Is Third Time The Charm For Gilead?

By Stephen D. Simpson, CFA | November 22, 2011 AAA

When in doubt, buy somebody out. Gilead Sciences (Nasdaq:GILD) has been trying for quite some time to diversify its business beyond HIV therapy. With November 21, 2011's announcement of a massive deal for biotech Pharmasset (Nasdaq:VRUS), Gilead is making a bold move for dominance in hepatitis C and perhaps acknowledging its own shortcomings. The real question for shareholders, though, is whether the extreme competition in the Hep C market will whittle away the value of Pharmasset's pipeline and make this yet another expensive blunder by Gilead management.

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The Terms of the Deal
Gilead announced on November 21, 2011 that it will acquire Pharmasset for $11 billion in cash, valuing Pharmasset at $137 per share in cash. That price is an 89% premium to November 18, 2011's close and makes Pharmasset nearly twice as valuable as Vertex (Nasdaq:VRTX) - a biotech with an interesting new hepatitis C drug already on the market, but one recently beset by worries of prescription trends and future competition.

Gilead had over $5 billion in cash and investments on the balance sheet as of the last quarter, and so it will need to raise about $6 billion in debt to complete this deal. That means about $10 billion in debt total, but Gilead's EBITDA and strong cash flow should be able to absorb that extra interest. (To know more about acquisition, read Analyzing An Acquisition Announcement.)

What Gilead Is Getting
Pharmasset has a pretty shallow and highly focused pipeline centered on treatments for hepatitis C. Shallow should not be misinterpreted as disappointing, though. Pharmasset's lead drug, PSI-7977, has shown exceptional results in clinical trials to date, including 100% SVR12 (sustained viral response) when combined with ribavirin. That is about as close to a cure as is possible without actually curing the disease and analysts have used words like "home run" in describing the potential of this drug.

If approved, PSI-7977 could be worth several billions of dollars in revenue in five or six years. While more data is needed on safety and tolerability, there is a good chance that PSI-7977 will make it to market. Unlike many other areas of biotech, early stage results in virology (and hepatitis C in particular) trials tend to hold true in pivotal studies as well.

Why Gilead Needs This Deal
Gilead needed to do a deal in Hep C in part because prior deals for Myogen and CV Therapeutics failed to deliver on their promise and allow Gilead to diversify away from its very successful HIV franchise. Gilead has had some remarkable success in HIV, but competition is building from Merck (NYSE:MRK), Johnson & Johnson (NYSE:JNJ) and Glaxosmithkline (NYSE:GSK). What's more, it is getting increasingly difficult to develop more effective HIV drugs, and Gilead will see much of its revenue decline over the next 10 years as its patents expire. (To know more about patents, read Patents Are Assets, So Learn How To Value Them.)

Worse still, Gilead hasn't done a great job with its non-HIV pipeline. The company has four credible drugs in trials for hepatitis C, but the Street has not given much credit to the company's odds of being a player in Hep C.

Taking a Big Swing
Maybe it's an exaggeration to say that Gilead management is pushing all of its chips forward on this deal, but its not much of an exaggeration. If PSI-7977 isn't a hit, it's hard to see how this deal can ever justify itself.

While PSI-7977 is indeed promising, this is an increasingly crowded field. Large players like Johnson & Johnson, Merck, and Bristol-Myers Squibb (NYSE:BMY) have major Hep C development programs, and there are a host of smaller names like Achillion (Nasdaq:ACHN) and Inhibitex (Smcap:INHX) that are hoping to make their name in the Hep C field. Even if other drugs cannot match the efficacy of Pharmasset's lead asset, there could be opportunities for market share on the basis of tolerability and price.

The Bottom Line
It's almost a given that some Gilead investors will be furious with this deal, seeing it as a an expensive way to paper over management's prior mistakes and failures. On the other hand, if Pharmasset's drugs live up to their promise, three or four years of those sales could pay for this deal. The longer-term question for Gilead shareholders may not be so much about whether Pharmasset's drugs can become successes, but whether Gilead management is any more up to the task of managing that success than they have been in the HIV franchise.

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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