Why Did Gilead Pay So Much for Pharmasset?

The health care sector was rocked yesterday by Gilead Sciences's $11 billion buyout of Pharmasset.

Located in Princeton, N.J., Pharmasset is a company that is developing a treatment for hepatitis C, a disease that affects an estimated three to four million Americans. As many as 170 million people worldwide are also estimated to have hepatitis C, which is often caused by use of contaminated needles.

The infection can cause serious liver damage, and treatment so far have involved a combination of pills and injections. Pharmasset is working on treatments will be all-oral (i.e. no needles) with considerably less negative side effects.

But still: the total worldwide market for hepatitis C treatments is estimated to be around $3 billion per year. Gilead is paying $11 billion for a company that has 52 employees, lost $92 million last year, and that is working on a drug that will not be available until 2014, if it proves to be successful.

Only time will tell whether Gilead's move is visionary or ill-considered. What it does highlight, however, is the fact that returns from research and development efforts in the drug industry have been steadily declining, despite the massive amounts of funds being thrown at new drug development.

Before yesterday, Gilead's management was widely regarded as one of the smartest in the biotech field. It is unlikely that they would suddenly become reckless and pay too much for Pharmasset unless they felt that the returns from buying the company would not outweigh what they could achieve on their own R&D efforts.

According to the consulting firm Deloitte, as discussed in an article in yesterday's Financial Times:

The average internal rate of return on R&D for the top dozen pharmaceutical companies fell from 11.8% in 2010 to 8.4% this year, while the cost of developing a new drug rose from $830 million to $1.1 billion.

The problem is not only the cost of developing new compounds. Bringing a new drug to market involves massive amounts of testing that can last for years, and often can wind up in failure. Even drugs that eventually are brought to market can be pulled; just last week the FDA pulled Genetech's Avastin, a widely-used treatment for breast cancer, from the market after patient data indicated that it carried considerably more negative side effects than trials had indicated.

The health care sector faces a number of significant headwinds in the coming years. Costs continued to rise, yet there is widespread support for trying to contain costs of medicine, including drug prices.

In other words,the days of high earnings growth for the health care sector seem to be largely in the past.