The Math Behind the Gilead's Recent Merger

| About: Gilead Sciences, (GILD)

Summary

As expected a strong merger strongly effected GILD's valuation.

Pricing of the deal shows strong growth expectations.

Management seems to be pushing for innovation through acquisition as another tool in their belt.

In my previous article (GILD M&A Scenario) on Gilead Sciences (GILD) I covered the possibility, viability, and possible effects of an acquisition. Although for this article I used INCY as a stand-in due to the previous murmur of possible action, the point of the article was the positive impact of an acquisition through added research and much-needed revenue growth. As previously predicted Kite Pharma (KITE) was acquired and immediately bolstered growth expectations as shown through a jump in equity valuation and analyst projections.

This jump is especially surprising because Kite Pharma currently has no earnings and the Gilead management doesn’t expect a positive effect on the bottom-line until three years in. To break down where the possible effects are let’s look at the numbers.

The first step here is to value KITE as GILD did during the acquisition. The value to shoot for here is $180, the per share value that GILD paid for KITE. Using this metric, the company has to have an astronomical 216.9% growth for the next three years. Although this is may seem outlandish at first, consider the following two catalysts. First, a strong, young pipeline can expect explosive growth after finding a foothold in the market. Second, Gilead’s ability to push this growth. Gilead is a large firm in the pharma space and has an established network that KITE’s products can tap into now being under their wing. These two factors could account for this growth, but moreover, since we are pricing the firm as it would function within GILD, some of the growth can be attributed to Gilead shaving time off other research schedules moving those respective revenue streams up in the timeline. The closer the money is to present day the more an investor has to pay upfront due to the time value of money. Next is expenses, which are frontloaded due to R&D expenses needed to push products out. Using a third level growth modifier we find that R&D will grow at 30% moving forward. A third level growth modifier uses the growth rate of the growth rate of the growth rate. The final value is then backed into a normal first level growth rate. This method is used to normalize shifty changes in predictions. Whereas the first growth rate over several years may be very inconsistent dialing into deeper layers the rate is generally more consistent. Refer to the excel sheet for a more intuitive understanding. 30% is lower than GILD’s R&D expansion as expected for a younger pipeline. The same growth method is used for SG&A, putting growth at 40%. These values bring the firm to positive EBIT in the third year and a final DCF value of $180.13.

These base growth values are now applied to a combined DCF value for the new firm. The EBIT is merged through adding both firm’s toplines. Note that the overall topline is still declining over the next three-year period as the initial growth of KITE is not strong enough to offset the declining growth GILD is experiencing right now. Since the synergies were already applied in the KITE DCF no additional topline synergies were applied at this step. For cost synergies, a 4% modifier was applied due to economies of scale and cost-cutting that GILD that are part of the ongoing merging process. AR and AP are projected based on previous levels of KITE. This is a crude measure, but small changes in these values do not change the overall value drastically, since GILD’s AP and AR dwarf KITE’s in comparison. Finally, the WACC is 10% and the growth rate is increased to 1.29% compared to 0% in the previous model. The increase in terminal growth rate is due to an expected increase in future growth. As the new additions to the pipeline fruit, they should increase the bottom-line. Moreover, this first move is an indication from GILD that the market can expect more acquisitions in the future to further bolster growth. These values bring the final share value to $100.07. This is right on target with Argus Research’s recent valuation upgrade to $100. (Argus)

The market, however, has not reached this value quite yet. Most likely due to investors being wary of the effects of the merger until they are crystal clear and there are hard numbers backing up the expectations.

There is some upside left in this trade for a few reasons. First, Gilead created the perfect scenario for more acquisitions moving forward thanks to the financing of this deal. Though Gilead had plenty of cash to finance the entirety of the acquisition without being put under financial duress they opted for a blended deal. This allows them more options for future deals. To further solidify this possibility Kevin Young mentioned that the firm intends to “maintain financial flexibility for future acquisitions.” It is likely that Gilead is looking for more research in budding areas. Additionally, though larger firms have more resources, strong innovation typically comes from smaller companies working under the radar on projects that initially have low likelihoods of success. Thus, a strong strategy for Gilead is to pick up these projects once the expected payout is much higher.

In conclusion, Gilead still has many options and strong prospects to grow. This first step has reinvigorated a trust in the management’s direction for the firm. From here on out it is imperative that the firm pushes to grow out their pipeline and bring the current revenue growth over 0. This is the next hurdle that once surpassed will solidify the longevity of the firm.

If you would like a copy of the excel model please send me a message or comment below. I will send it to you for free.

About the Author: Pranav Singh is the Chief Publisher of DAC1 and TOTD at Monthly Cash Thru Options, an options advisory newsletter, and educational service provider. For more information about the MCTO options trading services and investment track record please visit www.monthlycashthruoptions.com. You may also contact Pranav directly at pranav@monthlycashthruoptions.com.

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.

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