Monday shares of Kite Pharmaceuticals (KITE) surged nearly 30% on news Gilead (NASDAQ:GILD) was in talks to acquire the biotech company for $12 billion. According to Gilead management recent breakthroughs in Kite’s immunotheropy products convinced the company that now was the right time to strike a deal:

“It really became clear that it was going to work and it was going to work in more than one kind of tumor. … And then, importantly, that the manufacturing on an industrial scale could work,” Gilead Chief Executive John Milligan told investors on a conference call. “Now is the right time to get involved in this kind of therapy.” …

Kite is one of the leading players in the emerging field of CAR T, and is competing with rivals Novartis AG, Juno Therapeutics Inc and Bluebird Bio Inc in a race to get the first approved therapy.

The $180 share price equates to a 30% premium to KITE’s Friday closing price of $139. GILD closed up 1% on the news. For the year GILD is down about 1% due to its disappointing HCV franchise. Below is my takeaway on the transaction.

Kite’s Oncology Presence Fits Gilead’s Strategy

Kite is a clinical stage biotech company focused on the development of cancer immunotherapy products designed to to help patients fight cancer by harnessing the power of their own immune systems. According to the company’s public filings its engineered autologous cell therapy genetically engineers T cells to express chimeric antigen receptors (“CARs”) or T cell receptors (“TCRs”). The modified T cells are supposed to recognize and attack cancer cells.

Gilead has expressed an interest in expanding into oncology medicines due to their expected out-sized growth.Gilead previously tried develop its own oncology drug Zydelig, which was designed to block proteins inside cancer cells that encouraged the cancer to grow. The company subsequently halted six clinical trials for Zydelig in March 2016 due to serious side effects, including deaths.

Kite’s Car T treatments could potentially be the next catalyst to help offset Gilead’s sagging HCV franchise. Secondly, Kite could potentially piggy back off of Gilead’s own R&D in the field of oncology, so it could be a symbiotic relationship.

GILD Bulls Should Not Expect Dividends Immediately

Kite’s drugs are currently in the clinical trial stage so revenue opportunities could be limited for now. Gilead’s specialty lies in acquiring companies whose drugs are in the latter stages of development, and Kite fits that profile. The Food and Drug Administration (“FDA”) is expected to decide by Nov. 29 on the approval of Kite’s CAR T, axi-cel, for advanced lymphona. If approved, Kite plans to commercially launch axi-cel in 2017. It has also filed a Marketing Authorization Application to commercially launch axi-cel in the European Union next year.

Kite will be an expensive proposition in the short term. Kite’s revenue is expected to be approximately $200 million in 2018 and grow to about $1.2 billion in 2021, consisting primarily of Axi-cel. At $12 billion the deal equates to 10x Kite’s estimated 2021 revenue. In the short-term the transaction would create a negative arbitrage for Gilead as GILD currently trades at 3.0x run-rate revenue and 4.7x run-rate EBITDA.

To put the relative sizes of the two companies in perspective, based on Q2 2017 results Kite has run-rate revenue of $40 million compared to Gilead’s approximately $29 billion.

The above chart shows Q2 2017 revenue growth for the two companies. Gilead’s Q2 revenue of $7.1 billion was off 8% Y/Y. Kite’s Q2 revenue of $10 million was up 110%, yet would not have any meaningful impact on revenue growth for the combined companies.

Takeaway

Kite has the potential to deliver out-sized growth in the oncology space. Kite’s immunotherapy products are exciting to learn about, yet the drugs could cost up to $500,000 per treatment. The potential market size could expand if prices were to fall over time. Even if Kite achieves revenue of $1.2 billion in 2021 it still might not be enough to offset the diminution in Gilead’s HCV franchise. HCV currently generates quarterly revenue of $2.9 billion. Strategically, I love this transaction. Financially, it does not change Gilead’s outlook. GILD remains a sell.

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