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JUNE 23, 2003
Parsing the Price of Genentech A randomized Phase III study in previously untreated metastatic colorectal cancer patients evaluating Avastin (TM) (bevacizumab, rhuMAb-VEGF) plus chemotherapy versus chemotherapy alone met its primary endpoint of improving overall survival. -- Genentech, June 1, 2003 Did you see Genentech's stock jump? Who didn't? The morning after this news, it spiked up almost eight bucks. Now near $70, shares of this biotechnology pioneer have more than doubled in 2003. Quick! Gimme some of that. First, let's see what $70 buys you. For each share, you would get a claim on $2.86 in working capital; $2.15 in property, plant, and equipment; $3.90 in miscellaneous assets, including 50 cents worth of other biotech stocks, plus $4.29 in such intangibles as patents. Total assets: $13.20 a share. How about liabilities? The balance sheet lists liabilities of $2.77 a share. Subtract that from Genentech's assets, and each $70 share of stock would buy $10.43 in net equity. There's also this wild card: An arbitration panel is expected to rule by June 13 on Genentech's dispute with Tanox (TNOX ) its partner in developing Xolair, an asthma drug that is now awaiting Food & Drug Administration approval. Genentech warns that Tanox wants monetary damages "many times" in excess of $100 million. Each $100 million could be 19 cents a share in fresh liability. Genentech wants damages, too, but won't say how much. If net equity is only $10.43, what does the other $59.57 buy? No cash dividends. But you would be entitled to hold out lots and lots of hope for lots and lots of future profits. Right. Those patents and that biotech knowhow must be worth more than the balance sheet says. Doesn't Genentech boast a pipeline full of promising new products? Yes, it has several in various stages of the approval process. Some will doubtless generate sales one day. But as they do, some established products are fading. An older innovation, human growth hormone, is losing patent protection, while the market share of another drug, clot dissolver Activase, is declining because rivals' newer alternatives, such as Centocor's Retavase, are gaining. I heard on CNBC that this new cancer drug, Avastin, could be good for more than $2 billion in annual revenue, nearly as much as Genentech took in last year selling drugs. Let's suppose so and do a little mental exercise. Imagine Avastin has already been approved. Next, pretend it adds $2 billion to Genentech's sales this year. Then, all else equal, Genentech might earn a hypothetical profit this year of, say, $1.80 a share instead of Standard & Poor's forecast of $1.18, one of the higher estimates around. So what? Even if Genentech already had a monster hit with Avastin, at $70 a share it would be selling for 39 times this year's profit -- a steep multiple on insanely bullish assumptions. Why is that so insane? That's the future! Genentech has been in business since 1976 and has been selling drugs since 1985. None has ever brought in $2 billion in annual revenue. Its top seller, a non-Hodgkin's lymphoma treatment called Rituxan, was on the market for more than five years before it broke the $1 billion mark in 2002. What do you have against curing cancer? Nothing. But look at it this way: Suppose Genentech were a bond, not a stock, and it paid out all its earnings as a dividend. On a $70 share price, our fantasyland profit of $1.80 a share works out to a yield of 2.6%. You can get almost that much on a one-year bank certificate, insured by the feds. What if I just buy the stock and wait to sell it at a higher price to somebody willing to accept an even lower imaginary yield? Yes, you might be able to do that. Or why not invest instead in another cancer fighter? Merck, perhaps. It's yielding 2.5%, real cash. You might call it the Lesser Fool Theory.  By Robert Barker
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