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The Bear’s Case for Genentech

Posted on: November 7, 2008 - Email Article - Printable Version

Allen Lutz

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Trading at $79.84, shares of Genentech [DNA: 83.96, +0.96 (+1.16%)] now trade more than 11% below Roche’s tender offer of $89.00 a share issued in July. At the time the bid was announced, shares of Genentech rose to $99.00, reflecting the market’s view that Roche would have to come back with a higher bid. Later that day, Genentech rejected the offer stating $89 per share did not reflect the true value of its pipeline.

Let’s take a look at some of the reasons Roche decided to make a bid for Genentech. First, Roche [RHHBY: 0.00, N/A (N/A)] has been experiencing significant pressure to replace its antiviral franchise which has been holding up the company’s earnings over the past few years. Roche reported a 2% decline in quarterly sales as sales for one of its best selling drugs, Tamiflu, declined 69% to 428 million francs. The company, which already owns 56% of Genentech, said one of the main reasons it put in the bid was because of the recent weakness in the US dollar. However, due to the worsening global credit crisis and fervent demand for the American currency, the US dollar has appreciated about 14.5% against the Swiss Franc since the $89 bid was announced. That means the $89 per share bid will now cost Roche slightly over $99 per share.

Some analysts believe Genentech will not take any bid under $105 seriously. A $105 bid from Roche in July would be the equivalent to a $119.70 bid today. Talk about a foreign exchange effect! Roche is currently sitting on an AA- credit rating and about $4 billion in cash. Their credit rating was lowered by S+P earlier this year based on the Genentech bid. $4 billion is not a significant amount of cash considering two of its competitors, Pfizer [PFE: 17.75, -0.41 (-2.26%)] and Novartis [NVS: 48.11, -0.87 (-1.78%)], are sitting on $28 billion and $16 billion in cash respectively.

Based on my calculations, the 44% of shares Roche does not own is worth roughly $37 billion when shares trade at $80. If Roche were to put in another offer at $105, that would be a 31% premium to last Friday’s close and would cost them about $57 billion. Considering Roche only has $4 billion in cash, financing this type of acquisition would be extremely costly. The graph below shows how expensive it has become for companies looking to issue debt in the current environment. Based on the current financing market, Genentech and Roche’s interdependence, the dollar’s recent appreciation and Avastin’s imminent trial data, I do not believe Roche will be able to raise an offer over $105 within the next 6-9 months. In my opinion, any offer that would occur in the near term would be modest at best.

As you can see, the public has been less than enthusiastic about corporate debt recently as the credit markets have become frozen. While firms that hedge are worried about counter-party risk, others are wondering whether their banks will survive the week. The Federal Reserve is now propping up the commercial paper market by buying up corporate debt for the first time in history. The bottom line is “Cash is King,” and companies that do not need to borrow will not borrow. In this type of environment, Roche would have to issue some of the most expensive debt for a company with its credit rating based on the size of the issuance and the current environment. If the credit markets remain illiquid for the next six months, it would be irresponsible for Roche to raise its bid.

Roche and Genentech are also tied very closely together through marketing and research and development deals. Many of their drugs are co-marketed including Rituxan, Herceptin, and Avastin. Those three compounds were all in the top ten in terms of sales for biotechnology drugs last year. Also, some of Genentech’s board members are Roche directors which will obviously cripple their negotiating leverage for a higher premium.

Avastin is a very interesting drug that has historic potential for cancer patients and Genentech’s share holders. It is already approved for the treatment of metastatic colorectal cancer, non-small cell lung cancer, and metastatic breast cancer. It is currently in late stage study for adjuvant colon cancer which could increase sales by $5 billion if approved. Trial data is expected to be completed by late 2008 or early 2009.

Analysts believe there is a slightly better than 50% chance Avastin gets approval. Shares of DNA reflect a 50/50 chance of approval as well. If the drug does get approved, revenue growth projections from 2008-2012 will have to be increased significantly from 14% to about 23% according to a Cowen and Company report. Keeping margins consistent, or slightly contracting based on higher SG+A expenses (a very conservative view), shares of DNA may be worth $120 per share.

On the other side of the coin (no pun intended), Roche is in a quagmire. Let’s assume Avastin does get approved. If they raise the bid now, they will be forced to finance very expensive debt which should put a strain on their capital structure. But, if they wait and Avastin does get approved, Roche might be unable to come up with the financing needed to give a significant premium to $120 per share. On the other hand, if Roche makes the bid and Avastin does not get approved, they would have significantly overpaid for Genentech’s pipeline.

Whether or not Roche makes another offer in the near term, Genentech offers pretty a favorable risk/reward profile. If Roche walks away from the deal and Avastin does not get approved, shares could fall to $60. This is the bear case. The near term outlook does not look favorable for a deal, but even with the bearish near term, Genentech should provide a decent payoff for those who have the courage to wait it out.

-Allen Lutz

Disclosure: The mutual fund the author is associated with is long DNA.

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