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Tuesday, July 20, 1999

An Investment Opinion
by Warren Gump

Genentech's Stock Beating Again

Biotech giant Genentech (NYSE: DNA) came public (again) today, jumping $30 from its $97 offering price to close at $127. For those of you who not familiar with the story, the Genentech stock traded over the past several years was not normal common stock. Instead, it was a "special common stock" with unusual rights. Genentech's parent company, Roche Holdings (OTC: ROHHY), had the right to buy all of these shares for an escalating price that reached $82.50 on June 30, 1999. If Roche didn't exercise its right by that date, holders of the special common stock could force Genentech to buy back their shares for $60 apiece. These odd conditions basically put a collar on the old Genentech's stock price.

Last month, Roche announced that it was going to exercise its option and increase its Genentech ownership to 100%. Recognizing the value of having a publicly traded security that can be used for acquisitions and option compensation, however, Roche announced that it would reissue normal common shares representing about 16% of Genentech. Those are the shares that hit the market today. For the first time in quite a while, investors can invest in Genentech with full ownership rights (although with an 84% stake, Roche controls the show).

So what is Genentech and why am I devoting time to it? The company is now the second-largest biotech firm based on market capitalization. Although none of the company's drugs have reached blockbuster status -- more than $1 billion in annual sales -- it does have five notable products on the market, giving it the broadest major product line of any biotech firm. In addition, Genentech is also considered to have one of the best research and development (R&D) programs in the business.

Looking at the company's top line, 1998's product sales growth of 23% has accelerated further, thanks to surging revenue from two drugs. In the first six months of the year, product sales increased at a 48% clip to $503 million. Herceptin, introduced late last year for breast cancer, had sales of $86 million in the first half of the year (compared to zilch last year). In addition, non-Hodgkin's Lymphoma treatment Rituxan had an 81% increase in sales to $131.5 million. Combined revenues for other products, which include growth hormones Protropin and Nutropin, as well as heart attack drug Activase and cystic fibrosis treatment Pulmozyme increased 7% to $284 million. The company had royalty and contract revenue of $149 million in 1999's first six months, flat with the prior year.

Rising sales are extremely important to a biotech company, because it indicates that additional resources will be available to invest in R&D and support marketing efforts, not to mention boost the bottom line. Drug and biotech companies have some of the highest gross margins you'll find in any business. In the case of Genentech, that number hovers in the 80% range. For every dollar of product sales, the company only spends 20 cents on the cost of product sold, leaving quite a bit for other expenses.

Of course, those other costs are substantial. Selling, general, and administrative expenses eat up 33 cents of each dollar in revenue. This amount has increased a bit over the past year as the company incurred the costs of promoting its two new products. The other major expense for a drug company is R&D, which has claimed 28% of total revenue thus far in 1999. With more products hitting the market and sales moving higher, Genentech is trying to lower its R&D spending as a percentage of sales. Thanks to surging sales and a slight decline in the absolute level of expenses, this year's figure is down from 39% in 1998. While it would be disconcerting to see the company neglect the development of new products, Genentech's 28% R&D level is comparable to that of its peers.

Analysts seem to think that Genentech has some great things in its product pipeline. As someone with a financial background rather than a medical one, I can't provide too much analysis, but I assume it to be true given the company's terrific track record. Genentech is currently preparing regulatory filings for two drugs, Nutropin Depot for growth hormone deficiency in children and TNK for acute myocardial infarction. In addition, the company has four Phase III trials underway: two to extend use of Pulmozyme and Rituxan, and two for new drugs to help with asthma and acute coronary syndrome. The company also has several compounds in Phase II trials. To get some more details, you can check out the company's Web site.

From a balance sheet perspective, Genentech is rock solid. As of June 30th it had $1.7 billion in cash and marketable securities, the biggest hoard in the business. This should serve the company well should interesting acquisition or collaboration agreements emerge. In addition, it ensures the ability to continue investing in attractive research efforts regardless of short-term sales. Partially offsetting this cash is nominal long-term debt of $150 million.

As with any stock, there are several risks borne by Genentech stockholders. One of the biggest is potential adverse developments in the R&D pipeline. Since new medical territory is being explored, disappointments can pop up at any time. When that happens, the stock of the company invariably plunges as traders abandon ship. Genentech also faces some legal challenges. The most serious involves the University of California, which claims that Genentech infringed on U.S, patents in the development of Protropin and Nutropin. Earlier this year, a jury deadlocked 8-1 against Genentech. A new trial is now set to start on January 3, 2000. The potential stakes are quite high: UC is seeking $400 million in lost royalties and interest, a figure that could be tripled under federal patent law. On another front, competition from new drugs by other companies is also an ever-present threat in the business. At this point, however, it appears that Genentech is well positioned.

The last piece of the Genentech equation is earnings and earnings growth. The closest we can get to expectations for the company are those released prior to the Roche takeover. Analysts were looking for the company to make $1.74 per share this year, with long-term growth estimates of 25%. Due to some adjustments to agreements with Roche, this number could change when new estimates are released in the next month, but it should approximate new expectations. These figures exclude some recurring goodwill amortization created by the elimination of the special common stock, but most analysts will likely do that when they reinitiate coverage. Sticklers about value should note that about 21% of Genentech's earnings per share so far this year is attributable to interest income, which is generally less valuable to investors than operating earnings.

Genentech is a definite power to be reckoned with in the biotech industry. The growth of Rituxan and Herceptin are the engines of near-term earnings growth, while longer-term prospects are dependent on the company's well funded R&D pipeline (and the way it uses its cash stash). If valuation didn't matter, investing into Genentech would be a no-brainer to me. As someone who cares about the price I pay for companies in which I invest, I have to admit being a little reluctant. Wouldn't it be better to wait until something causes the stock to dip down? Perhaps, but then the stock might go much higher as sales continue soaring or new products make it through the pipeline.

As I make that statement, I envision the stock chart of America Online (NYSE: AOL). About three years ago, I passed on that company, hoping to pick some up at a more reasonable valuation. As you probably well know, that pullback never occurred. Holding the beliefs that biotechnology firms are poised to make dramatic breakthroughs and Genentech is one of the absolute leaders, I'll probably overlook my valuation concerns and consider taking a small stake when I can find the cash.

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