More Genentech Shares On the Way (News) October 8, 1999

More Genentech Shares On the Way

By Brian Graney (TMF Panic)
October 8, 1999

So, how would you like to make $2 billion in less than four months? Impossible, some might say. But judging from news out of biotechnology firm Genentech (NYSE: DNA) today, that's exactly what its Swiss parent, Roche Holdings, is set to do.

The story behind the financial magic trick started this summer. In June, Roche spent $3.76 billion to exercise an outstanding call option it had in its back pocket to purchase all of Genentech, acquiring the 35% stake in the firm it did not already own at a price of $82.50 per share. As documented by fellow Fool Warren Gump, a month later Roche then turned around and resold a 17% stake in Genentech to the public at $97 per share, raising $1.9 billion in the process.

With Genentech's shares trading north of $150 per share for the past six weeks, Roche decided that now was a good time to dip into the Genentech stock well once again. The parent announced today that it will sell another 15.6% stake in the firm to the public, or 22 million Genentech shares (including underwriters' over-allotments). Excluding the effects of a planned tag-along sale of bonds convertible into 5.5 Genentech shares, the move will result in a $3.8 billion payoff based on Genentech's closing price of $172 13/16 per share yesterday.

To sum up, Roche bought a 35% stake in Genentech for $3.76 billion and will end up selling a 32.6% stake in the company back to the public for a total possible price tag of $5.7 billion -- all in less than four months' time. Pretty nifty, eh? But instead of immediately decrying Roche's actions as some sort of unfair financial sleight of hand, investors should take a look at how the transactions have affected the relative attractiveness of Genentech as a possible investment.

Right off the bat, Genentech shareholders do not have what was effectively a collar on the stock anymore. Without the Roche call option providing a stock appreciation ceiling, Genentech's shares are now able to trade according to future expectations about its business results, not its future ownership structure. Roche said that the second stake sale announced today is intended to increase the liquidity of Genentech's shares, making them easier to trade "as requested by the market." Catering even more to investor psychology to make its shares attractive, Genentech added that it will split its stock two for one.

On the day-to-day business front, the changes are less noticeable but are more important. The size of Genentech's board has been trimmed and $1.67 billion of the purchase price paid by Roche in June has landed on Genentech's balance sheet as goodwill, which will be amortized. Moreover, Roche has granted itself a new option to obtain the European distribution rights for Genentech drugs in the pipeline after they cross the critical Phase II trial hurdle.

Roche can make the distribution decision as late as the end of Phase III trials and has agreed to fork over 50% of the development costs through Phase II and 75% of Phase III if it chooses to pick up the option for any drug. That could be an interesting advantage for Genentech, which could conceivably plow the cost reimbursement into expanding its research pipeline while also receiving a pretty generous royalty rate from the optioned drug.

As for all biotechnology companies, the richness of the product pipeline and the company's valuation level will ultimately determine long-term shareholder results. Without question, Genentech looks to be in good shape in the pipeline department. According to a recent Warburg Dillion Read report, the company has three drugs or indications in Phase II trials, eight preparing for or in Phase III trials, and two awaiting regulatory approval.

Good vibes about the company's existing cancer drugs Herceptin (breast cancer) and Rituxin (non-Hodgkin's lymphoma), which some are expecting to develop into blockbusters one day, are propelling the stock price. According to the company, sales of Herceptin were $47.9 million in Q3, up 4% sequentially. Meanwhile, sales of Rituxin were down 3% from last quarter but up 84% from a year ago at $72.4 million. Another cancer drug, the solid tumor fighting Anti-VEGF, has a bright outloook and is in Phase II trials.

Valuation may be of some concern at this point, but biotechnology investors should take some time to reacquaint themselves with the public-again Genentech. While no one can guarantee a $2 billion return, a few hours of research into its large, innovative, and promising drug pipeline today could reap substantial dividends if the company's valuation becomes more attractive down the road.

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