Genzyme: Short Term Traders Are Throwing Out the Baby with the Bathwater

Many value investors might normally consider biotech companies in the category to "be avoided" due to the number of overvalued, speculative, and early stage companies in the sector. Every rule, however, has its exceptions. Genzyme (GENZ) is a great company that is currently out of favor due in large part to mostly short-term issues related to contamination found at one of the Company's key manufacturing plants that has disrupted production of its most important product (Cerazyme). The company has been working hard to correct these issues and the FDA will be reinspecting the plant in the near future. Read on to learn why GENZ is a compelling value investment opportunity that has a high margin of safety but just happens to be in the biotech space.

The Company

GENZ is a global biotechnology company headquartered in Cambridge, MA that focuses on developing therapeutics that make a major positive impact on the lives of people with serious (often rare) diseases. An early focus of the company (founded in 1981) has been on relatively rare genetic diseases. Although the company started with a focus on a single rare disease, it has branched out substantially and now focus on five business segments: Renal (Kidney related), Therapeutics (enzyme replacement), Transplant (suppress rejection of organ transplants), Biosurgery, and Genetic Diseases. For more on the products and technology read this article.

Investors with short-term horizons are missing the fact that Genzyme is unique in a number of ways. Out of hundreds of biotech companies, it is one of around a dozen or so that are already actually profitable and have been cash flow positive for some time.

Unlike most biotech companies, Genzyme can fund its growth from existing cash flow, thereby limiting most of the dilution that comes with most other biotech companies. The company already has an existing approved product pipeline whose organic revenues and cash flow are worth more than the current price of the firm.

Also enticing: the company has a very robust pipeline of compounds in development, including a number of late stage compounds that could be approved and generate significant additional revenue within the next 2 to 4 years on top of an already solid business. The management of the company is both visionary and has a track record of executing and creating value for shareholders.

The Business

Genzyme has an outstanding track record of both topline and cash flow growth as summarized in the table below:

Year	Revenue ($ MM)	Cash from Operations ($ MM)
2008	$4,605	759
2007	3,813	918
2006	3,187	888
2005	2,734	731
2004	2,201	577
2003	1,713	387
2002	1,329	219
2001	1,223	225
2000	903	177
1999	772	204

Rare for its industry, the company has demonstrated that it is actually a very good capital allocator. The cash flow numbers are potentially more relevant in this case than the net income for the following reason.

The major investments made by the company are in R&D. Under GAAP, the company is required to expense R&D in the year incurred, even though the benefits of the investment don't materialize until many years later. The company has demonstrated its discipline in its R&D investments, which have led to many already successful and approved compounds as well as a robust pipeline.

If R&D expenses were capitalized and then expensed over time, the net income would approach and be much closer to the cash from operations figure indicated above. Genzyme has also been shrewd and selective in acquisitions it has made. For the most part, these acquisitions have been done for cash, thereby reducing the dilution to Genzyme's common stock holders and preserving most of the future value creation from acquisitions for itself.

The above track record as summarized in the company's financials is exceptional for its industry and is a testament to the company's management, particularly to the CEO, Henri Termeer, who has been with the company essentially over its entire history and has created and driven it to its present level of success.

Of course, the above table simply captures the past, and what we care about is the future. On this score, Genzyme is also promising, not only because management is exceptional and responsible in capital allocation, but also because past investments made by the company position it today with an exceptionally deep and broad pipeline with a number of potential future blockbusters that could help the revenue and cash flows above continue to double or triple in the next 5 to 7 years.

Although the company is attractive solely based on its current pipeline of approved products (which can still grow from here), the current pipeline "has 12 drugs in stage 3 of FDA trials, nearly 22 drugs in stage 2 of FDA trials, 7 in stage 1 and 11 in pre-development."

Most biotechs are lucky to have one or two promising candidates, whereas Genzyme has dozens in over five different areas. The company's past track record of taking compounds out of the lab and commercializing them is exceptional. If even a fraction of this success rate can be continued in the future, the company has exceptional prospects for revenue and cash flow growth from here. Many of these compounds, however, have blockbuster potential, and there are several billion dollar revenue opportunity therapies among its stage 3 pipeline alone.

Short-Term Issues and Moat related to manufacturing

On June 16, 2009, Genzyme announced that it had detected a viral contamination at its manufacturing plant in Alston, MA, that cost over $200M to build, and indicated that sanitizing this facility would disrupt the company's ability to produce enough quantities of one of its flagship products (Cerazyme, to replace a missing enzyme for those suffering from a type of Gaucher disease). The company voluntarily reported this issue to the FDA and put into place procedures to sanitize the facility (an intensive and expensive process) to try and get production restarted by late July 2009. Since several different biotherapeutics are produced at the Alston facility, production of Fabrazyme was also interrupted. This manufacturing issue is short-term in nature and will be corrected sometime in 2009.

A long-term implication of this development, however, also has investors worried. Specifically, GENZ previously has had little competition for its therapies. There have been no alternatives for patients and patient populations serving the rare/orphan diseases that Genzyme targeted with their lifesaving therapies often paid as much as $200K per patient per year (generally paid by insurance or governments). Given the disruption to the availability of Cerazyme, the FDA reached out to Shire Plc (SHPGY) and Protaxlix Biotherapeutics (PLX), who are both developing alternative therapies for Gaucher (to compete with Genzyme), but who's therapies are not currently approved (they are in 3rd stage of development).

These developments have worried investors that the door is now open to competition (which was inevitable and anticipated) for Genzyme's Gaucher treatment and that GENZ's manufacturing issues may have accelerated by some period the availability of competing therapies.

On the flip side, the difficulty GENZ has experience with its manufacturing processes is a testament to how difficult it is to manufacture biotherapeutics. Unlike conventional pharmaceuticals which involve mixing active ingredients, biotech manufacturing processes are much more difficult (and often unpredictable). This is because companies like Genzyme use bioreactors (which themselves are very expensive) to "grow" the enzymes or therapies they produce using recombinant technology. Genzyme is vertically integrated, and has the experience and the capital to do this well. Not many other companies in the world have this expertise, and the ability to manufacture biotherapeutics in quantity is a specialized skill set that will be increasingly valued in the future. The company has spent over $800M just developing its bioreactor manufacturing plants and has the in-house staff to capitalize on these efforts.

In late July, the FDA announced that it was going to visit the Alston plant to conduct an inspection, and this spooked investors. However, it seems that the most likely outcome of this visit is that the FDA will test and recheck the measures that GENZ has already taken. There is a decent chance that the visit would provide an FDA stamp of approval to the measures that the company has already taken, which might even end up reassuring investors.

Margin of Safety

When you buy GENZ at today's prices, you get a few things:

1. Existing approved product stream and approved therapy pipeline that should throw off additional revenue growth and cash flow.
2. Robust and deep development pipeline with many late stage compounds.
3. Outstanding management with history of value creation.
4. Bioreactors and manufacturing expertise that is rare and valuable.

The downside in GENZ is limited, because there are multiple large pharma companies that are struggling with how to replace revenue (let alone grow) revenue and they would love to buy a company like GENZ (even at a substantial premium) - probably close to $80 to $100 per share. However, it is unlikely that GENZ would sell because the combination of factors outlined above are powerful, and GENZ already has all the pieces that it needs to capture the value creation that will result from executing on its current position and strategy over time.

At approx 14x forward earnings, Genzyme is trading at a significant discount to its future earnings and cash flow. As earnings grow organically and short-term manufacturing issues are resolved, the combination of higher earnings and a higher multiple will make this an outstanding investment.

Disclosure: At the time of this article, my investment firm may be Long GENZ in some of the portfolios we manage.