This column was originally published on RealMoney on Oct. 11 at 3:08 p.m. EDT. It's being republished as a bonus for 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 Avastin

Genentech'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.

But there was more in store for Avastin. In March 2005, Genentech announced that Avastin plus standard chemotherapy extends survival in patients with non-squamous, non-small cell lung cancer, opening up an annual market for the drug worth more than $2 billion in the U.S. The stock jumped from $44 to $55 that day, adding roughly $12 billion in market capitalization. A few weeks later, Genentech announced that Avastin extends progression-free survival in when used as a first-line treatment for metastatic breast cancer. That news sent the stock up nearly $11 points to more than $69. The first-line metastatic breast cancer opportunity is estimated to be worth $2 billion to $3 billion annually, but the clinical benefit of progression-free survival vs. extending overall survival will be a consideration for the roughly $9,000 monthly cost of drug in this setting.

In less than two years, Avastin's success opened up annual revenue opportunities worth more than $6 billion for Genentech. Avastin continues to be examined for use in other cancers including hormone refractory prostate cancer, ovarian cancer (as a first-line treatment), renal cell carcinoma and pancreatic cancer. Combined, these market opportunities could be worth several more billion dollars annually. While Genentech certainly has been reaping Avastin's financial benefits, the drug is only annualizing at $1 billion currently, implying there's plenty of growth to come.

More Drugs on the Way

The 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.

Lucentis, Genentech's experimental drug for the wet form of age-related macular degeneration (AMD), a degenerative eye disease, demonstrated meaningful benefits in study data released this year. While Lucentis was not compared directly with Macugen, Eyetech Pharmaceuticals' ( EYET) drug currently marketed for AMD, its efficacy is widely believed to be superior. Lucentis could add another $1 billion in sales per year for Genentech.

Herceptin, Genentech's $500 million per year drug used to treat a subset of metastatic breast cancer patients (HER2-positive), demonstrated it improved disease-free survival and overall survival in early stage HER2-positive breast cancer patients. Ultimately, this is likely to add another $1 billion to the annual sales for this drug.

Rituxan is considered a wonder drug for non-Hodgkin's lymphoma, but the profits from it are split with Biogen Idec ( BIIB). While the drug should generate nearly $2 billion this year for the company, it's expected to be approved soon for use in patients with rheumatoid arthritis who respond inadequately to anti-TNF therapy. This indication should help to add another $500 million in sales over time.

On top of all of this, Roche markets these drugs outside the U.S. and pays Genentech a royalty on sales. Avastin, Herceptin and Rituxan sales through Roche could contribute an additional $1 billion per year in royalties to Genentech.

A Terrible Three Days

Genentech'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?"

On Sept. 23, Genentech announced it was halting a trial with Avastin in relapsed ovarian cancer due to side effects. The news sent the shares down about $2, to close around $86. The relapsed ovarian cancer setting was an opportunity probably worth only several hundred million dollars, yet the market punished the stock as if it was more meaningful. Genentech continues to investigate Avastin as a first-line treatment for ovarian cancer, which still could be a $1 billion opportunity.

I consider this "event" to be somewhat uneventful. While the side effects seen in this trial have been seen in other cancer trials, but at lower rates, we really can't make conclusions about the first-line ovarian cancer study side effects or efficacy profile. Yet for the sake of conservativism, let's assume ovarian cancer is not amenable to Avastin therapy.

On the following business day, Sept. 26, a story broke that has been discussed for quite some time among analysts: Low doses of Avastin could be used to treat AMD, supplanting the need for Lucentis. The Genentech bulls were quick to point out that retinologists would not want to imperil themselves to liability by prescribing an unapproved therapy for such a critical function as eyesight. On the other hand, the economics are incredibly compelling: Avastin would cost $50 to treat what Lucentis could do for $1,000.

While the therapeutic rationale of an application-specific drug makes sense here, I believe human ingenuity will win the day. The Lucentis molecule is a subset of Avastin's; both target the VEGF protein. While liability is certainly a consideration, an independent study or two should eventually prove equivalency (or better) with low-dose intravitreal Avastin. Lucentis will launch and could have a few quarters or years of nice sales, but mark my words, this drug will end up as a niche product, a victim of the success of Avastin itself. Unfortunately for Genentech and its shareholders, use of Avastin in AMD could not move the needle if it tried. Given that low profit addition against the loss for Lucentis, let's subtract a cool $1 billion from our abacus in potential new sales for Genentech's product portfolio.

The last of the recent trifecta of problems to hit Genentech's stock came the next day, on Sept. 27, and involves a patent Genentech current holds and receives royalties called the Cabilly patent. The company was notified that this patent was invalidated by the U.S. Patent and Trademark Office (USPTO). Initially reported to total around $300 million per year, David Molowa at UBS believes these patents contribute roughly $130 million in royalties per year on a net basis. Genentech confirmed the USPTO's decision, but explained there is a formal review process that still could uphold these patents.

If I was a betting man, and I am, I would say that the Cabilly patent is as good as lost. Assuming Molowa's $130 million estimate is correct, this patent contributed roughly 8 cents per share on an annual basis to Genentech's EPS. Considering the stock fell around $2.69 per share that day, the market punished the stock for that 8-cent loss to the tune of a 34 multiple.

Four More Bumpy Issues

I 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.

3 and 4. Stock Options and Culture: I combine these two issues because I believe they are inextricably linked. To a certain extent, as with manufacturing, the stock option and culture "problems" are high-quality ones, associated with the company's success. CEO Arthur Levinson and his team have been nothing less than brilliant, and as far as I am concerned, the management and employees should be rewarded for the incredible gains they have delivered to shareholders. The problem, though, is academic: Genentech has been using all its free cash flow to buy back stock in order to keep the share count in check, so to a great extent all this cash is being transferred to employees.

From this point forward, large stock option grants and thus transfers of wealth to employees would be incremental to future successes of the company -- i.e., gains in the stock price. But the company recently has stated that it will be increasing headcount 20%-25% per year, which will carry the requisite option grants. Obviously, the number of options granted will be increasing, but again, the exercise prices will be at current market prices and their value will be determined by the future performance of the employees, and thus the stock.

What falls out of this thought process to me has little to do with stock options but more to do with the culture of Genentech. Genentech is no longer a small company, so how will the incremental employees add meaningful value to the company? More importantly, will those who have done so much for the culture historically still carry the same importance in the future or even still be at the company? Though I believe this is hyperbole, I imagine the janitorial staff at Genentech pulling up to work in Porsches, which makes me wonder what the new employees will expect in terms of compensation and what the shareholders should expect in terms of future productivity.

I know this conundrum is not lost on management, but there is no simple solution.

New Valuation Model, Same Old Result

There 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.

I am not one to rely on Street research in general, but I will cite David Witzke of Banc of America Securities for my "sanity test" here because he has published estimates on Genentech for 2010. He projects 2010 revenue of $16.3 billion and EPS of $4.30 for Genentech.

So the question now is, what multiple on earnings do we use? Sitting here in late 2005, I still believe there is a chance Genentech will have earnings growth rates reasonably better than the market's ahead of it, and still will be the preeminent biotech company in 2010. As a result, let's use a multiple 2 times the current S&P 500 forward multiple, or roughly 35. Our year-end 2009 target then falls between $149 and $165 per share.

The last assumption for me to make is the discount rate, which determines the price at which Genentech should trade in order to generate annual returns. I will use 20%; using this discount rate over the four-year discount horizon yields current fair value between $72 and $80 per share. Using 15% suggests current fair value falls between $85 and $95 per share.

Of course, there are limitations to any valuation exercise. For instance, the company could continue to develop new therapeutics that are additive to profits and growth by 2010. But here in 2005, I believe the bulk of the pipeline has matured and the remaining opportunities are early stage ones. Of course, Genentech's ability to innovate and succeed should not be ignored, and other drugs or new indications could prove effective, such as Rituxan use in lupus.

I believe the risks and issues I have discussed, as well as the opportunities in front of this great company, merit a lengthy consideration of the valuation its stock carries. Owning a fully priced great company may expose you to risks you are not recognizing, or it may mean that you experience suboptimal returns in exchange for the risks incurred. Genentech is a great but fully valued company, in my opinion. Even if the company executes flawlessly over the coming years, investors are likely to receive less in return than they should demand. Caveat emptor.

P.S. from Editor-in-Chief, Dave Morrow:
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Justin Ferayorni, CFA, is the founder and principal of Tamarack Capital Management and was an analyst and portfolio manager at Bricoleur Capital. At the time of publication, Ferayorni had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ferayorni appreciates your feedback; click here to send him an email.

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