Roche Covets Genentech For Good Reason

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Includes: AMGN, BMY, GSK, RHHBY
by: Victor Cook

Personalized medicine - diagnosis and treatment based on sequencing DNA -- burst into the headlines on September 18, 2008 with the revelation by Google (NASDAQ:GOOG) co-founder Sergey Brin that he carries the rare Parkinson's disease marker LLRK2:

… I learned something very important to me -- I carry the G2019S mutation and when my mother checked her account, she saw she carries it too. The exact implications of this are not entirely clear. … Nonetheless it is clear that I have a markedly higher chance of developing Parkinson's in my lifetime than the average person.

Mr. Brin thus introduced us to the company that decoded his DNA: 23andme.com. Their website says:

The name 23andMe refers to the 23 pairs of chromosomes that make up each individual's genome. 23andMe connects individuals to their unique, paired set of 23 chromosomes.

Just two days before this revelation, Nicholas Wade reported in his New York Times story that David B. Goldstein, Director of Duke University's IGSP Center for Population Genomics & Pharmacogenetics, discounts the promise of personalized medicine:

"There is absolutely no question," he said, "that for the whole hope of personalized medicine, the news has been just about as bleak as it could be."

THE FIRST BIG BET
Roche Holdings AG (OTCQX:RHHBY) so coveted Genentech (Private:DNA) that on Monday July 21, 2008 it offered to buy the 44% of shares it did not already own. That offer represented an 8.8% premium on DNA's closing price on Friday July 18,2008. By most accounts, Roche is Goliath and Genentech is David in the valley of the Biotech pharmas. Based on two leading measures of size in the following table, RHHBY dominates DNA on sales revenue and leads on market value. The table includes three other peers: Amgen Inc. (NASDAQ:AMGN); Bristol-Meyers Squibb Co. (NYSE:BMY) and GlaxoSmithKline (NYSE:GSK).

Value and Sales 5 Firms 9.3.08

Roche sales revenues in the most recent quarter were $12.0 billion USD compared with Genentech revenues of $3.2 billion. On September 3, 2008, Roche market cap was $146.3 billion compared with Genentech value of $103.5 billion.

BACKSTORY
After 13 years and a $3 billion investment, the U. S. Department of Energy and the National Institute of Health completed the Human Genome Project [HGP] in 2003. At the time it was a groundbreaking result. An entire new field of science called Pharmacogenomics [PGx] is a direct outgrowth of that Project:

Pharmacogenomics holds the promise that drugs might one day be tailor-made for individuals and adapted to each person's own genetic makeup. Environment, diet, age, lifestyle, and state of health all can influence a person's response to medicines, but understanding an individual's genetic makeup is thought to be the key to creating personalized drugs with greater efficacy and safety.

Here is A History of the Human Genome Project published by Science Magazine. It begins with James Watson and Francis Crick's discovery of the double helical structure of DNA in the April 1953 issue of Nature. It concludes when the HGP consortium published its working draft in Nature (15 February), and Celera published its draft in Science (16 February) 2001.

ONE SIZE DOES NOT FIT ALL
The National Center for Biotechnology Information [NCBI] highlights the fundamental importance of personalized drug safety in the following comment:

A 1998 study of hospitalized patients published in the Journal of the American Medical Association reported that in 1994, adverse drug reactions accounted for more than 2.2 million serious cases and over 100,000 deaths, making adverse drug reactions (ADRs) one of the leading causes of hospitalization and death in the United States. Currently, there is no simple way to determine whether people will respond well, badly, or not at all to a medication; therefore, pharmaceutical companies are limited to developing drugs using a "one size fits all" system.

The white paper on "Personalized Medicine" published by Price Waterhouse Coopers in February 2005 reported the first step toward the greater efficacy of personalized drugs in the treatment of cancer:

The first combination diagnostic test and drug product, HercepTest from Dako and Herceptin from Genetech/Roche, was approved by the U.S. Food and Drug Administration [FDA] in 1998 for the treatment of a specific form of breast cancer.

For a recent update on the future of personalized medicine, see this 2007 paper on "Translating Pharmacogenomics: Challenges on the Road to the Clinic."

Perhaps the greatest challenge to personalized medicine is the time and cost of sequencing an individual's DNA. As Michael Copeland reported in his August 27, 2008 Fortune magazine story Genomes 'R' Us:

Today, with faster computers and improved techniques, a research lab can sequence your DNA in about six weeks at a cost of $100,000 to $300,000. Now a startup called Pacific Biosciences vows to do the job in 15 minutes for less than $1,000. The Menlo Park, Calif., outfit says that by 2013 it will have a microwave -oven-sized machine on the market that could bring genomics to the masses (page 46).

If Pacific Biosciences [PacBio] lives up to its promise to deliver such a DNA sequencer it likely will have a profound effect on personalized medicine:

The device's potential is sparking electric anticipation among some in the genetics community. "In all the things that I have seen in the past 20 years, I haven't seen anything as disruptive as what PacBio is cooking up," says Dr. Eric Topol, head of Scripps Genomic Medicine Program in La Jolla, Calif. "It changes everything in genomics."

To understand the issue I asked Nathan Markward of the Pennington Biomedical Research Center what was "disruptive" about the PacBio product. Here's what he said:

The "disruptive" nature of the PacBio technology stems from its potential to alter the traditional model of technology transfer and transmittance that begins at the academic or corporate bench and ends at the hospital bedside. A fast and cheap sequencer would, in theory, grant health care organizations the platform needed 1) to conduct patient-centered genomic research from within their own health information networks and 2) to develop genome-based predictive tools without assistance from universities and biotechnology corporations.

Although some would say that Dr. Topol's prediction about the disruptive nature of PacBio's technology is brash, others would agree. Michael Copeland concluded his Fortune article with this comment:

Indeed, such is the excitement about PacBio's device that one health-care technology analyst even brings up the G-word. Says Ross Muken of Deutsche Bank: "These guys have a shot at becoming the Google of health care, the company that comes out of nowhere and dominates."

MORE BIOTECH BETS
The potential of personalized medicine is largely responsible for the current big biotech bets by pharmaceuticals. Of course, so far the biggest of them all is Roche's bid to buy Genentech. As Andrew Pollack reported in the New York Times on July 22, 2008:

In a bold gamble, Roche offered Monday to pay $43.7 billion for the 44 percent of Genentech it does not already own, a move that would end the independent existence of what is widely considered the world's most successful biotechnology company.

A little over three weeks later Mr. Pollack reported that a special committee of Genentech directors rejected Roche's offer of $89 a share because it "substantially undervalues the company." On Friday September 19, 2008, Genentech closed at $92.27.

Moreover, Genentech is only one in a string of big biotech bets that created the deal boom identified by Telis Demos in his August 29, 2008 story Payday for Biotech (published in Fortune magazine, page 24):

Overall, dealmaking may be in a slump, but Big Pharma has been buying up biotech firms at a record pace - it's now the fastest-growing M&A sector, with deal value up 87% this year.

All of this presents a challenging opportunity for analysts: valuing various combinations of biotech and pharmaceutical firms. Readers of my book Competing for Customers and Capital can overcome challenges like these and become enlightened at the same time.

SEPARATE BUT EQUAL MARKETS
Investors are (or should be) informed by two separate but equally important groups - the markets for customers and capital. Capturing a company's performance in these dual markets is deceptively simple - just take the difference between its share of value [SOV] and share of revenue [SOR] in a peer group. I call this the value sales differential [VSD]. The following table reports the share of value and share of revenue for each company in this Biotech-Pharma peer group.

SOV and SOR 5 Firms 9.3.08

VALUE CREATION vs. SALES CHURN
The value-sales differential turns the table on Roche and Genentech. In the period covered by the following chart, DNA has a differential advantage of +12.1 points. In the same period, RHHBY has a differential disadvantage of -4.6 points. All three big pharmas in this peer group have negative differentials, while both the biotech firms had positive differentials.

VSD 5 Pharmas 9.3.08

What does the value-sales differential mean to an investor like yourself? The VSD is the fulcrum on which a company's future balances. Will the future of your company be dominated by value creation -- or sales churn? The differential will show you where you are headed today and likely to be tomorrow. Each path requires different strategic directions.

The bigger a company's positive VSD becomes the brighter is its future. The company's value creation dominates its sales churn.

If the VSD is negative, the company's market value is migrating to its peers.

The bigger a company's negative VSD becomes, the darker is its future. The company's sales churn dominates its value creation.

Of course, this is just a snapshot -- at one point in time. The VSD metric is more revealing and more robust when it is risk-adjusted for volatility over time.

WHY ROCHE COVETS DNA
In the chart above, I selected the image of a pill bottle as the background for the value-sales differentials as a symbol of the old medicine for the masses. The real reason Roche covets DNA is that "one-size-fits-all" pills are becoming passé.

Moreover, companies like privately held Pacific Biosciences, Complete Genomics, and VisiGen Biotechnologies along with Illumina Inc. (NASDAQ:ILMN), Applied Biosystems Inc. (NYSE:ABI), Helicos BioSciences Corp. (HLCS), Monogram Biosciences, Inc. (:MGRM) and Sequenom, Inc. (NASDAQ:SQNM) all are working on gene sequencing technology. Michael Copeland further reported in his Fortune story that:

If a gene sequence could be ordered up as easily as an MRI - and the genetic blueprint of hundreds of thousands of individuals compiled - scientists could zero in on the mutations that cause Alzheimer's, leukemia, or prostate cancer; pharmaceutical companies could design more precise drugs; and doctors could predict what infirmities you are likely to face and start to head them off.

I guess this is what Mr. Brin meant when he concluded he was genetically predisposed to Parkinson's disease:

Until the fountain of youth is discovered, all of us will have some conditions in our old age only we don't know what they will be. I have a better guess than almost anyone else for what ills may be mine -- and I have decades to prepare for it.

BIG BETS ON BIOTECH
This post is the first in a series on big bets in biotech. In the next ones I will track a number of leading pharmaceutical companies and the biotech firms that are challenging them. The questions I hope to answer are these: Over the long run how did they get where they are - and where are they likely to be in the future? If you want to read a working paper on how the theory applies to big pharmaceutical companies, see Marketing Meets Finance.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.