New Digs for Genentech Shareholders: The Roche Motel

Roche has scored in a big way, buying the remaining 33% of Genentech it doesn't own at below the market price.
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Genentech

(GNE) - Get Report

shareholders lost.

In a clever deal that Swiss drug company

Roche

ginned up, it will buy the part of Genentech that it doesn't already own for $82.50 a share, the strike price it negotiated in 1995. Roche scores in a big way, buying the remaining 33% at below the market price. Genentech closed Wednesday at 86 1/2 a share.

Roche will continue to score big when it spins off up to 19% of Genentech in an offering slated for the next couple of months. It will file a registration statement in the middle of this month.

For Genentech, it's a wash: Employees will be told to hold on and that Genentech will remain the quasi-independent research shop it has been for the last nine years. Employees will still be able to get options on Genentech stock, and there likely will not be a brain drain, analysts predict.

But all the saps who bought -- or told investors to buy -- Genentech stock above 82 1/2 a share were just plain wrong. "The losers are the Genentech shareholders. Roche has just screwed anyone dumb enough to have bought over $82.50 a share," says one New York health care hedge fund manager who had no position in the stock.

"It was almost a dare," adds Jon Alsenas of

ING Baring Furman Selz

. "The market was saying Genentech is worth so much more than $82.50 that it was willing to take the risk of having the rug taken out from under them." (Furman Selz rates Genentech a hold and hasn't done banking for the company.)

On the news Thursday, Genentech's stock fell 4 1/2 to 82.

These investors and analysts didn't figure that Roche would take their dare. As if the big company wouldn't be dictated by the finances. It was kind of like thinking that

The Donald

dates models for the scintillating conversation. More importantly, many on Wall Street didn't foresee that Roche might buy the company and then spin off a portion to investors.

Salomon Smith Barney's

Meirav Chovav,

Merrill Lynch's

Eric Hecht and

BancBoston Robertson Stephens'

Jay Silverman were the analysts with buy ratings going into the Roche decision. The three couldn't be reached for comment.

Some analysts, however, were cautious. Along with Alsenas,

CIBC World Markets'

Matt Geller,

SG Cowen's

Eric Schmidt and

Goldman's

May Kin Ho were among those with holds.

Roche bought the first 60% of Genentech in February 1990 for about $2.1 billion and spent about $400 million on the open market in the intervening years, estimates Alsenas. Buying the remaining portion of Genentech will cost Roche about $3.7 billion.

But Genentech was sitting on $1.3 billion in cash and cash equivalents and another $767 million in long-term securities at the end of the first quarter. That means Roche's net cost is about $4.1 billion. Genentech's market cap is $11.07 billion. Not a bad investment for Roche.

And it gets better when Roche spins off the Genentech stake. Analysts say they expect the price to be well in excess of 100 a share, possibly 110 to 120. Selling 19% at 110 a share would give Roche around $2.75 billion, depending on the structure of the company. It's a brilliant arbitrage by the Swiss; no wonder investors are cheesed.

Roche and Genentech didn't return phone calls seeking comment.

Questions remain about what kind of baggage Roche will saddle Genentech with. Roche will have to give back some of the cash for working capital, certainly in the hundreds of millions. The lower that grant, the worse for Genentech. Then there's the question of what kind of rights Genentech will have to its products. Today, Roche gets the right of first refusal on marketing Genentech products outside the U.S. If Roche alters that deal to make it more attractive for itself, the Genentech spinoff would be less attractive. Further, it's not known what kind of governance Genentech will have. Currently, Roche has two of the 13 Genentech board seats.

Genentech is widely regarded as the premier research concern in biotech, and President and CEO Art Levinson is viewed as one of the best in the business. Genentech's

Herceptin

for breast cancer and

Rituxan

for lymphoma (developed by

Idec

(IDPH)

) are both growing nicely and bettering expectations. Genentech's pipeline is regarded as strong with approval of

TNK

, a heart attack drug, and

Nutropin Depot

, an extended release version of human growth hormone, expected in the next year or so. In July, the company will make public Phase III data on

Xubix

, an oral anti-clotting agent. An allergy drug, called

anti-IgE

, has promise.

But the pipeline has had two high-profile failures recently. Its nerve growth factor bit the dust in Phase III and the company had a setback with its blood vessel growth drug this year.

Analysts estimate that the company will earn $1.73 a share this year, $2.19 a share next year and $3 a share in 2001. At 110 a share, Genentech would trade at 50 times 2000 earnings, a pretty hefty price. Analysts seem to think it's appropriate to buy stock at twice its growth rate these days.

Then again, they thought that Roche would leave Genentech alone.