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Genzyme Shares, Beaten Down, Offer Significant Upside

|Includes: Sanofi (SNY)
It is tough to find new good stocks when markets have run, as they have so nicely in recent months. When the best stocks are up the most and only broken stories lag, investors must toil harder to put new money to work. One potential gem is the stock of Genzyme (GENZ, $50/sh), a high caliber biopharmaceutical company that in recent months has had more than its share of grief. Biotech you say? Not for the faint of heart, for sure, as the handsome growth of the sector has always been paired with abundant technological, execution and regulatory risk. That said, a succession of events has driven the share price well off its 12-month high, embedding much of this risk. And though challenges remain for the company, the road to its recovery is increasingly clear and the upside accordingly abundant. We thus rate the stock a Buy and introduce an initial price target of $65.
The Fundamental Genzyme
For some years, Genzyme has achieved consistently strong growth (~20% CAGR) by leveraging strong technological innovation, targeting a succession of well delineated disease areas for growth. It is Biotech, after all, so its products, processes and businesses are complicated and hard to summarize. Hence, we’ve fashioned an easy-to-retain summary below (“A Look at the Company”). Briefly, the company develops, manufactures and distributes a small number of therapeutic substances targeting key disease areas in which management can leverage its scientific research expertise. The company initially targeted rare genetic diseases that deprive individuals of key proteins (mostly enzymes), proteins that can be bio-manufactured with genetically engineered cells. This forms the basis of its largest segment, Genetics. Through licensing, acquisition, and internal development, the company leverages other core technologies in addressing other disease areas listed in the table below.
This Genetics business accounts for nearly half of revenue and is founded on a handful of very expensive (and profitable) drugs. The company is increasingly diversifying its business, however, as it introduces new high growth products from its ample pipeline. Yet, this is a very slow process, due both to extended development cycles and a very high regulatory burden. Thus the company’s high product concentration is not only risky but slow to diversify. Still, the rewards are equally evident in the business model. The Gross Margin (non-GAAP 72.8% in the most recent quarter) is sufficiently high to support a very high R&D and SG&A burden (15.5% and 25.7% of revenue, respectively). Also necessitating the high profitability, it is a capital intensive business (with Capital Expense 14.5% of revenue in the June quarter). Indeed, net of these high investment needs, free cash flow is more modest as a percentage of revenue (13.1%). Yet the need for cash liquidity (net cash is currently $833 million or $3.16/sh) is clear because rapid technological advance requires the company to readily license and acquire critical technologies and agents. This profitable business consumes cash.
In short, Genzyme, with its diversified offering of advanced and emerging products, has traditionally leveraged a rich and promising pipeline to generate superior growth in revenue, earnings and cash flow. Having peaked a year ago at $83/sh, the stock offers great promise from current levels, if in fact things are on the mend. Accordingly, it is wise to understand just what has so troubled the stock.
When it rains, it Pours
Genzyme has experienced a succession of negative events, one that demonstrates how easily strong performance falters in this challenging industry. Both regulatory issues and manufacturing issues have arisen to test the faith of investors. Note that all of them effect the Genetics business, hence our silence (here) on the other segments. Let us take these issues in turn.
The initial challenges have arisen from the company’s efforts to scale up manufacturing for Myozyme, a highly successful new product used in the treatment of Pompe disease. Essentially, to meet burgeoning demand, Genzyme needs to transfer production from 160 liter bioreactors (in which the genetically altered cells produce the desired substance) to 2000 liter bioreactors at its Allston Landing facility. The FDA approval of this transition has remained outstanding for well over a year. As shortages loomed, analysts’ revenue estimates fell with the stock in tandem. By increment, trouble mounted over time. The FDA affirmed the therapeutic equivalence of the larger capacity production of Myozyme, however noting slight changes produced in the desired molecule when bio-manufactured in the larger vessel. Accordingly, the company will seek approval for, and market, this therapeutic under the name Lumizyme.   Following a two month inspection last fall, the FDA identified a range manufacturing issues that required remediation. Even worse, despite engaging the company in their correction, it filed an official warning letter at the end of February, which seemed to blind-side the company and investors (sending the stock from the mid-$60’s/sh to near $50/sh). The prospect of approval for the 2000 liter process was now more remote, even as marketing approval from the EC in Europe was received for 4000 liter production at its Belgium facility. Such are the pitfalls of Biotech.
Other issues have arisen to compound these problems. In June, the company discovered a virus in one of 6 bioreactors at the Allston facility, forcing a halt in production and the sanitization of the facility. This has created shortages of two its highest volume drugs, Cerezyme and Fabrazyme (details in the Table below). Note that the virus, which they have only recently learned to identify, affects not humans but the cells used in production, limiting productivity. Exacerbating constraints of these two products was the fact that the company had diverted capacity for these two biologics to meet the Myozyme demand with the process under FDA review. Even worse, production of these biologics (from cell culture through packaging) requires more than three months, which has created a significant gap in both production and revenue generation. It has also created shortages for patients needing these critical therapies. Things go from bad to worse, indeed. 
In response to these unhappy circumstances, the company has reacted pretty vigorously, despite what appears to be significant mis-communication with the FDA. It has sought to determine just how much of the large amount of Cerezyme under manufacture is free of the virus and available for sale. (Not much, as it turns out.) Mindful of looming competition and patient need, it has developed optimal ways to minimize the impact of the shortages (initially 6 to 8 weeks in each case) on the patient population, limiting availability to only more severe cases. And for us investors, it has revised financial guidance with a range of estimated revenue that depends on the amount of recoverable Cerezyme. To maximize capacity for all three therapeutics, management has also elected to transfer all Myozyme production to the Belgian facility using 4000 liter bioreactors, which has already been approved by the EC, though the FDA approval is only now underway. 
Not all are impressed. The FDA has elected to re-inspect that Allston facility to assure full implementation of the required measures. There also has been a flurry of shareholder lawsuits that seem opportunistic, if not unfounded. Moreover, the FDA has accelerated patient access to Shire’s competing products to both Cerezyme and (possibly) Fabrazyme, as well. The former is in the final stages of Phase III testing and can be sold ahead of approval. The latter is available for sale in the EU. It has also allowed Protalix BioTherapeutics to expand its Phase III Clinical trial for its Gaucher treatment to include patients temporarily lacking access to Cerezyme.   This may well advance the date both Shire and Protalix can effectively compete with both drugs, though switching such therapeutics is hardly a trivial matter. Moreover, whereas Shire and Genzyme use genetically-modified mammalian cells to manufacture their enzyme therapies, Protalix relies on a plant-cell derived enzyme, which will no doubt raise issues for some.
So where does this leave things? In sum, the facility has been sanitized in Allston and production of Cerezyme and Fabrazyme is underway, as is Myozyme in Belgium. To minimize the chance of recontamination, the company has elected to discard most all of the Work-In-Process Cerezyme, thus affirming the low ends of the range of its guidance. Genzyme has treatment protocols in place to deal with the impact of the shortages on patients and the FDA has allowed early access to competing products in the late stages of clinical development. Note, however, that not all patients lacking medication will necessarily switch. These enzyme therapies prevent the build-up of troublesome substances in key organs, which with milder forms of the diseases occurs slowly over time. So the path out of these dark woods seems pretty clear. It remains a tough business, however, where only strong growth and favorable entry-points can increase the probability of achieving strong capital gains. 
Valuation and Recommendation
Biotech stocks are more risky but generally offer superior returns in turn. Genzyme and its shares, tracing recent stock movements against the past year’s events, are instructive, having fallen 40% in several cacophonous thuds as the company served up the nearly full range of things that can go wrong. Yet if there is but one story in this picture (and surely there are more), it is that the downside from $50/sh appears limited. Yes, stocks can always go down farther.   But a succession of bad news has come since the stock bottomed around $50/sh. Moreover, there are obviously eager investors on the sidelines as capital seems to flow in the absence of bad news.
At this level, the shares are a good value. BioPharma investment offers the opportunity for complex modeling that we will have to describe elsewhere. That said, at just 2.3x out-year (i.e., 2010) consensus revenue and 11.8 EPS, the stock looks over sold. Once constraints pass and revenue growth returns, more normal growth multiples of 3x Revenue and 15x earnings should obtain, easily allowing a target from here in the mid $60’s/sh. From current levels, the first leg up should appeal to most investors. As the valuation reverts to the mean and stock appreciation is driven more by company growth, however, the risks will grow with the rewards.   Once this stock delivers its initial gains, it will be most suited to only more risk-tolerant investors.
The author does not own Genzyme shares.

Genzyme: A Look at the Company
   Prepared by Pierr Johnson
·              The Genetic Disease segment (46% of Q2 revenues) remains its largest, targeting a small number of Lysosomal Storage Disorders (LSDs) with advanced biologic therapeutics. As their names suggest, they are all Enzyme Replacement Therapies (ERTs) for rare genetic disorders. Key products here include Cerezyme (it’s oldest and largest at 23% of revenue, for Gauchers disease), Fabrazyme (11% for Fabry disease), Myozyme (7%, with burgeoning demand, for Pompe disease).
·              The Cardiometabolic and Renal segment (second largest at 20% of revenue) has as its foundation products Renagel and Renvela, which are older and newer versions of the same small molecule therapeutic for chronic kidney diseases (totaling 14% of company revenue as its second largest product). The other business units employ a similar range of technologies. 
·              The Biosurgery segment (11% of revenue) offers a handful of biotheraputic products used in orthopedic pain remediation (Sinvisc 14% of revenue) and surgical repair. 
·              The Hematologic Oncology segment (5% of revenue, having nearly doubled in the most recent quarter) offers a small number of protein-based and small molecule therapeutics to specific treatment applications for Leukemia. 
·              The Other segment (18% of revenue) includes a range of genetic, diagnostic and transplant targeted products and services.