This column was originally published on RealMoney on Oct. 11 at 3:08 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.Since early 2003, Genentech's ( DNA) stock has been on a phenomenal tear. It's up fourfold, which is amazing when you consider that it sported a $20 billion market capitalization at its outset. In these last two-and-a-half years, management's sharp focus on extremely well-validated science and large, unmet markets has borne tremendous fruit for shareholders. The company has long been a key holding for the biotech intelligentsia as a result of management's scientific slant, but the company's clinical success has been nothing short of astounding: It has been batting nearly 1.000 since 2003 in drug trials. Shareholders who have been patient enough to hold tight have been rewarded over and over, and the stock became a self-fulfilling prophesy of success, almost hitting $100 per share before a few concerns emerged that sent the stock into the $80s. While Genentech's financial future undoubtedly looks bright, Genentech's stock still carries an incredibly high valuation by any metric. Investors must ask, "What am I paying for and what should I expect in return as a Genentech shareholder?" I believe that most prudent long-term investors will conclude that they're paying for a great company, but one that's so fully valued it won't deliver the kind of returns that will make its considerable risks worthwhile.
All About AvastinGenentech's stock began its blastoff on May 19, 2003, when the company announced that its experimental drug, Avastin, markedly extended survival in metastatic colorectal cancer patients. The stock leapt almost 50% that day, closing at a split-adjusted $27.43. This trial's success opened up an annual market of $1 billion to $1.5 billion in the U.S. for Avastin in colorectal cancer. Avastin's first sales came in the first quarter of 2004, when the stock was trading in the $50s. Over the course of 2004, Genentech was able to increase sales over 2003 by 40% while increasing earnings per share by 44% on an adjusted basis. Avastin's sales in its first year totaled $545 million in the U.S. and continued to grow quickly. While these financial successes were incredible, the stock was rangebound for most of the year, trading between $40 and $60.
More Drugs on the WayThe rest of Genentech's drug development portfolio has been working overtime as well. Between late 2004 and late 2006, Genentech will have introduced two new drugs, Tarceva and Lucentis, and supplemented two existing drugs, Herceptin and Rituxan, with new indications that should increase Genentech's revenue potential by an additional $3 billion. Tarceva, an orally administered drug for lung cancer, was approved in late 2004. It should quickly become a $400 million to $500 million per year drug. Genentech splits the profits on this drug evenly with OSI Pharmaceuticals ( OSIP), though, which means the drug will have less of an impact on profitability.
A Terrible Three DaysGenentech's new product introductions starting in early 2004 address markets that could increase product sales between $7 billion and $10 billion over time, on top of a product sales base of $3.7 billion in 2004. In addition, the $1 billion in royalties from Roche sales overseas mentioned above could be added to that pile. It's no wonder that with all this profit opportunity ahead of the company, Genentech's stock has been en fuego. A recent flurry of events surrounding the company, though, has the stock trading in the mid-$80s, leaving shareholders and other observers asking, "Is this a good entry point to a great growth stock for the future, or is it time to get off this rocket ship?"
Four More Bumpy IssuesI believe four major issues must be considered when evaluating this stock. These issues could shape the value of the company over the next few years, and frankly, I have not formed firm conclusions on them myself. 1. Manufacturing: Genentech has enjoyed so much success so quickly that it will need to execute its manufacturing plan perfectly in order to avert capacity problems. Heaven forbid any seismic activity were to kick up around its manufacturing plants, especially in South San Francisco. It could seriously derail the company's ability to satisfy demand. 2. Avastin, Avastin, Avastin: If you have read this far, you have to have recognized the significant opportunities and equally significant risks posed by Avastin. Avastin theoretically could address markets worth $9 billion in sales in the U.S. on top of the $1 billion per year it generates now, and I can assure you there will be a lot of visible hands going after all that loot. Genentech certainly has the advantage of being first in the market. All subsequent agents will have to go head-to-head against Avastin, which will require longer trials, i.e., more time and money. Nevertheless, you can guarantee the capital allocation process at many other pharmaceutical and biotech companies will include this high-value target.
New Valuation Model, Same Old ResultThere is no doubt that Genentech will put up phenomenal earnings growth over the next few years, but the stock trades for nearly 65 times my $1.33 earnings estimate for 2005 and 41 times my 2006 estimate of $2.07 per share. While this is not cheap, many would suggest that Genentech could "grow" into its multiple. So how do we determine what to pay for this type of growth? For companies experiencing hyper-growth such as this, I find it useful to look further out to the future and use a more reasonable multiple on a relatively lower earnings growth year, and then discount that figure backward to determine what I'm willing to pay today for the stock in question. Using 2010 as a target year, let's create a few assumptions to estimate what Genentech will look like. As I mentioned, Genentech's product sales base in 2004 was roughly $3.7 billion, not including an additional $870 million in royalties and contract revenue. For argument's sake, assume this grows at a compounded rate of 12% over that period of time, but first subtract that pesky $120 million as a result of the Cabilly patent. Then let's assume that by 2010, Genentech is able to achieve 80% penetration into the market opportunities I have discussed above, which include $6 billion for proven Avastin markets, $500 million for Tarceva, $1 billion for Herceptin, $500 million for Rituxan and none for Lucentis. On top of this, let's assume Genentech has a 50% chance of capturing 50% of the remaining $3 billion in Avastin opportunities, which included ovarian cancer, and add $800 million in Roche royalties. After running this math, we arrive at $16.8 billion in 2010 sales. Using a figure for operating margins between 45% and 50% of in 2010 (2004's operating margin was 30%), a 35% tax rate and 1% share count growth from 2005 through 2010, we arrive at EPS figures between $4.25 and $4.75 per share. These figures do not include costs for stock option expensing.
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