After the market close on September 11th, Gilead Sciences, Inc. (NASDAQ:GILD) announced that it had raised $9.916 billion after underwriting discounts with an expected close on September 14th, 2015. Last week’s capital raise led a strong rally across biotech on speculation on whom GILD may buy, if they are in fact raising the capital for M&A. Incyte Corporation (NASDAQ:INCY)’s relative outperformance is noteworthy, closing +10.87% since our note on Thursday morning and closing the week at a fresh all-time high of $131.01. Importantly, INCY outperformed every other potential GILD takeover target by no less than 2x. We believe there remains at least +11% to +42% upside should an acquisition be announced.

For comparison, we highlight that VRTX only rallied +4% since Wednesday’s close. VRTX is an important company to contrast with INCY because there is an ongoing debate among the buy-side on which of the two GILD is more likely to acquire. All available evidence continues to support our view that INCY remains the most likely target for GILD, not VRTX.

We base this on last week’s substantial outperformance in combination with a +61% increase in bullish positioning in the options market.

Specifically, we highlight the following important changes since Wednesday’s close that provide additional support to our thesis:

  • Total Call Open interest increased by +61% in just two trading days.
  • The JAN’16 $135 and $165 Calls account for 40% of total open interest, and have a delta-adjusted notional value of $600M, or 2.66% of INCY’s current market cap.
  • For comparison, VRTX’s two highest O.I. Calls only account for 0.56% of VRTX’s current market cap with a delta-adjusted notional value of $182M.
  • Put-to-Call ratio on OI increased +102% since Wednesday’s reading of 0.25 to only 0.48 after Friday’s close reflecting both hedging and heavy spread trading volumes that represented 36% of total daily options volume.
  • Based on the aforementioned it appears that a large trader(s) is positioned for an acquisition to occur between the $135-$165 strikes by JAN’16 expiration.
  • INCY’s ATM Straddle (OCT’15) suggests a move of +/- 15%. VRTX ATM Straddle +/- 12%.

According to a recent buy-side survey conducted by EvercoreISI’s Mark Schoenebaume, the buy- side ranks VRTX first, while INCY ranked second. We believe the buy-side fails to account for several long-term strategic drivers at GILD that will drive their motive to acquire. The buy-side appears to be of the opinion that “anyone should buy VRTX” irrespective of corporate culture, headcount, and strategic fit because they also believed VRTX was the #1 target for BIIB. Thus, the buy-side literally appears to only “want” VRTX to be acquired, not really taking into account several important variables when considering M&A targets such as strategic fit, synergies, headcount, long-term strategic interest’s or whether the potential target could provide value creation with GILD’s internally developed pipeline assets.

The buy-side’s lack of specificity when selecting a potential acquirer for VRTX doesn’t pass the “smell test” to us, and as such provides evidence that their call for GILD to acquire VRTX is not founded on sound strategic rationale. Chief among these weaknesses is that VRTX fails to fulfill GILD’s long-term strategic pipeline needs over the next 20 years. We implore that this could be the key objective for GILD; not simply acquiring cash flows from cystic fibrosis, which GILD has little long-term strategic interest. VRTX simply represents a 5-7 year influx of cash flows, but fails to provide long-term strategic pipeline value. While it is possible, that GILD could acquire VRTX, we would seriously have to reconsider our long-term bullish view on GILD should that be the outcome here, and would likely be sellers of GILD after that announcement.

We believe that the key motive for GILD will be centered on acquiring assets that can enhance the value of internally developed assets in oncology. INCY fulfills these criteria, and remains the best long-term strategic fit for GILD over the next 10-20 years. Recall, GILD disclosed during their 2Q15 conference call that its has 30 clinical trials in oncology, and 0 in cystic fibrosis.

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