Roche-Genentech: A Drug Powerhouse

Given the biotech's promising pipeline, Roche's CEO may need to raise his $43.7 billion offer to buy out Genentech's minority investors

Just months into his new role as chief executive of Roche Holding (RHHBY), Severin Schwann is moving quickly to cement one of the most successful biotech pharmaceutical partnerships in history. Eighteen years after taking a majority stake in U.S. biotech Genentech (DNA), the Swiss drugmaker announced plans to buy out minority shareholders for $43.7 billion. "It's a good time to take the partnership to a new level. We didn't wake up one day and say: 'Now is a good time to take Genentech private,'" Schwann told BusinessWeek in a telephone interview. "This transaction is about strengthening innovation; it is not about cost-cutting."

If consummated, the deal will solidify what is seen within the industry as a model of effective collaboration between Big Pharma and its smaller biotech brethren. It will merge Roche, the leader in the emerging field of molecular diagnostics, with Genentech, a company on the cutting edge of gene-based therapies. It also will be the biggest deal to date for the Basel drugmaker. And the hefty price tag is an indication that Roche recognizes the potential of pairing innovative therapeutics with gene-based diagnostics to unlocking the potential of personalized medicine.

The deal also underscores the pressure pharmaceutical companies are under to fill their pipelines. When Roche first bought into Genentech in 1990, it was a small San Francisco biotech with a handful of promising cancer treatments but little money to develop them. Today, thanks in large part to Roche's deep pockets and clinical development expertise, Genentech has a stable of blockbuster cancer treatments including Avastin for breast, lung, and colon cancer, breast cancer drug Herceptin, and Rituxan for the treatment of non-Hodgkin lymphoma and rheumatoid arthritis. A world leader in oncology, Genentech, with estimated 2008 revenues of $13.5 billion, is second only to Amgen (AMGN) among global biotechs.

Bold Gambit

In recent years, Roche has leaned heavily on Genentech for its success. Genentech drugs accounted for nearly one third of Roche's 2007 revenues of $44 billion. Together, the new company will boost its position in the U.S., the world's most competitive pharmaceutical market, where it will become the seventh-largest drugmaker, with U.S. revenues of more than $15 billion.

Launching an unsolicited bid for the remaining stake in Genentech is a bold gambit. While the acquisition will give Roche full control over one of the industry's most productive biotech companies, it also risks jeopardizing the independent and entrepreneurial culture that has made Genentech so successful. Roche's strategy of acquiring majority stakes in promising biotech and diagnostic companies while allowing them to run independently is viewed by analysts as the best way to foster cooperation between biotech and Big Pharma.

Schwann is adamant that a full-scale takeover will support, not stifle, innovation. A complete union will make it easier to share technologies such as RNAi, a natural mechanism that the body uses to silence certain genes, and assets such as libraries of potential biological targets for new drugs. "We have an enormous respect for the unique science-driven culture at Genentech, and it is important that we keep this culture and build upon it," Schwann says. "The moment you start blending corporate cultures, you run the risk of mediocrity," he adds.

Big Nod to Genentech

Schwann intends to keep research independent. The Genentech Founders Research Center, a massive state-of-the-art complex devoted to biotech research, will operate autonomously. And in what Schwann says is a "big signal" to Genentech, Roche will move its existing commercial U.S. headquarters from Nutley, N.J., to Genentech's base in San Francisco. The U.S. business of both companies will trade under the Genentech name, and sales and research staff will probably increase.

Yet some analysts reckon that Roche hopes by buying Genentech, some of its magic will rub off. Andrew Weiss, a pharmaceutical analyst at Bank Vontobel in Zurich, describes the deal as a reverse takeover. Sure, Roche's market value of $152 billion dwarfs Genentech's $95 billion. And Roche's 2008 revenues, which Weiss estimates will hit $44 billion, are more than triple Genentech's. But it's Genentech's super-productive research and development machine that is responsible for much of Roche's success. Now some analysts believe it will be Genentech, not Roche, calling the shots when it comes to R&D. "It's about turning Roche into a megasized Genentech," says Weiss.

Roche is likely to have to increase its offer to succeed. With a slew of clinical trial results expected in the next 18 months, analysts expect Genentech's share price could soar on the back of positive data. Genentech's Avastin is in clinical testing as a secondary treatment for colon and breast cancer, and Rituxan is being investigated as a possible lupus treatment. Some analysts believe positive outcomes could bring Genentech an additional $5 billion in peak sales for Avastin alone. The Holy Grail, of course, is pairing Genentech's therapeutics with diagnostics that tell doctors which patients can benefit. This is the breakthrough Roche achieved with Herceptin.

Roche says it believes it has made a full and fair offer, at a 9% premium to Genentech's closing share price on July 18. But many believe it underestimates the pipeline potential of the U.S. biotech. "We believe Roche is attempting to capture Genentech's significant future growth on the cheap," Oppenheimer (OPY) analyst Bret Holley wrote in an investment note. With $10 billion in free cash and a further $5 billion in securities, Roche has the financial strength to up its offer if needed. "If all these trials fail, then the acquisition looks pretty pricey. But if they succeed, it will be a steal," Vontobel's Weiss says.

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