Nope, Gilead Sciences Wont Get Bought out

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Rumors have been swirling around the internet that Gilead Sciences (NASDAQ: GILD) is going to get bought by a big pharma. Heck, my Foolish colleague Sean Williams has entertained the possibility. Lots of smart people are discussing this.

With all due respect to them, here's why I think they're wrong.

(Probably) the minimum scenario for a buyout

Now, to be clear: This is all speculative. I don't read minds, and I can't predict the future. All that said, I can't imagine that Gilead's management would approve a sale for anything less than the 52-week high of $111.11 per share. Given that healthcare buyouts often value the target at new highs instead of just returning it to old ones, a $111.11 buyout price seems like the bare minimum management would entertain. That number is a 37% premium to the stock's recent price of about $81 per share, which implies a buyout price of roughly $147 billion.

That $147 billion figure is larger than the market cap of every American pharma company aside from Johnson & Johnson (NYSE: JNJ)and Pfizer (NYSE: PFE), so everyone else is immediately out of contention. (Side note: I'm leaving the European folks out of this, given that most have minimal overlap with Gilead's core areas of expertise, and the only significant competitor, GlaxoSmithKline, has a market cap around $100 billion and is awash in debt.)

It would be difficult -- but not impossible -- for either Pfizer or J&J to actually make something so expensive happen. Both are sitting on a fair amount of long-term debt -- Pfizer has $30 billion in long-term debt on its balance sheet, while J&J has $25 billion, according to data from S&P Market Intelligence-- and would have to load up a lot more to effect a buyout. However, Pfizer recently exited a $152 billion proposed merger with Allergan, which indicates that, if it's desperate enough, it could swallow Gilead for $147 billion.

J&J CEO Alex Gorsky has been a little cool to the idea of big acquisitions, noting on the most recent earnings call that "the tuck-in strategy, particularly in pharma -- or actually, in all of our segments, medical device and consumer, are... where we feel that we can create the most value." (This and other quotes courtesy of S&P Market Intelligence.) Now, Gorsky did leave the door open a crack, noting, "We do think that there are other opportunities to create value as well, and again, in mid- and larger deals." But this implies that a big splash isn't J&J's first choice. I don't see how a management so lukewarm on big deals would be willing to spend half of J&J's market cap on Gilead.

Of course, all of this assumes that Gilead's management would be amenable to the $147 billion price -- which would value Gilead at about 10 times trailing 12-month earnings.

This seems more reasonable

I think Gilead's management would only take a deal like the one I outlined above if it becomes convinced of what the market seems to believe -- that Gilead's best days are, in fact, behind it. So far, they have given precisely zero indication of that. As COO Kevin Young recently remarked at a conference, "We have no sense of desperation."

But forget management's quotes -- look at their actions.Gilead has done a few small deals in the last year (most notably licensing the autoimmune drug filgotinib from Galapagos), but it hasn't tried to make a splash with a big acquisition. That tells you a lot about leadership's confidence in their current strategy -- develop the internal pipeline and keep an ear out for some good small and mid-size M&A opportunities. They're confident things will turn around. They're confident they can return Gilead to growth.

A confident management team won't sell for $147 billion, which is much less than Gilead will be worth if they can juice more growth. A confident management will demand more. Consider this: If Gilead's leadership agreed to sell, and demanded merely that Gilead be valued at the same trailing 12-month P/E ratio as the market, the cost of the buyout would almost double to an astounding $271 billion.

That likely puts Gilead outside Pfizer's ability to finance, given that it represents a purchase value 30% bigger than Pfizer's total market cap. And imagine how interested in a large acquisition J&J would have to be to purchase Gilead for a price equal to about 85% of J&J's market cap. I don't think that's where they'll go.

What to watch for, instead

Gilead management has made it clear that they're searching high and low for acquisitions. And there's plenty of other evidence that they're hunting. Gilead is ramping down its share buybacks even as its free cash flow continues to be strong. The company just issued $5 billion in new debt, despite being flush with cash.

It doesn't take a genius to see that they're likely planning on an acquisition or three. That will bring into sharper focus management's broader strategy of returning the stock to growth. And when that happens, I firmly believe that this buyout speculation will end.

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Michael Douglass owns shares of Gilead Sciences and Johnson and Johnson. The Motley Fool owns shares of and recommends Gilead Sciences. The Motley Fool has the following options: short October 2016 $85 calls on Gilead Sciences. The Motley Fool recommends Johnson and Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.