Genentech, Inc.
Ticker:
Sector:
Industry:
Employees:
DNA
Healthcare
Biotechnology
9,500
Analyst Recommendation
I. Screening
Moderate Buy
Results of Screener
Stock screener provided by Yahoo Finance was used to
identify potential investment opportunities for the Mizzou
Investment Fund. The screener returned 2 results Genentech and Gilead Sciences. After a brief overview
of the two companies, Genentech was selected for further
research primarily for its higher earnings growth estimate
for the next year, lower debt to equity ratio and a lower
beta.
Quantity:
20 shares
Stop-Loss:
$61.00
Take Profits: $100.00
Pricing
Closing Price:
52-Week High:
52-Week Low:
$ 81.59 (11/10/06)
$ 100.20 (12/06/05)
$ 75.58 (05/02/06)
Market Data & Valuation
Market Cap:
86 billion
Diluted EPS:
$1.73
P/E:
47
Dividends:
Div. Yield:
Payout Ratio:
na
na
na
Profitability & Effectiveness
ROA:
16.85%
ROE:
26.54%
Gross Margin:
84.70%
Net Profit Margin:
23.83%
Financial Condition
Debt/Equity: 0.24
Current Ratio: 2.72
Quick Ratio: 2.13
Screener Parameters
A complete list of parameters used in the screener is
provided in the Exhibit A. The screener parameters were
applied to the biotechnology industry to increase the
Fund’s exposure to healthcare industry. Products
developed by biotechnology companies have gradually
emerged as an important (and sometimes the only)
alternative for treatment of severe illnesses. Large cap
criterion was used to identify companies with a
demonstrated ability to develop commercially feasible
products.
II. The Firm and its Market
Company Profile
Genentech, Inc. is a biotechnology company that discovers,
develops, manufactures and commercializes biotherapeutics
A company
criteria
willGenentech
be a valuable
for
significantmeeting
unmet these
medical
needs.
addition
to
the
Mizzou
Investment
Fund
and
it will be
manufactures and commercializes multiple
biotechnology
consistentand
with
the fund’s
overall
objectives.
products,
receives
royalties
from
companies that are
licensed to market products based on its technology.
Considered the founder of the biotechnology industry,
Genentech has been delivering on the promise of
biotechnology for almost 30 years, using human genetic
Zaza Tugushi
information. Today, Genentech is among the world's leading
ztgw3@mizzou.edu
biotech companies, with multiple products on the market for
serious or life-threatening medical conditions and over 40
projects in the pipeline. The company is the leading provider of anti-tumor therapeutics in the
United States. AVASTIN is its best known product used to treat various types of cancer
including colon and some forms of lung cancer. LUCENTIS is designated for the treatment of
1
neovascular age-related macular degeneration, the leading cause of blindness in people over the
age of 55.
Market Position and Competition
Genentech has a strong market position and is a leader in a biotechnology industry. Genentech
already introduced several successful products. These are Avastin, Herceptin, Rituxan, Tarceva,
and Xolair. The Company has 40 new drugs in the pipeline in the various stages of development
and the FDA approval. The Company aggressively pursues the FDA approval to use some of its
existing drugs for treatment of broader range of certain deceases. For example, Avastin is used
primarily to treat colon cancer and Genentech asked the FDA to use the same drug for treating
certain types of breast cancer. Such approvals would boost the current sales of Avastin and other
drugs significantly. The FDA approval for an extended use of Avastin is expected by the middle
of 2007.
Competitors of Genentech include number of companies in the healthcare industry. Yahoo
competitor comparison table falls short of comparing relative companies and therefore is not
included in this section. Major competitors of Genentech are biotechnology companies such
Amgen (the 2nd largest biotechnology company after Genentech), Gilead Sciences, Biogen Idec
and others. However, traditional pharmaceutical companies such as Pfizer, Bristol-Myers
Squibb, Novo Nordisk, GlaxoSmithKline, Novartis and others are also competing with
Genentech. But the business model of latter and the nature of their products are significantly
different and do not compete directly with the products of Genentech.
III. Economic and Industry Environment
Biotechnology stocks had a strong start in 2006 but by mid-May gave back the gains achieved in
the previous six months. However, earnings prospects provide reasons for optimism. The Value
Line survey suggests that new products and regulatory approvals should keep sales on a steep
incline resulting in improved margins. The Value Line predicts slightly lower margins for 2006
as a result of booking stock option expenses for the first time and larger R&D investments by
biotech companies. This is cited as a major reason for avoiding heavy investments in the
biotechnology sector at this time.
Still, the biotechnology industry offers lucrative long-term returns. The industry operating and
profits margins are outstanding and more importantly are expected to increase in the next several
years. According to the Value Line
estimates, sales in the industry will
increase 42% from 2005 to 2007.
Revenues of Genentech are expected
to increase by 67% over the same
period of time. While these
estimates should be treated
cautiously Genentech is expected to
outperform the industry on every
attribute listed in the table.
As with the most industries, performance of Biotechnology industry is tied to the performance of
the overall economy. Genentech performance, fueled by the regulatory approvals of its major
drugs, from the mid-2003 has been phenomenal. In recent months the Company stock price has
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been lagging behind the performance of the Biotechnology industry and overall stock market but
its long-term return is still well above the industry and market returns.
It seems that the biotechnology industry is gaining an upward momentum following a year of
sluggish performance. 3-month and 6-month returns are once again above those of total U.S.
market index.
IV. Valuation
First step in valuation of Genentech was to calculate appropriate discount rate. The discount rate
was calculating using CAPM formula.
Discount Rate = Risk-free Rate + Beta (Market Return – Risk-free Rate)
Beta = 0.4515 (source: Asset Detail File)
Beta = 0.3100 (source: Yahoo Finance)
Beta = 0.9900 (source: MSN Money, Zack’s and Reuters)
Market Return = 8.74% (obtained from the Investment Fund Management Asset Detail file as of 11/ 7/ 2006)
Market Risk Premium = 8.74% - 4.586% = 4.154%
10-Year T-Bond Rate = 4.586% (11/07/06)
Discount Rate = 4.586% + 0.31 x 4.154% = 5.87% (using Beta from Yahoo Finance)
Discount Rate = 4.586% + 0.4515 x 4.154% = 6.46% (using Beta from Asset Detail File)
Discount Rate = 4.586% + 0.99 x 4.154% = 8.70% (using Beta from MSN Money)
The discount rate seems somewhat unrealistic considering inherited risks of biotechnology
sector. The main reason for the low discount rate is the low beta. The discount rate used in the
valuation models will be calculated using the higher beta of 0.99 to produce conservative
estimates. Genentech does not pay dividends, thus rendering all dividend discount models
useless.
a) Owners’ Earning Valuation Model
Net Income, Depreciation and Capital Expenditures were calculated using the financial data from
the last four quarters. Since the fiscal year is approaching its end, annual data from previous
year would be outdated to produce accurate estimates. The 1st stage growth rate is 23%, revenue
growth rate in the next 5 years estimated by Value Line. The 2nd stage growth was assumed to
be 5%, which is 20% of the high growth stage, producing an intrinsic value of 150.79 per share.
The current price of Genentech is $81.59 which is 45% below the estimate intrinsic value. The
details of the model are provided in the Exhibit B.
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The table displays the sensitivity of the
intrinsic value of the stock to change in
the 2nd stage growth rate.
b) Discounted Cash Flow (DCF) Valuation Model (Damodaran)
The second valuation model was used to evaluate the accuracy of the Owner Earnings model
taking into considerations additional factors. First, various growth rates were assigned weights.
The 1st and 2nd stage growth rates are the same ones used in the previous valuation model to
produce comparable results.
63.08% (Earnings per Share growth – 5 years)
23.00% (Earnings growth – Value Line)
10.76% (Net Income, Equity, Tax Rate)
Historical Growth Rate:
20%
Outside Prediction of Growth:
30%
Fundamental Prediction of Growth: 50%
The result of the valuation is $89.19 per share, which is about 10% above the current stock
price. The complete output of the model is provided in the Exhibit C.
V. Financial Analysis
Exhibit D: Income Statement. Income Statement looks very good. Net Profit margin has
improved over the past 5 years and reached 23% in 2006. The improvement in the Net Profit
margins derives from an improvement in operating margins. The Company does an outstanding
job of keeping its costs down while increasing the revenues. Cost of Goods sold has decreased
from 17% in 2001 to 13% in 2006.
Exhibit E: Balance Sheet.
Balance Sheet of Genentech looks solid. Most of the items on the statement are increasing
slowly without major irregularities. Change in Cash in 2005 has increased to 10% of total assets
from usual 3% to 6%. It is a result of long-term debt issued by Genentech in 2005 for capital
expenditures. In 2006, cash has decreased to its usual proportion of total assets. As a result of
increase in long-term debt, the capital structure changed producing higher total debt to equity
ratio. Accumulated deficit account has been decreasing and is at its lowest levels in the last 6
years.
Exhibit F: Cash Flows. Analysis of cash flows produces mixed signals. On one hand, cash
flows from operating activities have been increasing and are already higher (in just three quarters
of 2006) than the total operating cash flows in 2005. Cash flows from financing activities
increased primarily as a result of heavy capital expenditures. Cash flows from financing
activities alternate between negative and positive figures. The biggest concern is the lack of
consistency in the Net Change in cash. The total change in cash has been negative in three out of
last 5 years. Year-to-date change in Net Cash is also negative.
VI. Other Considerations
Corporate Culture
In October 2006, Genentech was named by Science magazine as the “top employer and most
admired company” in the biotechnology and pharmaceutical industries. The company has placed
first in each of the five years that Science has carried out this survey. The survey identifies the
companies with the best reputations as employers based on whether they treat their employees
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with “respect and whether their work-culture values align with employees' personal values.” The
importance of content workforce cannot be exaggerated. Although, employee satisfaction is not
directly reflected on financial statements, ultimately it improves the bottom line by retaining
talented scientists in the organization as well as by attracting new ones.
Risks
Many risk factors associated with performance of Genentech are similar to those facing drug
manufacturers in general. One of the major issues is the delay and negative ruling on patents by
the Food and Drug Administration. Other risks involved are:
 Disappointing product sales (Avastin in particular)
 New competition
 Pipeline setbacks
 Potential manufacturing constraints
Genentech is determined to reduce these risks. In particular, the Company increased its capital
expenditures to avoid the possibility of manufacturing constraints. If some of its products are
approved for treatment of broader range of cancer (Avastin, Herceptin), the boost in demand for
these products will result in manufacturing constraints.
Analyst Ratings
The number of analysts following Genentech has recently increased from 30 to 35. BUY and
HOLD recommendations have not changed in the last three months. However, STRONG BUY
recommendation has increased from 7 to 13. This increase is a result of opinion of analysts who
initiated the coverage of Genentech. The 1-year target price for Genentech varies from $95.31 to
$105 per share. The Value Line estimate for 2009-11 ranges between $150 (high end) and $100
(low end) per share by 2009-11. S&P 500 Stock Report rates Genentech as Strong Buy.
VI. Analyst Recommendation
Based on the research, Genentech is a good buy and the recommendation is MODERATE BUY.
Despite the excellent earnings potential in the coming years, there are still some factors that
prevent recommending STRONG BUY. The Company has a high P/E ratio indicating the
possibility of overvalued stock price. Valuation models do not support this notion but the stock
price has been on a steep rise. In addition, very high P/E ratio may not be appropriate for the
portfolio of Mizzou Investment Fund. Availability of free cash is final issue in recommending
STRONG BUY.
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As a final thought, the Fund lacks the exposure to the healthcare industry. The long-term
outlook of this industry is strong and the sooner the Fund positions itself in the sector the higher
the possibility of above-the-average returns. Considering the factors discussed above, I
recommend buying 20 shares of Genentech, 2% of total portfolio value, for limited exposure to
the healthcare industry. Recommended stop-loss is $69 or 15% below the current market price
to limit downside risk. Recommended target price for taking profits is $100.00, a 52-week high,
for a 22.50% gain. Setting a determined profit objective will resolve a hesitation to take the
profits off the table.
Sources
MSN Money
Reuters
S&P 500 Stock Report
Value Line
Wall Street Journal
Yahoo Finance
Zack’s
Disclaimer: This analysis does not necessarily reflect the beliefs of the University of MissouriColumbia or the College of Business. The insights and opinions are of the students of Investment
Funds Management and should not be used in personal investment decisions. The University of
Missouri and the author of this analysis take no responsibility for the validity of the valuation
and analysis.
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Exhibit A: Screener Criteria
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Exhibit B: Owners’ Earning Valuation Model
8
Exhibit C: Discounted Cash Flow Valuation Model
9
Exhibit D: Income Statement
10
Exhibit E: Balance Sheet
11
Exhibit F: Statement of Cash Flows
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