(FORTUNE Magazine) – When Genentech announced the clinical success of its new cancer drug, Avastin, on May 19, investors were having a terrible Monday. Most stocks got clobbered--at the close the Dow had sweated off 186 points, over 2%, and the Nasdaq 46 points, nearly 3%. But for Genentech, it hardly mattered. Its stock sprouted wings. It shot up $16.95, or 45%, adding nearly $9 billion of market value.

Sure, the market is starved for upbeat surprises. But the fact that Genentech held on to its gain as the week progressed says more about Avastin. The medicine's colon-cancer trial marked the first major success with a new class of intensely-watched cancer drugs that work by cutting off tumors' blood supply. Genentech reported that Avastin's survival benefits in combination with standard chemotherapy "far exceeded" what the study aimed to prove--not bad for a drug many analysts had written off after an earlier clinical disappointment.

Genentech's market cap of about $30 billion is now bigger than that of some Big Pharma players like Schering-Plough. Even more remarkable, last year Genentech became the top U.S. seller of branded anti-tumor drugs, jumping ahead of such giants as Novartis and AstraZeneca. With Avastin's likely launch in early 2004, Genentech's earnings should rise by more than 20% a year through mid-decade--a growth rate most drugmakers can only fantasize about.

Yet the most exciting thing about Genentech isn't its stock price or even its growing preeminence in the cancer wars. Rather it is the implication of Genentech's strategy for the rest of the pharmaceutical world. The industry's litany of pain seems endless: expiring drug patents, skyrocketing costs, clinical flops, allegations of price-gouging, product recalls, massive lawsuits, marketing scandals. You wouldn't think any major drugmaker--even one perched on a sunny hill in South San Francisco, as is Genentech--could look this healthy.

There are many reasons for this biotech bellwether's success--young patents and a prescient CEO, to name two. But Genentech's biggest advantage is its revolutionary method of developing and marketing drugs. Instead of lunging after one-size-fits-all blockbusters like Pfizer's Lipitor or Merck's Zocor--cholesterol-lowering medicines that each rack up billions of dollars in annual sales--Genentech pursues "targeted therapies," drugs aimed at relatively small subsets of patients. Such medicines are designed to fix known molecular glitches underlying diseases like cancer. The glitches usually are specific only to certain forms of the diseases, so targeted drugs tend to have limited markets. Yet targeting offers a huge plus: The drugs often produce the same kind of dramatic benefit doctors get when they identify the specific type of bacteria causing an infection and hit it with exactly the right antibiotic.

Genentech launched the first highly targeted therapy five years ago--Herceptin, a breast-cancer drug that is prescribed only to the 25% or so of patients whose tumors harbor a particular genetic quirk. Now the company is taking the concept to the next level and demonstrating that a big-league drugmaker can achieve heady growth without a heavy focus on blockbusters. In fact, it's arguable that when you put Genentech under a microscope, what you see is the fast-growing embryo of the slimmer, smarter drug industry of the future.

Before decoding this new creature's DNA, let us briefly examine its business habitat. The scene is a primeval swamp, where the rulers are drug giants that reap tens of billions of dollars in annual sales, yet increasingly seem like dinosaurs in a tar pit. One peril they face was highlighted by a recent U.S. Supreme Court ruling that will let Maine wrest discounts from drugmakers for its uninsured residents: The industry is losing control of its pricing. Managed-care organizations are another threat. They're demanding more bang for their pharmaceutical buck and shifting a growing fraction of drug bills to patients. That's generating the political will needed to overwhelm the powerful pharmaceutical lobby.

Then there's the most familiar drug-company killer. Between 2002 and 2007, patents will expire on 35 drugs with aggregate global sales of more than $73 billion a year, according to Datamonitor, a market researcher in London. But only 14 potential blockbusters are expected to be launched through 2006. Struggling to cope, Big Pharma has tried to substitute marketing muscle for scientific success--for example, by spending some $3 billion a year on controversial direct-to-consumer ads. Yet sales of branded drugs are expected to rise only 5.3% a year between 2001 and 2010, according to a report by IBM Business Consulting Services. To meet investor expectations shaped in the days when the industry routinely racked up double-digit growth, pharma CEOs increasingly opt for mergers and cost cutting. Such gambits temporarily boost profits but don't address the basic productivity problem that's dragging the industry down.

In a way, it makes perfect sense for Genentech to blaze a trail out of the drug-industry swamp. It is the world's first biotech, founded more than a quarter-century ago. It was the first biotech to go public and the first to bring a genetically engineered drug to market. Nevertheless, the company spent its early years trying to become a blockbuster-producing giant. By the late 1980s, Genentech's odds looked good as it rolled out TPA, a drug for dissolving blood clots that precipitate heart attacks. But TPA's projected blockbuster sales never materialized--it failed to perform significantly better than a much cheaper, older drug.

TPA's fizzle put Genentech in a bind. To raise capital to pay for the development of its growing roster of proto-drugs, it sold a 60% stake in 1990 to Swiss-based Roche Holding for $2.1 billion. Genentech also picked up bad Big Pharma habits, resorting to dubious ploys to bolster sales--among other things, it allegedly promoted unapproved uses of its bioengineered growth hormone. The tactics led to a multiyear federal investigation, which finally ended when the company agreed to pay a $50 million fine.

In 1995 the board ousted CEO Kirk Raab and asked Arthur Levinson, then research director, to take over. "It sure surprised the heck out of me," he says. "They hadn't even told me I was on a succession path to CEO. If someone had told me, I would have said, 'Take me off!'" Truth be told, though, he was perfect for the job. First, there was his demeanor--an appealing mix of nerdiness, candor, and jocularity that's the very epitome of Genentech's culture. Then there was his track record--among other things in his 15 years at the company, he'd helped spearhead Herceptin, the groundbreaking breast-cancer drug that already was beginning to show exciting clinical results.

Perhaps most important, Levinson had an inspiring idea about betting the farm on blockbusters: Don't do it. "At the end of the day," he says, "a drug's value comes down to the degree of patient benefit it offers"--not the number of people it's prescribed for. "Even a drug that works with just 10% of patients [afflicted with a major disease] can make economic sense."

Many pharmaceutical veterans still don't buy it. After all, if a one-size-fits-all blockbuster that brings in $3 billion a year costs no more to develop than a targeted therapy that grosses only $300 million a year, how would it make sense to pursue the latter?

Levinson is quick to concede that he likes a blockbuster as much as any CEO: "It's wonderful if you have drugs with billion-dollar-plus sales." In fact, Genentech boasts one such a drug--Rituxan, for treating an immune-cell cancer called non-Hodgkin's lymphoma, which it jointly markets with IDEC Pharmaceuticals of San Diego. The drug racked up sales last year of $1.16 billion. Avastin, the Genentech drug that blew the lid off the stock in May, is also likely to top $1 billion in annual sales.

But the point is that Genentech no longer lives or dies by blockbusters the way Big Pharma does. One reason it can afford that luxury is obvious--its size. Despite Genentech's hefty market cap, the company is still small compared with most of its pharmaceutical rivals. Its revenues last year were $2.7 billion, up 24% from 2001; pro forma profits (which don't include special charges related to patent litigation and accounting changes) were $484 million, up 20%. Thus the company doesn't need a raft of blockbusters to hit its ambitious growth targets.

Nor does Genentech need to sell billions of dollars of drugs each year to feed a large standing army of sales reps. Chief operating officer Myrtle Potter says that Genentech's marketing arm numbers only about 500--roughly one-tenth the size of the sales forces at places like Merck and Bristol-Myers Squibb, the giants where she worked for 15 years before Genentech recruited her in 2000. Like other Big Pharma transplants at Genentech, Potter is convinced that small is beautiful. "Virtually no energy here goes into pomp and circumstance," she says. "That lets you put more into things that add value."

So how much more efficient is Genentech? Last year, Potter discloses a little reluctantly, just eight Genentech salespeople handled Pulmozyme, a cystic-fibrosis drug that brought in $138 million. Such low overhead makes perfect sense with targeted therapies, which are typically prescribed only by medical specialists. In contrast, flogging conventional drugs for ills such as high cholesterol typically requires reaching out to tens of thousands of doctors.

The calculus of targeting has more to do with overall returns than size or overhead. Indeed, as Novartis has shown with Gleevec, a $600 million-a-year targeted drug for a type of leukemia, drug giants are perfectly capable of exploiting the new math too. That's because, as Genentech's rapidly growing earnings demonstrate, the true value of a drug appears at the bottom line, not the top--and profits count more than revenues at any company.

Consider Herceptin. A course of therapy with the breast-cancer medicine can easily run up bills over $20,000. You might think Genentech would face endless wrangling with managed-care companies about the high cost. But it hasn't. Explains Susan Desmond-Hellmann, Genentech's chief medical officer: "If I'm a [managed care] payer, 75% of the women in my breast-cancer program will have tumors that Herceptin won't help. I can identify them with diagnostics"--tests for the gene glitch targeted by Herceptin. "So I won't wind up paying for Herceptin in patients it doesn't help. I can't do that with standard chemotherapy drugs. So payers see Herceptin as a very valuable therapy."

A distinguished oncologist, Sue, as everyone seems to call her after two minutes' acquaintance, adds that targeted therapies like Herceptin utterly transform the psychology of selling drugs. "As an oncologist, you go around telling people bad news every day," she says. "You cannot imagine how good it feels to be able to tell a patient, 'I know what's wrong with you, and I have a medicine specifically for your problem.'"

Potter, who besides being COO is Genentech's top marketer, notes another major benefit of this feel-good psychology: It helps buy priceless face time with doctors. "It's not unusual for our sales people to have one or two hours with a physician" to explain the complexities of targeted therapies, she says. "When I was with Big Pharma, we were celebrating and writing bonus checks if my sales reps got three minutes with a physician." To be sure, today's targeted therapies aren't cures. They sometimes fail even when prescribed exactly as they're supposed to be--the science of targeting is still very much a work in progress. But their efficacy rates tend to be much higher than doctors are used to seeing.

Last fall, for example, Genentech reported that an incredible 94% of treated patients showed stable or improved vision in a trial of a drug it's developing for macular degeneration, the leading cause of blindness in the elderly. The drug, designated rhu-FAB V2 while it awaits a more marketable moniker, works like Avastin. Both are so-called anti-angiogenesis drugs that target a naturally occurring protein called VEGF, which spurs abnormal blood-vessel growth. Such growth damages the retina in macular degeneration. It also plays a key role in feeding certain kinds of tumors--Avastin, for example, has shown special promise in treating a form of kidney cancer called clear-cell renal carcinoma.

Targeted medicines also tend to have relatively benign side effects compared with drugs that are less precisely aimed. Herceptin's side effects are so mild that some breast-cancer patients have taken it continually for years in hopes of warding off relapses, though that use is still experimental. Preventive use promises to transform at least some cancers into diseases that patients will live with instead of die from--or even be cured of completely, rather than "going into remission."

For Louise Cooper, a 49-year-old schoolteacher in Los Angeles who was diagnosed with breast cancer in 1998, this exciting prospect already seems real (though she knocks on wood when discussing it). After finding a breast lump while taking a shower, she underwent a partial mastectomy followed by six months of chemotherapy. "The chemo just trashed me," she says. "All my hair fell out--eyebrows, eyelashes, everything. Then all my fingernails fell off; I had to walk around with bandages on my fingers, and it was painful to touch anything. I had sores in my mouth, and after a while I couldn't drink anything except through a straw. My memory started to go--they call it 'chemo-brain.'" Extreme fatigue seemed the worst--an avid marathoner, she tried to jog but could go only 50 yards before slowing to a walk.

To prevent a relapse, Cooper's doctor prescribed a yearlong course of Herceptin, after a lab analysis of cells from her tumor showed she was in the minority of patients who are candidates for the drug. The contrast to chemo was "amazing," Cooper says. "I had no side effects from Herceptin--literally nothing." In fact, she adds, five months into the Herceptin therapy, she completed a 135-mile ultra-marathon in 40 hours. The race course seemed especially fitting: It began in Death Valley and ended at Mount Whitney, the highest U.S. peak outside Alaska.

Such stories lend strong support to the idea that targeted therapies make economic as well as medical sense--it's hard to imagine a better pick-me-up for the beleaguered drug industry than life-saving, premium-priced cancer quellers that patients take year after year.

Ever the bellwether, Genentech is already benefiting from that lucrative logic: Some 40% of doctors who dispense Rituxan, the lymphoma drug the company co-owns with IDEC, prescribe it as "maintenance therapy" for patients who are in remission and trying to stay that way. (This application of Rituxan counts as an "off label" use, unapproved by the FDA. But there is no law against trying it.)

Rituxan, like Herceptin, is a monoclonal antibody. A class of drugs that almost by definition qualify as targeted therapies, monoclonal antibodies are designed to single out specific molecules for destruction with smart-bomb precision. Today such drugs account for some 70% of Genentech's sales, a percentage that's set to rise: Avastin is one, as is Xolair, an asthma drug Genentech is expected to launch later this year with co-developers Novartis and Tanox, a biotech in Houston.

Despite their pedigrees as targeted therapies, the drugs are beginning to rack up blockbuster-sized sales. Rituxan, for example, has repeatedly exceeded analysts' growth projections even though it doesn't treat any of oncology's big four--lung, colon, breast, or prostate tumors. It is now the No. 1 branded anti-tumor drug in the U.S.

Of course, even the prototype drug company of the future isn't immune from uncertainty--drug development will always be a crapshoot. But no company is managing the risks better than Genentech. Thanks largely to its targeted approach, Genentech has an impressive ten drugs on the market and 20 more in the pipeline. To help keep new products coming, it signed 26 deals for access to outsiders' technology and expertise last year, says Joseph McCracken, head of business development.

Factor in a few more years of growth, and you've got a business with the fiscal heft of a standard-issue Big Pharma company--but with a whole different look. For one thing, it will be selling two or three times as many drugs as today's typical drug giant, yet its marketing arm will be smaller. And its scientists won't have to shelve work on life-saving, limited-market drugs in order to chase the next blockbuster. For an ailing industry, that could be just what the doctor ordered.

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