Genentech: Priced for Perfection

Genentech (NYSE:DNA) recovered from numerous setbacks in 2002 to have a great year in 2003. The FDA recently approved three of its drugs (Xolair, Raptiva, and Avastin) and revenue grew to $3.3 billion, up 28% over 2002. With the introduction of the new drugs, the company's revenue and earnings are expected to grow substantially over the next few years.

While these drug launches are good for the company, investors may have missed the opportunity. The stock is up over 200% from the low of the last 12 months and the current market cap is a lofty $55 billion. The pressing issue is not whether or not Genentech is overvalued, but to what extent. Is it even possible for the current product lineup to create the growth that will justify the current valuation?

I took two approaches to determine the extent to which the market is overpaying for Genentech's growth. First, I compared Genentech to other drug developers with similar market caps. The purpose of this relative valuation analysis was to try to get a feel for what Genentech's valuation could be if its new drugs accelerate revenue and earnings growth. I put together a table of revenues, earnings, and market caps comparing the company to another large biotech, Amgen (NASDAQ:AMGN), and two pharmaceutical companies, Eli Lilly (NYSE:LLY) and Wyeth (NYSE:WYE). All figures are in billions except for the trailing P/E ratio.

Genentech's market cap is comparable to these other drug companies, but the company's revenues and earnings are a fraction of what the other companies generate. Therefore, Genentech's P/E is far in excess of the P/E ratio from the other drug companies. Genentech has a higher market cap than Wyeth, which has a whopping $12 billion more in revenue. Genentech doesn't even have one-third of Wyeth's profits.

Some may make the argument that the rapid growth Genentech is about to experience justifies the higher multiple and a market cap in line with some of the large pharmaceutical companies. However, I think the rationalization that high growth justifies the high market cap is flawed and cannot be supported -- even using the most optimistic of assumptions.

For example, annualized revenue growth of 25% will nearly double revenue to $6.4 billion in 2006. I estimate that these revenues would generate earnings of approximately $1.2 billion. Even after three years of robust growth, which does seem likely to occur, Genentech would still have less than half of the revenues and earnings of the pharmaceutical companies. Of course, that is not the problem. The problem for investors is: What happens to Genentech's market cap even if the company delivers such stellar performance?

What is a drug company with $6.4 billion in sales and $1.2 billion in earnings worth? The table above suggests a market cap less than $50 billion would be appropriate for such a company. Yet, that is essentially Genentech's market cap right now. Hmmm.

To take another approach, applying a more reasonable P/E multiple of 40 to the $1.2 billion in earnings I estimate for 2006 gives a market cap of $48 billion. Uh-oh. That is 13% below the current market cap. No matter how I look at it, it appears that Genentech's investors could see very strong earnings growth yet experience very little appreciation in the value of their company.

With several years of growth already priced into the stock, current shareholders need to hope for the maintenance of exceptionally high multiples for several years. Alternatively, investors could hold for a much longer time frame under the assumption that over a period of, say, 10 years, a high-quality company like Genentech will outperform the market.

However, with growth expectations already priced in, "stock stagnation" will likely be the best-case scenario over the next three years. The primary risk is that the sales growth, which the market assumes will occur, is slower than expected. Slower-than-anticipated growth will cause the current P/E multiple to contract and the decrease in value could be significant. With such a hefty premium, if Genentech stumbles at all, it will be very costly.

Tom Gardner welcomes Charly Travers as guest analyst for the current installment of Motley Fool Hidden Gems . If you like what you see here, sign up for your 30-day free trial of the newsletter and find out what undervalued small cap Charly has unearthed.

Unlike Genentech, guest columnist Charly Travers stopped growing a long time ago. He does not own shares in any of the companies mentioned in this article. The Motley Fool is investors writing for investors.