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Genentech: Splice at the right price?
Stock Spotlight: The second-biggest biotech firm trades at a premium but it outshines its peers.
October 6, 2005: 3:45 PM EDT
By Aaron Smith, CNN/Money staff writer
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NEW YORK (CNN/Money) - Big drug companies like Pfizer and Merck were once regarded as safe havens. But in the wake of the Vioxx scandal, many healthcare investors are now flocking to biotechs... and Genentech has established itself as the sector's rising star.

The entire biotech industry has done well this year but shares of Genentech (Research) have outperformed many of its peers, gaining 58 percent year-to-date.

Based in South San Francisco, Genentech is the world's second-biggest biotech, with $3.7 billion in 2004 sales. Only Amgen (Research), with $10 billion in sales in 2004, is larger.

Genentech, which already has several key cancer drugs on the market, will announce its third-quarter results on Monday, and analysts are projecting a 36 percent surge in revenue to $1.6 billion, with a 25 percent jump in earnings per share to 30 cents.

In an industry dominated by start-ups that are struggling to produce revenue, Genentech is considered a relatively stable bet.

But is Genentech worth its heady price?

Shares have slipped a bit lately due to some concerns about a rejection of its Cabilly patent, which covers a process for manufacturing antibodies. The stock is now about 12 percent below its 52-week high as some investors worry that a portion of Genentech's royalty stream from Cabilly could be at risk.

So will the stock keep sliding or can Genentech bounce back after it reports earnings?

A healthy pipeline

First, a quick explainer about what makes biotechs different from other drug companies. Biotechs develop drugs through the use of living things, such as genes. Many of the companies in the sector are growing far more rapidly than traditional pharmaceutical firms. Genentech, for example, is expected to report an earnings increase of 43 percent this year.

Of the major biotechs, Genentech is thought to have one of the best portfolios of drugs.

Analysts usually mention three in particular: Rituxan, a treatment for non-Hodgkin's lymphoma that generated $891 million in sales during the first half of 2005, Avastin, a drug that slows the spread of colorectal cancer when combined with chemotherapy and which brought in $449 million in revenue during the first half, and Herceptin, a treatment for women with HER-2 positive breast cancer that had $282 million in sales during the first half.

Analysts tend to be bullish when projecting sales growth for these drugs, and not just because of existing market popularity. Genentech conducts additional studies on its drugs to try and find other uses, which would translate into more patients and more revenue.

"There are several drivers for potential earnings growth that I don't think are reflected in the stock," said Jason Kantor, analyst for RBC Capital Markets. Pending FDA approval, the company is seeking to have Avastin expanded for the treatment of lung and kidney cancer, Rituxan for arthritis and lupus, and Herceptin for early-stage breast cancer.

And Genentech helps to insure future growth by spending heavily on research and development. In 2004, Genentech invested $948 million, or 21 percent of its operating revenues, into R&D. That's a slightly higher percentage than what Amgen spent on R&D last year.

"What we're looking at is a company that's investing heavily in the future," said Ian Somaiya, an analyst for Thomas Weisel. "The company is one of the best at designing and running clinical trials, identifying the right population as well as the right dose to study the drug in."

Analysts are also excited about the company's pipeline. The company plans to launch vision loss treatment Lucentis in 2006, and Rodman & Renshaw analyst Michael King projects that drug will achieve blockbuster status by 2009.

Biotech bonanza

A series of mergers in the industry this year has also boosted Genentech's profile. Because large pharmaceutical companies are starved for growth, some have turned to the biotech sector as a way to bolster their drug pipelines.

Pfizer (down $0.31 to $24.49, Research), the world's biggest drug maker, announced on June 16 it would acquire Vicuron Pharmaceuticals Inc., a small Pennsylvania biotech, and completed the deal on Sept. 14.

Vicuron's sales totaled just $3 million during the first six months of this year, compared to $25.5 billion for Pfizer. Facing the impending loss of several blockbuster drugs, Pfizer was after the biotech's pipeline: Vicuron has filed applications for two anti-infective drugs with the Food and Drug Administration.

"We've got a need to acquire products in the near term with all our patent expirations," said Pfizer spokesman Paul Fitzhenry.

In addition to the Vicuron deal, Pfizer bought San Diego biotech Angiosyn on Jan. 21 for $527 million. GlaxoSmithKline (up $0.22 to $51.17, Research) and Johnson & Johnson (down $0.92 to $61.33, Research) also bought biotechs this year and Swiss drug giant Novartis (up $0.09 to $51.23, Research) is currently in negotiations to buy the remaining shares of California biotech Chiron (down $0.29 to $43.02, Research) that it doesn't already own for an offer price of $7.5 billion.

With a market value of $88 billion, Genentech isn't considered a likely takeover target. But Somaiya said that the pickup in merger activity does help to validate the industry and has been a big part in the solid performance for Genentech as well.

A bitter pill?

Genentech's success comes at a steep price though. The stock trades at 48 times 2006 earnings estimates, a multiple which is considerably higher than that of its biotech peers and much higher than the valuations of traditional pharmaceutical firms.

But Somaiya said the company's price is "deservedly rich," since analysts expect earnings per share to jump 44 percent in 2006. That's also higher than the industry average. He added that for the next few years sales and earnings should continue to increase in excess of 30 percent a year.

With all that in mind, King said Genentech is "the best company in the industry" and worth its price.

"I've seen plenty of stocks that look really cheap, but they're not really cheap because they're little growth," said King. "Clearly, Genentech is the new dynasty of biotech."

None of the analysts interviewed for this story own stock in the companies mentioned here.

To read about the projected boom in cancer drugs, click here.

For a look at more biotech stocks, click here.  Top of page

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