Genzyme Cuts Back for Future Gains: Biotechs Must Revert to Lean Growth

by: EP Vantage

It might be true that Genzyme’s (GENZ) recent efforts to get its house in order predate the emergence of Sanofi-Aventis (NYSE:SNY) on the scene, but there is nothing like the slathering jaws of a predator at the window to sharpen the mind.

The company wasted little time pushing on with the sale of its genetic testing arm, notable progress considering Abbott Laboratories (NYSE:ABT) and Elan (NYSE:ELN) have struggled to off-load their unwanted units, while 1,000 job cuts have been found fast. This good speed no doubt reflects the board’s desire to demonstrate they are up to the job of independently pushing through change following Genzyme’s annus horribilis. But they will also be mindful of the fact that should Sanofi walk away, shareholders will want to know how they intend to deliver returns, something that big biotech as a group is not as good at as it used to be.

Diminishing returns

Before bid speculation emerged in July, Genzyme shares were trading at a little over $54, down 5% on the year. Clearly the company has specific issues, but it is not alone in poor share price performance. Indeed, none of the other big US biotechs – Celgene (NASDAQ:CELG), Amgen (NASDAQ:AMGN) and Gilead Sciences (NASDAQ:GILD) – has generated share price gains this year, and it seems likely Genzyme would have been in a similar position had Sanofi not appeared.

An analysis by EP Vantage in July revealed that amongst the most valuable drug makers in the world, Gilead was one of the worst performers this year (Big pharma continues to struggle in first half, Indian generics consolidate gains, July 1, 2010).

This picture of declines does not change much over a 12-month view, with only Celgene managing to return a 5% share price improvement. Over 24 months it is even bleaker: Gilead shares down 35%, Celgene off 21%, Amgen 13% lower and Genzyme, even with the bid premium, 10% cheaper than in September 2008.

Of course wider markets are also down but these companies have well underperformed indices, with the Nasdaq down 3.5% and the Dow Jones 9.5% over the same 24 month period.

Historically low

Indeed, an analysis by ISI Group published earlier this month found that the five largest US biotechs by market value – the above group plus Biogen Idec (NASDAQ:BIIB) - are trading at a combined average price-earnings ratio of 13 times 2011 earnings, the lowest for seven years. Indeed the average P/E ratio for big biotech would be even lower without the bid premium in Genzyme's share price, which means it has by far the highest P/E ratio of 20 times earnings in 2011.

A high P/E ratio indicates that investors are anticipating strong earnings growth, and is normally associated with high risk and high growth sectors like biotechnology. A P/E ratio of 13 might still be a lot higher than other sectors, but the fact that the number is so low against the historical benchmark suggests that expectations of strong earnings growth are dimming.

Genzyme’s “five step” growth initiative revealed in May is no doubt trying to address this issue, as well as responding to the ongoing manufacturing issues. If these biotechs want to regain their lofty earnings multiples, they need to become the leaner growth engines they once were.

The sale of the genetics business for $925m is a good first step. In a statement Monday, Genzyme’s chief executive, Henri Termeer, says the sale “…shows how our management team is uniquely positioned to unlock the underappreciated value of Genzyme’s diverse businesses for shareholders. The completion of this sale allows us to focus our resources on core growth areas and create stronger returns on invested capital.”

Of course he is making a case for remaining independent here, but he is also addressing the burning issue facing all these big biotechs: how do we generate the returns that shareholders have become used to?

Action needed

If Sanofi walks away Genzyme shares will no doubt fall back to the mid $50 range.

This is unlikely to happen and the deal will probably get done for a bit more than the $69 currently on offer; Sanofi is unlikely to have gone in with its best offer.

It is questionable whether this efficiency drive will tempt more money from Sanofi, but these are actions that needed to be taken anyway.