The chatter about Gilead (NASDAQ:GILD) making an acquisition in the near future is gathering pace. Appointment of Dr. Alessandro Riva as the new head of Oncology has given fuel to these rumors. Gilead had a poor 2016 amid the falling sales of its Hepatitis C drugs. There was a need for a new drug that could make up for the falling sales. The new cancer drug is doing well but it is not enough to cover the fall in sales from the Hepatitis C drugs. As a result, it was felt that the company needed to add a new drug from outside through an acquisition. The management also touched on this matter but made it clear that they will not do a deal in this environment when there are huge premiums attached to deals in the sector. Gilead has always tried to look for value and that is what they are going to do in the future.
However, a lot has changed since then. Poor results from the pipeline in the last few months have increased the pressure on the management. Gilead cannot have another year like the last one. The management will find it hard to explain why it keeps on hoarding cash. Special dividends are also not likely to please the shareholders either who have lost substantial wealth in the last 12 months. Real support for Gilead's price will only come from the sustainable growth in revenues. Whether this growth comes from an acquisition or internally. Most likely, it will come from an acquisition.
Dr. Alessandro's connection with Incyte (NASDAQ:INCY) has resulted in these rumors that Gilead might be looking to buy Incyte. Mind you, this is not a bad idea. In fact, it fits perfectly. Gabelli analyst Jing He was the first to highlight this possibility. I was looking at possible targets for Gilead a few days back when I stumbled upon this small article from Barron's. They cited a research note from Piper Jaffray's Joshua Schimmer, in which he had argued that Gilead should follow Incyte's lead and try bringing some innovation to its R&D. In the end, they mentioned that may be Gilead should just buy Incyte.
I started digging on this possibility and tried to come up with reasons why Gilead should buy Incyte and will it be the best use of its cash piles. Some of the reasons that I came up with were also highlighted by Jing He in her note. This is what she had to say about this possibility:
We believe adding Dr. Riva to its executive team makes Gilead more likely to buy Incyte, which is led by a team of Novartis veterans and has collaborated with Novartis Oncology on its key drug, Jakafi, as well as capmatinib (NASDAQ:PHII). Dr. Riva also acted as interim President of Novartis Oncology in 2014, after Hervé Hoppenot left the position to become the CEO of Incyte. Dr. Riva and Mr. Hoppenot both served senior management roles at Novartis Oncology in the past decade and earlier at Aventis (now Sanofi). Incyte and Novartis have co-developed Jakafi since 2009 and Novartis is responsible for Jakafi's ex-US commercialization. We believe Dr. Riva will bring unique perspective on oncology drug development, especially on Jakafi and capmatinib.
This is the reason behind her belief that there is a chance that Gilead will buy Incyte. Following are the reasons that make it a no-brainer for Gilead.
If Gilead acquires Incyte, the company will get 1) Jakafi US sales and ex-US royalty ($1bn 2016 revenue est.), 2) royalty of baricitinib, a rheumatoid arthritis (NYSE:RA) drug expected to be approved in 1Q'17 and commercialized by Eli Lilly, and 3) a strong oncology pipeline including multiple on-going combo trials with immune-oncology drugs. Although baricitinib is not an oncology drug, we believe Gilead is comfortable with this asset due to its exposure in RA through licensing agreement with Galapagos.
So, Gilead will not just be getting an established drug but it will also get a pipeline which is complementary to its own product line and pipeline. While this looks like a good match, the main issue might be the one that has been holding Gilead management in the past. Incyte's valuation is quite rich, the stock is trading at a forward P/E ratio of almost 66x and the EV/EBITDA multiple is also fairly high. Incyte has only one approved drug and although its sales have been rising, the drug still generates around $1 billion in sales. Its revenue to market cap is at around 20x.
Its EBITDA figure has picked up slightly in the last three quarters but it is still just $245 million for the last twelve months. At this rate, the EV/EBITDA crosses 78x. This is by no means a cheap valuation. If we add the premium which will most certainly be needed to persuade the Incyte board to consider selling, then it is not hard to imagine that Gilead management will have to break the habit of being prudent in order to make this deal happen.
However, there are also some positives hidden in the fundamentals of the company. First, the gross margin for Incyte is more than 92%. This is in line with Gilead's own gross margins. Despite the discounts offered by Gilead, its gross margin is still at 85%. It was around 90% when the company started selling Sovaldi and Harvoni. Two more positive nuggets come from the balance sheet. Incyte has less than $700 million in debt (long and short-term) and the cash balances are at $717 million. So, the net debt figure is also favorable. While these are attractive figures, the effect of this strength will be a further addition in premium.
From all the angles, fundamentals and business mix, Incyte looks a good fit for Gilead. However, the valuation is the biggest stumbling block. It all boils down to the price that Gilead management is willing to pay in order to stop the decline of the stock price. It has become clear that the management will have to take such a step because the cash piles on the balance sheet are not impressing the investors. They are more focused on declining Hepatitis C sales and until Gilead is able to show the market that this decline in sale can be made up from another source, the stock price will remain under pressure.
I still believe that Gilead's fundamentals are strong and it is a good investment to hold for the long-term. But the management needs to take a little bit of risk now. It has to do something that brings back the excitement for Gilead. Incyte might look expensive but it is exactly what Gilead needs. Its pipeline and drug, Jakafi, can support future growth in sales.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.