Genentech: Good Company, Bad Investment

Like my colleague Philip Durell, lead analyst for the Fool's Inside Value newsletter service, I am a true-blue investing cheapskate. Actually, I'm a cheapskate in general. Just ask my wife. Especially when it comes to identifying worthwhile investments, though, I'm all about the valuations -- at least when it comes to the initial phase of research. Why waste precious time investigating companies that are overpriced?

I'm generally much more interested in companies such as Johnson & Johnson (NYSE: JNJ  ) and Inside Value pick Pfizer (NYSE: PFE  ) -- which are trading close to 52-week lows -- than I am in the likes of Rule Breakers pick Akamai Technologies (Nasdaq: AKAM  ) or Qwest Communications (NYSE: Q  ) , both of which are within spitting distance of their respective 52-week highs.

To be sure, even dyed-in-the-wool cheapskates know that, sometimes, even companies whose stocks have taken on rocket boosters remain attractive investments. I'd argue, however, that biotech behemoth Genentech (NYSE: DNA  ) , whose stock has shot up by roughly 76% this year, ain't one of them. Indeed, given what I prefer to call my frugal cast of mind, the San Francisco-based drugmaker is a prime example of how a good company can make for a bad investment.

Good company ...
I'm not a doctor, nor do I play one on TV, but even casual followers of the pharmaceutical industry are likely to be at least vaguely familiar with some of Genentech's product line. The company is responsible for such widely prescribed cancer fighters as Rituxan and Herceptin, as well as Avastin, a recent "blockbuster" drug that chokes off the blood supply to tumors. The company also produces Xolair, a medication designed to treat persistent asthma.

What's more, the company is in sound financial shape. For the trailing-12-month period that ended with September, Genentech's free cash flow -- cash from operations less capital expenditures -- came in at more than $652 million during the third quarter of fiscal 2005.

One last point on the plus side: Genentech's forward-looking prospects. To be sure, given the regulatory obstacle course that every drugmaker has to navigate -- not to mention the inherent business risk of clinical setbacks -- analyst estimates for companies in the pharmaceutical industry need to be taken not with a pinch of salt, but rather with a block of it.

Still, according to data available from First Call/Thomson Financial, the median growth rate that analysts expect for Genentech over the next five years is 31.5%. Meanwhile, even the most pessimistic of the forecasts calls for the company to grow earnings at a 23% clip over that stretch of time.

Not too shabby, eh?

. Bad investment
Before answering that question, let's examine the company from a valuation perspective. For starters, even after Friday's decline of 2.5%, Genentech's stock -- which currently hovers around $96 a pop -- is just a stone's throw away from its 52-week and five-year high-water marks. And then, of course, there's the matter of its price multiples.

Stock valuations in the biotech industry are expensive in general, but on a trailing-12-month basis, Genentech's price-to-earnings, price-to-book, price-to-sales, and price-to-cash flow figures all dwarf those of the broader market. And as gauged by its P/E ratio -- Genentech's is currently near 90 -- the company makes peers such as Gilead Sciences (Nasdaq: GILD  ) and Amgen (Nasdaq: AMGN  ) look positively cheap.

True, some companies deserve to trade at a premium relative to both the broader market and industry peers. But again, I'd argue that investors have bid Genentech up too far, too fast.

How do you know?
An excellent question. I'm a big fan of healthy skepticism, and that's why I'm also a big fan of discounted cash flow analysis when it comes to taking stock, so to speak, of a company's valuation. DCF is hardly a silver analytical bullet, but because it's much more difficult for a company to fudge cash than earnings, it's the methodology I prefer.

And speaking of preferences, I'm also a big fan of the DCF calculator that comes gratis with a subscription to the Fool's Inside Value newsletter. In earlier commentaries, I've extolled the virtues of this tool, which provides prospective investors a straightforward way of determining whether a company is worth further research -- or too hot to handle.

So what does the DCF oracle -- I mean, calculator -- say about Genentech?

Well, after plugging in numbers for discount rate (i.e., the return that you as an investor require, given a company's business risk), cash flow, estimated earnings growth, stock price, and shares outstanding, the answer is ...

Genentech looks considerably overvalued right now. Even after using fairly aggressive earnings estimates and a lowball discount rate of 9%, the DCF calculator estimates the company's intrinsic value to be significantly below its current price. Biotech junkies may want to hit the company's financials to determine why that's the case, but given my, um, skinflintiness, I prefer to see what's available over on the market's sales rack.

On that rack, I think, lie superior investment returns.

For related biotech Foolishness:

Pfizer is aMotley Fool Inside Valuerecommendation. Akamai Technologies isaMotley Fool Rule Breakerspick.

Looking for top-notch companies at bargain-basement prices? A subscription toMotley Fool Inside Valuecan help you find the market's best bargains. Sign up today for a free 30-day trial.

Shannon Zimmerman is the lead analyst for the Fool'sChampion Fundsnewsletter and doesn't own any of the securities mentioned. The Fool has a strict disclosure policy.


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