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Was Gilead's Acquisition of Pharmasset a Dose of Bad Medicine?

March 05, 2012 | About:

Bad medicine can make it difficult for a patient to get well; sometimes, it can even make the person worse. The same can be said on Wall Street, where drug-related problems can have detrimental effects on an investor’s portfolio. This is the case with Gilead Sciences Inc, a $34 billion biopharmaceutical company in Foster, CA. The company’s decision to overpay in order to acquire a company responsible for a new hepatitis C medicine is leaving many of its investors feeling ill.

The Pressures of Competition in Pharmaceuticals

The possibilities in hepatitis treatment are huge. Many of the major players in the pharmaceutical market are rushing to gain a foothold. Vertex Pharmaceuticals (NASDAQ:VRTX) and Merck (NYSE:MRK) have

recently received approval for medicines that fight the illness. These approvals are forcing competitors to speculate on other producers, so they don’t fall too far behind. It is this pressure that likely led Gilead Sciences to make the decision to purchase Pharmasset in order to get its hepatitis medicine, only to have questions raised about the drug’s effectiveness.

These questions were voiced after a Gilead study where eight patients were given the new drug, and 75% of them relapsed within a couple of weeks. While a first study doesn’t kill a trial drug, it can wreak havoc with its numbers on Wall Street. Gilead Sciences stock was soaring after 4th quarter results showed the company share prices rising almost 15% in the past year. The company reported quarterly revenue gains of 10.10% and earnings of 5.7%.

The sale price of Gilead’s acquisition of Pharmasset was steep. Including an incredible 90% premium, the total would rise to $11 billion; an amount that the company admits will wipe out its earnings though 2014. Add on top of that price the poor initial showing, and investors are likely scrambling for answers. Suddenly, the Bristol-Myers Squibb (NYSE:BMY) purchase of Inhibitex for $2.5 billion to get its hepatitis drug seems like a bargain, and the “diamond in the rough” growth strategy by Spectrum Pharmaceutical (NASDAQ:SPPI) seem to be very wise moves for development and acquisition.

Bristol-Myers Squibb Buys Inhibitex

Bristol-Myers Squibb enjoyed a very profitable 2011. The New York City-based company saw its market cap swell to nearly $55 billion as its stock price jumped almost 27%. The company enjoyed a quarterly revenue increase of close to 7%, while its earnings soared 76%. The company is well-positioned, with a debt to equity of 35 and $5.3 billion of free cash flow.

Currently trading around $32 per share, Bristol-Myers Squibb has a 52-week range of $24.97 - $35.44 and a one-year target of nearly $34. The company is also a very good dividend payer, with an annual dividend of $1.36 and a yield of 4.2%.

Spectrum Buying Instead of Developing

Spectrum Pharmaceuticals is also doing very well. Carefully picking its acquisition targets, the company's stock exploded in 2011, more than doubling with an increase of 110%. Also impressive was its quarterly revenue growth, as the company saw the amount of money coming in swell by nearly 205%. By keeping its costs of development low, Spectrum is practically debt-free, with only $17,000 showing on its books. For being a $780 million company, its cash flow is impressive as well, as it has almost $150 million in total cash.

Although it does not pay a dividend, Spectrum is a solid growth stock. Trading at just over $13 per share, Spectrum is trading near the top of its 52-week range of $6.46 - $16. The company is expected to break through the top of that range, as it has a one-year target estimate of nearly $19.25.

Gilead's Numbers Suffer

After its 15% share price climb and 10% gain in revenue, this purchase may have already affected the company’s financials. In spite of a forward price to earnings ratio of 10.36, the company stock looks overvalued when you consider its price to book ratio of nearly 5. In addition, Gilead’s debt to equity ratio has climbed to 115, meaning that it is not as efficient at making money. With no free cash flow available, the company will be forced to seek funds from outside sources it revenue wanes, driving up operating costs even further.

The company’s current share price is around $45, with its 52-week range at $34.45 - $56.50. At $58 per share, the one-year target estimate is very good, but the current pressure will make it difficult to achieve that result. A 40% increase in share price since the first of the year was largely wiped out, as the company lost nearly $11 per share (around 20%) on the news of the poor results of its latest drug.

High Reward Investment

For its part, the move by Gilead Sciences is somewhat of a calculated risk. The treatment of hepatitis is a prime reason to invest so much money. The 2009 estimates in the United States were that treatment of hepatitis C cost around $30 billion, growing to an estimated $85 billion in twenty years. By purchasing existing companies it is possible for the larger pharmaceutical firms to bypass most or all of the lengthy and costly approval processes mandated by the Food and Drug Administration.

Investment costs can be a gamble, especially when they involve $11 billion transactions to purchase a company. Right now, it is important to continue monitoring Gilead Sciences Inc in order to determine what happens with its hepatitis drug. Should subsequent tests prove to be successful, this could be a very good investment; however, I recommend leaving it on our watch list until additional results are available.

About the author:

I'm mostly interested in income investing using dividends, preferred stocks and other debt instruments, and pair trading.

I fundamentally analyze every business from the top down.

In my personal life, I have a strong Jewish faith and enjoy playing Scrabble and entrepreneurship.

Visit StockCroc's Website

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