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.

Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.

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.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

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

Related Articles
  1. Investing News

    What You Can Learn from Carl Icahn's Mistakes

    Carl Icahn has been a stellar performer in the investment world for decades, but following his lead these days could be dangerous.
  2. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  3. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  4. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  5. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  6. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  7. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  8. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
  9. Investing News

    A 2016 Outlook: What January 2009 Can Teach Us

    January 2009 and January 2016 were similar from an investment standpoint, but from a forward-looking perspective, they were very different.
  10. Mutual Funds & ETFs

    3 Vanguard Equity Fund Underperformers

    Discover three funds from Vanguard Group that consistently underperform their indexes. Learn how consistent most Vanguard low-fee funds are at matching their indexes.
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center