bet the company’ deal stream or are the deals of a size to roil the market.

• Making a lot of mergers isn’t necessarily a bad thing. Shearson was very good at doing mergers quickly and efficiently. For Gilead, the Myogen merger went pretty quickly, being completed in November 2006. Like many things, the more you do the better you get and that holds for mergers.

Audit Integrity found Gilead’s issuance of $1.3 billion in convertible notes for share repurchase as both overly complex and expensive. In "The Quest for Value" G. Bennett Stewart says that such instruments are attractive to high growth high-risk companies, such as Gilead. He does not say that they are inherently poor options, but that some costs are ignored. They complicate tax financial planning, however, and add to transaction expense. Again, the amounts are negligible in relation to total market capitalization.

Because of the above Audit Integrity believes that Gilead has a number of financial reporting issues that raise forensic risk concerns being signs of financial engineering. Let’s see if they, in fact, are such:

• "Large year-over-year growth in Inventory over Revenues and Work-In-Progress as a percent of Inventory are flagged as concerns." Put another way, sales rose 28% and total inventory 42%, which Audit Integrity saw as a sign that the Gilead was hiding expenses in inventory. During 2006 Gilead purchased $63.7million worth of Sustiva from BMS as part of a joint venture. Ignoring those amounts alone would mean that inventories increase only about 30%. In view other mergers and internal growth the amount of inventory appears more reasonable. These and other changes, including a write-off, in this account are clearly explained in the notes to third quarter financial statements: no transparency issues here. Audit Integrity never takes into account that in a merger, you recognize revenues of the acquisition only after the merger on the consolidated statements, so that banal comparisons like this one are inapplicable and hence meaningless.

• Audit Integrity believes that: "In the expense arena, long-term Deferred Charges are very high relative to industry medians as are both current and long-term Deferred Tax Assets." Audit Integrity recognizes the $147.9 million related to the conversion hedge, but ignores the effect $53 million effect of the Corus acquisition on deferred tax assets, and the changes related to option exercise.

• Lastly, Audit Integrity faults the quantity of marketable securities for Gilead. "We also flag Investments as high relative to industry peers ($600 million in short-term and $1.8 billion in long-term investments.)" Gilead, after reclassifying some these investments as long-term (held to maturity) had $2.3 billion in current and $350 million in long-term marketable securities. Of greater concern is what actually constitutes the investments that Audit Integrity classifies as long-term in the peer group. It might be that they are unconsolidated subsidiaries or other equity investments: Audit Integrity has not chosen to share that information. Duplicitous managements like to show themselves more liquid rather than less, attempting to classify as current assets marketable instruments for which there is no market. It also seems that Audit Integrity might be, as discussed above, conflating equity investments with marketable securities, though there is no way to tell.

Based on the above, Gilead may be risky, but those risks are just part of a business model which seems to serve Gilead well. Audit Integrity assumes that mergers and performance-based compensation are indicators of fraud risk in and of themselves, then confirms the judgement by various accounting measures. Mergers are not distinguished by size, and the red flags do not take growth into account be it internal or from mergers, problems documented above. By being so sensitive, the measures can be seen by some as false-negatives, which seems to be the case for Gilead Scientific. The only companies that would be clean are those that are both simple in structure and static.