Kite Pharma (NASDAQ:KITE) – Market cap as of 23/09/2017: $10.28bn

Gilead Sciences (NASDAQ:GILD) – Market cap as of 23/09/2017: $108.74bn

Introduction

On August 28, 2017, Gilead Sciences, Inc. and Kite Pharma, Inc. announced that the companies have entered into a definitive agreement pursuant to which Gilead will acquire Kite for $180 per share in cash.

Kite was valued at approximately $11.9 billion and this deal was unanimously approved by both the Gilead and Kite Boards of Directors. The deal, which established Gilead as a leader in cellular therapy, is anticipated to close in the fourth quarter of 2017. The transaction will provide opportunities to the buyer for diversification of revenues, and is expected to be neutral to earnings by year three and accretive thereafter.

About Gilead Sciences

Gilead is a biopharmaceutical company headquartered in Foster City, California that was founded in 1987. Its shares trade among the NASDAQ Biotechnology Index and the S&P 500.

Gilead debuted on the NASDAQ in January 1992 and its IPO raised $86.25 million in proceeds. In 2002, Gilead sold its cancer assets to OSI Pharmaceuticals and changed its corporate strategy to focus on antivirals.

Historically, the company has made many acquisitions and has been successful in converting such acquisitions into valuable cash generating units. Gilead had previously bet successfully its money on Pharmasset, which at that time had an experimental hepatitis C treatment. At a certain point, Gilead was selling its hepatitis C drug for $1,000 per a combo, which was a daily dosage. Over the years, the number of Americans affected by Hepatitis C have been declining and this, together with fierce competition in the sector, has cause the company to struggle in the past years.

About Kite Pharma

Kite Pharma Inc. was founded in 2009 by an Israeli-American oncologist, Arie Belldegrun. The clinical-stage biopharmaceutical company is based out of Santa-Monica, California.

The company has been successful in developing a drug that uses the white-blood cells of the human body to fight the tumor. However, their losses have been increased from $101m in 2015 to $267m in 2016. R&D expenses – an important indicator for the firms operating in this sector if we consider that pharmaceutical industry spends more on research and development, relative to its sales revenue, than almost any other industry in the US – amounted to $76.4m in 2015 and increased to $197.9m for the year ended 2016.

Industry Overview

In the last few years the Pharmaceutical industry has been struggling with several challenges and, in particular, the major contributor to the realized volatility was the political framework. As a consequence, the Nasdaq Biotechnology Index fell 21% in 2016, but has regained ground in 2017, climbing 11%. The recent growth in the sector is closely tied to global health care expenditures which, in 2017 and successive years, are expected to be fueled by increasing demand from an aging population and by the prevalence of chronic and communicable diseases. Moreover, another potential growth driver includes improved economic activity in the Middle East and APAC. Globally, in 2015 health-care spending was 10.4% of GDP. This figure is not expected to grow in the near term: as a matter of fact, this value is expected to reach $8.7 trillion (10.5% of GDP) by 2020.

At the same time, overall the biotechnology segment’s revenues increased at a 3.7% CAGR, from $263.7bn to $293.5bn, between 2010 and 2016. Furthermore, the global biotech revenue is expected to rise to $314.7bn by 2021.

The biotechnology sub-industry is divided into agricultural and medical biotech, but the latter, with revenues exceeding $150bn annually, receives the major part of research funds. Despite the stable growth, biotech companies have always operated in a world of uncertainty brought about by an unstable customer engagement and an unpredictable regulatory compliance, in an environment where cost and pricing may make the difference and where clinical and operational innovations are the key to growth and success.

The volatile industry trend is reflected also in the M&A activity, which in 2016 was at the lowest level in six years. Deal making has slowed since Donald Trump became US president, as several drug-makers have been waiting for more clarity on drug pricing and tax reform. However, a rise in transaction was expected in the second part of 2017 and Gilead’s need for a deal was particularly acute. The decision to go ahead with a major deal could lead other large companies to follow the trend giving new energy to the healthcare M&A sector.

Deal Structure

According to the agreement, Gilead will make use of a wholly-owned subsidiary to commence a tender offer to acquire all of Kite’s outstanding shares at a price of $180 per share through a cash consideration. The successful completion of the tender offer is to be followed by the acquisition of the entirety of the non-tendered shares in an offer through a second step merger, in which the price will be the same as the one in the tender offer.

The $180 price per share implies a $11.9 billion valuation and a 50% premium to Kite’s 30-day volume weighted average stock price. The premium is reduced to 29% if measured on the price at which Kite’s shares closed the trading day preceding the announcement of the deal. Gilead is to finance the acquisition with a combination of cash on hand, bank debt and senior unsecured notes.

Following the deal, Kite’s R&D and commercialization operations will remain in Santa Monica, California, where the company is based. Product manufacturing will also retain its current location, which is instead in El Segundo, California.

Deal Rationale

A full appreciation of the reasons behind Gilead’s decision to acquire Kite requires some historical context. In 2011, Gilead made a $11bn bid for Pharmasset. The acquisition was as risky as it was expensive, but it had the potential to be an outstanding success. At an 80% premium, Gilead was buying a company whose only real asset was a molecule that, if approved, could provide the first effective cure to Hepatitis C. The molecule eventually hit the market in 2013 and, under the brand name Sovaldi and with a price tag of $80,000, it became the fastest selling drug in history. Gilead’s bet paid off handsomely, boosting its revenues from $9.7bn in 2012 to $32.6bn in 2015.

As, due to increased competition, sales from Sovaldi began to cool, Gilead started looking for new sources of revenue growth. In this context, the Kite deal is an almost exact replica of the Pharmasset one. The company has developed a treatment that holds great promise, but has yet to be approved by the FDA. As in the previous case, Gilead paid a hefty premium and has shown a remarkable willingness to take risk. The treatment in question, known as Car-T, is a one-time treatment consisting in the re-engineering of the patient’s blood cells so they can identify and attack cancer cells. The therapy is complex and expensive, with an estimated cost of goods hovering around $200,000 per patients. Yet, if successful, it could be marketed in the neighbourhood of $750,000 per patient. Initially, the pool of potential patients would be small, being limited to the sickest patients with a specific type of lymphoma. In the US, there are currently some 40,000 patients affected by the special types of lymphoma, myeloma or leukaemia for which this therapy is warranted. In all cases, patients are only eligible if they are at the most advanced stage of the disease. However, the number of potential patients are expected to grow over time. Kite has been developing additional programs and compounds to broaden the treatment utilization in earlier lines of therapy, while also exploring possible uses in solid tumours of which hundreds of thousands of new cases are diagnosed each year.

The success of the therapy will be the main determinant of the fortunes of the deal. A similar treatment by Novartis, with a $475,000 price tag, has recently been approved by the FDA. The decision increased the odds of an approval, but it also gave way to an early competitor in the nascent segment. The companies expect approval in Q4 2017 in the US and in 2018 in Europe. To accelerate the rollout of the treatment, they have already carried out the necessary preparations for the manufacturing and the US commercial launch.

The deal is expected to be neutral to earning by year three and accretive thereafter. Unlike Gilead, whose payoff from this deal will only become clear in a few years, Kite is an unquestionable winner. With the acquisition, the firm joins the highly exclusive club of biopharmaceutical companies whose product was promising enough to attract a deep-pocketed buyer who will maximize the treatment’s success prospects by employing its world-class infrastructure, while generously rewarding its shareholders.

Market Reaction

On the day of the announcement, shares of Gilead Science experienced a rise of 2.9%, while Kite Pharma shares were trading at $178.29, with an upsurge of 28% compared to the previous day.

In 2017 the shares of the two Companies have had two different stories. Indeed, prior to the Kite deal, Gilead shares had drifted mostly sideways as investors expected the company’s next big growth source. On the contrary, Kite Pharma’s stocks had tripled in value.

Advisors

Bank of America Merrill Lynch and Lazard are acting as financial advisors to Gilead. Centerview Partners is advising Kite, together with Jefferies and Cowen & Co.

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