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Friday, March 19, 1999

An Investment Opinion
by Warren Gump

Could Roche Pass On Genentech Option?

An interesting story is developing between biotech giant Genentech (NYSE: GNE) and Swiss pharmaceutical and chemical company Roche Holdings (OTC: ROHHY). Back in 1995, Roche took a majority stake in Genentech. Simultaneously, all Genentech stock not owned by Roche was converted into "special common stock." Under terms of this unusual security, Roche has the right (using Genentech as a conduit) to purchase all outstanding shares through June 30, 1999. Since Roche can have the stock called at $82.50 and Genentech's earnings and pipeline is quite strong, many people assume Roche will exercise the option. For some reason, however, Genentech stock is trading above the call price at $83 11/16.

Let's stop and think about this for a second. Roche has the right to call all of Genentech's stock for $82.50, yet the stock is trading above this level? That doesn't make a heck of a lot of sense. Why would you pay more than the call price of a stock? It sounds like a guaranteed way to lose money. An investor buying the stock today is at risk of Roche coming in and saying "Hey, I want those shares and have a legal right to buy them at $82.50." (Actually the current call price is $81.00 per share; it increases to $82.50 on April 1.) If an investor paid more than that amount, she loses the difference.

Why, then, is Genentech stock trading above the $82.50 call price? Some people are speculating that Roche will not exercise the call provision. Intuitively, this doesn't make a lot of sense given the very bright prospects for Genentech. Seeing the opportunities ahead for both the company and industry, I would think that Roche would like to get its hands on 100% of biotech's second largest company.

My intuition may not lead to the ultimate decision by Roche, however. In an interview with Bloomberg in January, Genentech CEO Art Levinson stated that he would prefer that the company stay independent. He added that he had no control over Roche and how they would proceed is unclear. Initially, I couldn't really think of a reason for Roche to pass on Genentech. How could Roche, with a fiduciary responsibility to its stakeholders, decide to forego an opportunity to make what appears to be a terrific investment?

The answer dawned on me earlier this week when evaluating the situation further. Roche might actually benefit from having a small stake in Genentech publicly traded. As a separate entity, Genentech will likely continue to trade at the lofty multiples associated with the high growth biotech world. Having a higher valued currency will enable the company to be more competitive when battling other firms for acquisitions and strategic alliances. For some perspective on the valuation difference between the two companies, the market currently accords Roche a price-to-earnings (P/E) ratio of about 30, compared to 51 for Genentech.

If Roche were to own all of Genentech, the company's $181 million in net income would be just a ripple in the $3 billion pond of net income produced by Roche. While analysts would certainly be interested in the progress made by the biotech division, it would not have a huge impact on the overall performance of Roche. Genentech's rapid growth would be overshadowed by the much slower growth of all of Roche's other business. If traded separately, however, investors could continue placing a value on Genentech's huge opportunities.

Last week, U.S. chemical giant DuPont (NYSE: DD) decided to spinoff its life sciences division as a tracking stock. The reasons for issuing this new security were to provide investors with a pure play on this faster growing business, to facilitate future transactions, and to provide better incentives to life sciences employees. If DuPont is going to all of the trouble of segregating the company into two to have a pure play on a life sciences company, would it really make a lot of sense for Roche to buy up what is in essence a pure play on some of its biotech operations?

I don't know what Roche will do with Genentech, but it will be interesting to watch. Does management believe it would be better to own 100% of a fast-growing company that will be buried among its other myriad operations, or would they prefer to own a majority of the fast growing company with the remainder publicly traded? We should learn the answer to this question in the next three months.

Call Your Boss a Fool.

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