Strange Gilead Should Start By Buying Medivation

| About: Medivation, Inc. (MDVN)

Summary

Gilead's R&D expense is very low compared to its profits.

Every other big pharma has much higher R&D expense as a proportion of gross profits.

Gilead's current therapeutic areas are too narrow to support a $150 billion market cap.

Gilead can acquire Medivation as it's in play right now.

Gilead's capital return program is completely out of whack with the rest of the drug industry.

Gilead is strange

Gilead (NASDAQ:GILD) has returned a staggering $21 billion in share buybacks ($18 billion) and dividends ($3 billion) since the beginning of 2015. While this is something that would be considered very impressive in any other industry like banks or railroads or cable, this capital allocation pattern is completely out of whack in the drug industry.

To see why, I looked at 3 other big drug companies - Bristol-Myers Squibb (NYSE:BMY), Merck (NYSE:MRK) and Roche (OTCQX:RHHBY). This is what I got from Google Finance for 2015 (figures in billions.)

Name Market Cap (Billions) Gross Profit R&D expense Net Income
GILD 123 29 3 18
BMY 120 13 5.8 1.6
MRK 155 30 6.5 4.4
Roche 220 34 9.3 8.9
Click to enlarge

Even if we look at operating cash flow, Gilead has the highest at $20 billion followed by Roche and Merck with $15 billion and $12 billion respectively.

Gilead makes a lot more profit than the others, but spends a lot less on R&D.

Moral of the story

The stock market awards a nice valuation to drug companies that are spending big on R&D to discover new drugs. Gilead can quadruple its R&D spending, and yet remain the most profitable drug company after-tax.

Instead of spending its profits on R&D or acquisitions, Gilead has been returning all of it to shareholders. This kind of capital return happens only in industries with very little reinvestment opportunity, like Pharmacy Benefit Managers or cable companies. Gilead is unique in the drug industry for returning all its profits to shareholders. This is causing shareholders to believe that Gilead doesn't have a strategy to grow or replenish its pipeline.

Gilead needs to be flexible

Gilead has so far maintained (including in the Q1 2016 earnings call) that it will acquire in areas that fit its capabilities. But this won't suffice. Gilead has reached a size where it should be playing in a lot of therapeutic areas. Other drug companies of its size participate in a much larger set of therapeutic areas. Even Regeneron (NASDAQ:REGN), which is much smaller, has an eye drug, a cardiovascular drug, asthma drug, and a cancer drug, all four of which are multi-billion dollar opportunities.

Restricting itself to antivirals and liver drugs will not be able to support a $150 billion market cap. Risk-adjusted, these areas are too small, and there is no guarantee that Gilead will have the leading drugs there.

If Gilead doesn't have a broader set of capabilities, it should build them with acquisitions.

Gilead should acquire Medivation

Planting a Phase 1 or Phase 2 seed would cost less but would take years. But fortunately, for Gilead, a great opportunity has presented itself in the form of Sanofi's (NYSE:SNY) hostile pursuit of Medivation (NASDAQ:MDVN).

These are the reasons I believe Gilead can/should acquire Medivation:

1. They are both neighbors in Silicon Valley, making integrating the acquisition easier. Medivation has just 625 employees.

2. Medivation does not have a staggered board, i.e. every board member is up for re-election every year. This means weak takeover defenses and a hostile Sanofi in pursuit.

3. Medivation's Xtandi patent expires in 2026 and some analysts project peak sales of $7-9 billion. (Though Medivation gets half of US profits and a royalty on ex-US sales from teens to low twenties.)

4. Xtandi is growing very fast as it moves "upstream." Just 20% of urologists have prescribed it so far. Medivation says the remaining urologists do not yet know about its great results compared to Casodex.

5. Xtandi's label expansion was recently approved in Europe a few weeks ago by the CHMP. Label expansion PDUFA date in the US is in October 2016 (this is based on the trials where it did very well against Casodex last year.) Not only would there be more patients on the drug, the duration of treatment would also increase leading to even more revenue.

6. Xtandi has shown good results in Triple Negative Breast Cancer Phase 2. This is what the oncologist investigator said:

This is the most exciting data we have had in triple-negative breast cancer and certainly supports moving this therapy forward in development," said Traina.

7. Medivation also has two other cancer drugs in early stage trials.

Opportunity in Gilead's backyard

Roche acquired Genentech of South San Francisco and is now enjoying revenue from multiple mega-blockbuster cancer drugs as a result. AbbVie (NYSE:ABBV) has made two large oncology acquisitions in Silicon Valley, Pharmacyclics of Sunnyvale and StemCentrix in South San Francisco. Now Sanofi has made an unsolicited offer for Medivation.

Gilead should not miss out on this opportunity right in its backyard. The acquisition can be completed quickly. The market wants to know that Gilead will behave like a grown-up $150 billion market cap company. The only way to do this is to participate in all therapeutic areas like a grown-up by making acquisitions and increasing R&D spending.

Gilead should stop its share buybacks immediately. The market would have been a lot more comfortable if Gilead's cash pile was $42 billion right now instead of $21 billion.

Disclosure: I am/we are long GILD.

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.