Genentech/Roche: The End Of An Era

Roche offers to buy out Genentech’s minority stakeholders for $89 per share, or $43.7 billion, to create the seventh largest U.S. pharma company.

July 21 marks a turning point in the three-decades-long history of the biotech sector. No company has been more closely tied with this exciting, heady science than Genentech, a venture-backed fledgling startup that used its academic know-how to grow into one of the industry's leading lights.

As news broke that Roche had made an unsolicited bid to buy out Genentech's minority shareholders and create a wholly owned subsidiary out of the biotech, one question continually resurfaced: is it possible for Roche to preserve the independent spirit that birthed Avastin , Herceptin and a host of other novel therapeutics with this transaction?

Under the deal, Roche would acquire the outstanding shares of Genentech for $89 per share in cash for a total payment of approximately $43.7 billion. The offer, representing only an 8.8 percent premium over Genentech's closing price of $81.82 on July 18, caused many in the investment community to balk. Even compared to Genentech's closing price a month ago on June 20, the offer represents a premium of just 19 percent.

Roche already owns a majority 55.9 percent stake in Genentech from a partnership dating back to 1990, and thus ultimately controls the company. But Genentech has closely guarded its independence, even under Roche's protective wing, fostering a culture that nurtures scientists and encourages them to pursue independent research projects and publish their work in peer-reviewed journals.

That openness is one of the primary reasons the biotech was able to recruit A-list talent such as Marc Tessier-Lavigne from the University of California, San Francisco and Richard Scheller, a former Howard Hughes Medical Institute investigator and Stanford University professor, to work at the biotech.

Even Roche has promoted the relationship as a unique business model, one that has allowed Genentech to thrive independently, yet with the resources of a big pharma. Roche's management maintains it has every intention of upholding Genentech's innovative culture, including a separate research and early development unit led by Genentech with operational freedom and independent decision making.

"I would like to reiterate from my side how big [our] respect is for Genentech's achievement, how big the respect [is] for Genentech's culture," CEO Severin Schwan said during a same-day conference call. "We have sent very, very strong signals to Genentech [about] how much we appreciate the strength Genentech brings into our organization. We have talked a lot about keeping the independence of research and early development to foster this culture."

Yet if the transaction is completed, Roche will move much of its U.S. pharma operations, including commercial operations, from its headquarters in Nutley, N.J., to Genentech's site in South San Francisco, with all of its U.S. commercial pharma operations carrying on under the Genentech name.

With that action alone - not to mention the eventual cost cutting and integration that are sure to follow - Roche would dramatically alter Genentech's culture. Genentech currently employs nearly 11,000; some 14,000 work for Roche's U.S. operation.

While the majority of those Roche workers will remain in New Jersey, especially those focused on diagnostics, the combined heft of Roche U.S. and Genentech is eye-popping. Hours after the deal was announced, analysts were widely criticizing Roche for its move.

"This deal causes an irrevocable breach in relations between Genentech and Roche," wrote Bernstein Research analyst Geoffrey Porges. In a research note, Porges opined that with this action, Roche will "have killed one of the great research entities in the industry's history and the golden goose that has fueled much of Roche's growth in an effective and symbiotic way."

So why is Roche looking to acquire Genentech now after almost 20 years of what by all measures has been a fruitful collaboration, one from which both sides have benefited?

Roche said the deal will allow the companies to more easily share research, technology and intellectual property. Under the current structure, the companies don't automatically share R&D, although Roche can option ex-U.S. rights on Genentech drugs anytime through Phase III. Of 75 of Roche's current pipeline projects, 28 are products that came to the company via its Genentech partnership. Among them are ocrelizumab in Phase III for rheumatoid arthritis and in Phase II for multiple sclerosis, and pertuzumab in Phase III for HER2 positive metastatic breast cancer.

The combination could also allow the company to tap advantages in personalized medicine more easily, fusing Roche's expertise in diagnostics with Genentech's pipeline projects.

Increasing challenges in the U.S. drug market certainly look to be one driver, especially now in the current economic environment. Indeed, Roche expects the combination to generate pre-tax cost synergies of approximately $750 million to $850 million.

In addition, Roche's licensing agreement for ex-U.S. right of first refusal to Genentech products would sunset in 2014-2015, which some analysts suggested could have prompted Roche to act now.

The announcement also comes ahead of several impending key data releases by Genentech that could impact the stock price; upcoming catalysts include Phase III data evaluating Avastin on adjuvant colon cancer and Tarceva in non-small cell lung cancer patients. If the news is positive, it could increase the marketing potential for the drugs.

Although management said the current offer does reflect future growth opportunities such as Avastin in colon cancer, the bid seems low, and it's unlikely Roche will acquire Genentech in the near-term without a fight.

"We expect Genentech to refuse the bid and strive to remain independent as the company did successfully in 1999," Lazard Capital Markets analyst Joel Sendek said in a same-day note.

At the very least, Roche will likely end up increasing its bid before finalizing a deal with Genentech's minority shareholders.

A fierce fight is nothing new to Roche, however. The company endured seven months of negotiations before acquiring Ventana Medical Systems - a deal, incidentally, that was also orchestrated by Schwan, then the head of Roche's diagnostics unit. Roche made a hostile bid to acquire the tissue-based test maker for $3 billion last June but was repeatedly rebuffed by Ventana's board, which felt Roche's offer was not up to snuff (¹ (Also see "Roche Diagnostics Head Schwan To Succeed Humer As CEO In 2008" - Pink Sheet, 19 Jul, 2007.)).

The company ended up offering $89.50 per share, or $3.4 billion in cash, a substantial increase over its opening offer of $75 per share (² (Also see "Roche Finally Gets A Nod With $3.4 Billion Bid For Ventana" - Pink Sheet, 22 Jan, 2008.)).

The bid for Genentech is, of course, different in many regards to Ventana. For one, Roche has no intention of selling its majority stake in Genentech. Given such an ownership structure, that makes it all but impossible to foresee another company stepping in to play white knight and make a competing offer. As Roche management claimed during the call, the deal with Genentech doesn't warrant a change of control premium that would be seen with a full-on acquisition.

But for the deal to succeed, management will have to convince Genentech shareholders of its value. More importantly, they will have to convince Genentech's top flight talent to stay and continue their hard work for Roche. It's by no means certain that's in their DNA.

-Jessica Merrill ([email protected])