Could Gilead Go For Celgene?

| About: Gilead Sciences, (GILD)

Summary

Gilead wants to become a major player in oncology.

An acquisition would be a good way to engage in the huge oncology market.

Gilead would be able to acquire Celgene, thanks to its vast free cash flows and cash position.

This would equal a huge boost to Gilead's top and bottom lines and broaden the pipeline immensely.

This is a way to grow further once Gilead's HCV business has reached its peak.

Analysts and investors want to see Gilead (NASDAQ:GILD) make an acquisition. I believe Celgene (NASDAQ:CELG) could be a target, and I'll look at how such an acquisition could be financed.

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Gilead is active in the HIV and HCV area, and has stated that it wants to get involved in the very large (and very profitable) oncology market. Gilead's first oncology product, Zydelig, has turned out to be not very successful, and recently Gilead has stopped several drug trials for Zydelig, after severe side effects occurred in patients using the drug.

Since Gilead has no other cancer drug on the market (although the company has some drug candidates for CLL, Myelofibrosis, Gastic Cancer, etc., in its pipeline) an acquisition in this area would make sense. Celgene is a major player in oncology, with an established franchise, a huge pipeline, a great growth outlook, and, lastly, the company is very profitable and cash flow positive. In other words, Celgene offers everything Gilead could be looking for in an acquisition: Celgene's deep and broad pipeline would allow for future top and bottom line growth once Gilead's HCV business has reached its peak, and Celgene's strong profits and cash flows would make it easier to finance the acquisition. Buying Celgene would establish Gilead as a major player in oncology, which Gilead seeks to become in the future. This obviously would be a huge deal for Gilead, but I believe not an impossible one. There are several ways such a deal could happen:

Gilead could buy Celgene via an all-stock offering; in this case, Gilead would not be forced to get any cash from the banks or other financiers. Nevertheless, I believe such a move wouldn't be great for shareholders, as this would vastly dilute the company's share count and, due to Celgene's higher multiples, this would mean a decline for the company's earnings per share. Let's look at an example: Celgene trades at a market capitalization of $77 billion and has trailing (non-GAAP) net income of $3.9 billion. Gilead trades at a market capitalization of $128 billion and has trailing (non-GAAP) net income of $19.2 billion. If Gilead bought Celgene at a 50% premium over the current price, Gilead would have to issue 1.24 billion new shares, bringing Gilead's share count to 2.61 billion shares - with trailing net income of $23.1 billion ($3.9 billion + $19.2 billion), this would mean trailing EPS of $8.85 per share, which would be well below Gilead's current trailing EPS number. I thus don't see Gilead making such a move (all-share offering), since it would be hurting current shareholders.

Gilead could, however, also pursue an all-cash deal. Gilead has a cash balance of $26.2 billion (end of 2015), Celgene has a cash balance of $6.5 billion (end of 2015), combined this means a cash position of $32.7 billion. When we assume that the company would want to keep a little cash on its balance sheet, we can say that $30 billion could thus be used for an acquisition without any additional financing. When we, again, assume a 50% premium for the takeover, Celgene would cost $115 billion. With $30 billion in available cash, Gilead would have to take on $85 billion in additional debt. From Gilead's last major bond offering last fall, we know that the company can access short-term debt at low rates: In September, Gilead took on three-year bonds for 1.85%, five-year bonds for 2.55% and seven-year bonds for 3.25%. Let's say that Gilead would be able to finance $85 billion at a rate of 3.0% for five years (which is a higher rate than in September, to be conservative). This would mean annual interest payments of $2.55 billion, which would reduce Gilead's net income (and cash flows) by $2.1 billion (adjusting lower pre-tax income for Gilead's 16% effective tax rate). Over the last year, Gilead generated free cash flows totaling $19.6 billion, Celgene generated free cash flows of $2.2 billion. The combined company would generate $19.7 billion in free cash flows (Gilead's $19.6 billion + Celgene's $2.2 billion - $2.1 billion in interest payments). In the following table, I show how Gilead could pay off the $85 billion in debt in a couple of years:

Year Debt beginning of the year Repayment of debt Debt end of the year
2016 $85.0 billion $19.7 billion $65.3 billion
2017 $65.3 billion $19.7 billion $45.6 billion
2018 $45.6 billion $19.7 billion $25.9 billion
2019 $25.9 billion $19.7 billion $6.2 billion
2020 $6.2 billion $6.2 billion --
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I assumed that free cash flows would remain at the current level (in reality FCFs would likely grow for the next years due to Celgene's strong expected growth, but I wanted to be conservative here). I further assumed that Gilead would spend all of its cash flows for debt repayments. In reality, the company could optimize this further by not issuing $85 billion for five years, but rather $20 billion for one year, $20 billion for two years, etc., which would mean slightly lower interest rates and thus lower interest payments, which in turn would mean slightly higher free cash flows and even faster repayment.

Let's now look at what would happen if Gilead chose to keep its dividend payments (and grow the dividend by ten percent each year):

Year FCF Dividend

Starting debt

Repayment Ending debt
2016 $19.7 B $2.6 B $85.0 B $17.1 B $67.9 B
2017 $19.7 B $2.9 B $67.9 B $16.8 B $51.1 B
2018 $19.7 B $3.1 B $51.1 B $16.6 B $34.5 B
2019 $19.7 B $3.5 B $34.5 B $16.2 B $18.3 B
2020 $19.7 B $3.8 B $18.3 B $15.9 B $2.4 B
2021 $19.7 B $4.2 B $2.4 B $2.4 B -
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We see that Gilead would be able to repay the $85 billion in debt almost completely in five years even if the company chose to increase its dividend by ten percent each year. Since this calculation does not include any growth in free cash flows yet (which would be highly likely due to Celgene's strong growth, international ramp up of HCV sales and cost cutting due to synergies for the two companies), I believe it is not unlikely that Gilead would be able to fully repay the $85 billion in debt it would have to take on in five years, even if the company continued to raise the dividend aggressively.

We see that such a takeover is not at all impossible for Gilead, even if the company chose to go the shareholder friendly route by not issuing any new shares but rather going for an all-cash purchase. In a couple of years, all the debt for the deal would be paid back, and Gilead would now not only own its HIV business and its HCV business, but also be the holder of Celgene's large oncology franchise, which would add more than $10 billion to Gilead's top line each year (and has the potential to grow a lot more over the next years). Since Celgene is down 15 percent over the last year, the timing would not be bad at all if Gilead wanted to make this acquisition.

Takeaway

Gilead's own efforts in the oncology space were not very fruitful yet, an acquisition could thus be the right step. With its deep pipeline and strong franchise, Celgene would be a great addition to Gilead's existing drug portfolio, and thanks to Gilead's immense cash generation, such a deal would not be unrealistic, even if Gilead chose to pursue an all-cash deal in order to not dilute its share count.

Disclosure: I am/we are long GILD, CELG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.