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Why This "Worst Deal" Could Work

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Recently, the pharmaceutical giant Merck (NYSE: MRK  ) has been receiving a bit of heat from commentators who believe that the company offered way too much money for the hepatitis c therapeutics developer Idenix Pharmaceuticals (NASDAQ: IDIX  ) last week. Although the $3.85 billion acquisition gives Merck full rights to a promising mid-stage hepatitis c drug called samatasvir, many people believe that Gilead's (NASDAQ: GILD  ) blockbuster hep c drug Sovaldi (sofosbuvir) may deplete most of the market by the time Merck's combo (including samatasvir) can apply for FDA approval.

Why Merck's been under fire
If we are limiting our discussion to the US hep c patient population, I would fully agree that Merck made an unfavorable bet with its bid for Idenix. However, many people seem to miss the fact that the US only has about 2% of the world's hep c patients. Even if Gilead utterly dominates the US market for hep c in the next 3-4 years, Merck can target well over 100 million non-US patients who have few (if any) options for elimination of the virus.

Outside the US, Merck wouldn't be able to match the prices that Gilead currently charges for a 12-week regimen of Sovaldi in the United States ($84,000). However, Merck could later decide to partner with local distributors who would commercialize Merck's drug in exchange for tiered royalty payments. These are often structured as percentage-based payments that offer passive income to the parent company based on the drug's performance.

Why it could work
Although the income would take much longer to materialize, it would come at little to no cost to Merck (aside from the developmental and acquisition expenses it is already incurring). This would make it commercially viable for Merck to target the huge hep c populations in developing countries without issues of scalability or large, upfront investments.

I think Merck realizes that it cannot launch a hep c drug that will take off sprinting like Sovaldi did (with $2.3 billion sold in its first full quarter on the market), but there are many dollars waiting to be picked up by reasonably priced hep c products that work better than generic antivirals. On the global scale, hepatitis c is a numbers game that cannot be won by overpriced drugs. Even if Gilead's Sovaldi fully saturates US market by the time Merck launches a competitor, it only means that the low-hanging fruit are gone.

It's also worth noting that Gilead's Sovaldi would not always erase market share for other hep c therapies. Because antiviral therapies often have synergistic effects, we could eventually see Sovaldi and Merck's drugs used in combination (and in fact, Merck is already testing a three-drug combo including Sovaldi in the hope of finding a faster-acting cure for hepatitis c). Drug layering is a growing trend in medicine, and it gives latecomer cocktails like Merck's a fighting chance against drugs that have already saturated the market years after launch.

Of course, there are risks
Having said this, it should be stated that the Idenix acquisition was an aggressive move that could easily end up backfiring should a cocktail including samatasvir be drastically inferior to Sovaldi. An FDA rejection of samatasvir could also kill Merck's multibillion-dollar investment outright, depending on the company's ability to salvage the product in such a scenario.

Unless a successful drug combination trial is performed, Merck's cocktail would also have to compete directly with AbbVie's (NYSE: ABBV  ) experimental hep c therapy, which received priority review from the FDA yesterday. FDA approval of this product is seems likely, which puts more pressure on Merck to focus on ex-US markets.

Gilead spent a lot more for Sovaldi (through the $11 billion acquisition of Pharmasset in 2011), but the company is on track to make its money back pretty quickly. Although the Merck acquisition of Idenix is smaller in size, it is riskier and much less "efficient" in terms of its ability to break even. Assuming the Sovaldi run rate continues, the Pharmasset acquisition will have paid for itself by some time in 2015. The Idenix acquisition, on the other hand, may not pay for itself for quite some time -- and that assumes regulatory approval.

Final thoughts
Although Merck has the ability to fund new R&D projects, its larger corporate structure means the company isn't as nimble as smaller biotechs. Outright acquisitions are simpler, and more cost effective in most cases. Why would Merck want to develop its own drugs when it can acquire phase 2/3 drugs that already come with built-in research teams?

As of Q1 2014, Merck reported over $15.8 billion in cash on its balance sheets. Merck could be using this money to pay off the $8.5 billion in long term debts reported on the balance sheet, but a low interest rate environment make this an unattractive option for corporations without any solvency issues.

Merck may have overpaid for Idenix, but I do believe that aggressive acquisitions still make a lot of sense for this company given its situation. Merck has recently been focusing much of its R&D efforts on the mid-stage PD-1 inhibiting cancer drug pembrolizumab, which has shown phenomenal efficacy against difficult forms of cancer (late-stage skin, liver, renal, etc.). We won't know for a while whether the hep c play has paid off -- but this is a big market with lots of opportunities.

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