With Roche's unsolicited attempt to buy out Genentech's minority shareholders for $89 dollars a share, a bid totaling nearly $44 billion, the company is wagering heavily that it will not destroy one of the industry's most successful pharma-biotech collaborations. But has Roche laid out a straight flush or lost its ace to a bluff?

By all measures, the Roche/Genentech collaboration has been a triumph, held up by both companies - and outsiders around the industry - as a model of how the right combination of biotech independence and big pharma financing can spur innovation. Together, Genentech's academic know-how and Roche's deep pockets brought blockbuster drugs like Avastin (bevacizumab), Herceptin (trastuzumab) and Rituxan (rituximab) to market. But it's also fair to say that neither company would be where it is today - or likely independent - if not for the other.

Much has been made of Genentech's unique culture following Roche's July 21 offer to purchase the remaining 44 percent of Genentech stock it does not already own for $89 per share and create a wholly-owned subsidiary out of the biotech. A sizeable portion of the analyst and investor community have decried the move - at least at its current price - saying Roche's bureaucracy will surely crush Genentech's innovative spirit.

But with 11,000 employees and a suite of blockbuster products marketed around the globe, it has been years since Genentech deserved the moniker "fledgling start-up." "Genentech is a big, big company. A very successful one, sure, but it's no longer an entrepreneurial entity," notes Michael Ross, managing partner of the venture capital firm SV Life Sciences LLC and a former Genentech employee.

In these days where rationalization - not innovation - has become the norm, it seems Genentech has become a victim of its own success. It has simply grown too big and maintaining its independence costs too much for Roche not to consider taking 100 percent of its profits.

Roche And Genentech: A Long History

The Genentech of 2008 vastly differs from the Genentech of 1990, when Roche first acquired its majority stake in the company. Back then the biotech was a scrappy underdog facing financial difficulties despite having successfully brought to market several drugs. Its clot buster Activase , successfully approved by FDA, failed to achieve blockbuster status, and investors abandoned the stock sending the share price to a low of around $20 (see chart: " ¹ A Brief History of the Roche/Genentech Partnership: ").

At the time, Roche played white knight, offering $2.1 billion for a 60 percent interest in Genentech and an option to buy the remaining 40 percent until June 30, 1995. As the 1995 deadline approached, the two companies renegotiated their original deal, agreeing to a put/call provision that gave Roche the right to buy Genentech shares at $82.50 and allowed the biotech's shareholders to force a buy-out at $60, effectively putting a floor on the stock's value.

In 1999, Roche bought up the shares in Genentech it did not own and then almost immediately reissued 20 million shares in an IPO at $97 apiece, an 18 percent return on its investment. Roche later sold another 22 million shares at $143.50 for a 74 percent gain. Ultimately, for an investment of $5.8 billion, this arm's-length relationship netted Roche an immediate return of $2.87 billion in cash, a 56 percent stake in the firm, and ex-US rights on a host of highly valuable large molecule oncology products.

A Start-Up No Longer

Over the years, Roche has become increasingly dependent on Genentech's pipeline for its growth. Of Roche's 2007 sales, for instance, 28 percent were derived from Genentech products and roughly a third ($55.2 billion) of its $154 billion market cap stems from its 56 percent ownership of the biotech. Moreover, one-third of the Swiss pharma's Phase II and III pipeline is comprised of Genentech programs.

And with this interdependence, it has become impossible for Roche not to notice that Genentech is no longer the streamlined start-up of yore. Indeed, the employees at the South San Francisco biotech nearly equal Roche's entire U.S. operations, based in Palo Alto, Calif., and Nutley, N.J.

Combining the resources of the two outfits creates an organization with potential sales of at least $15 billion; it will be the seventh largest pharmaceutical operation in the U.S., bigger than the global pharma businesses of Abbott, Schering-Plough and Bayer. That fact alone suggests there may be a powerful argument for combining the two operations in the hopes of extracting industrial efficiencies.

Roche's management said as much in their July 22 investor meeting, calling Genentech "a fully integrated large pharma company with all of its advantages and all of its disadvantages." Chairman Franz Humer told investors, "I think where we have to remain flexible and not become dogmatic is when we see all of a sudden two large pharma companies with two parallel structures in an environment that is getting so much more cost conscious."

But that does not mean Roche will abandon its Genentech-like partnering arrangement when it comes to other, smaller entities. The company has said it has no plans to change its existing partnership with Chugai, the Japanese partner in which it also owns a majority stake.

In addition, Roche Pharma CEO William Burns pointed to the company's July 22 announcement to acquire the privately-owned Madison, Wis.-based RNAi delivery technology company Mirus Bio as an example of Roche's flexible management style. Mirus employs only about 50 people and will remain a separately owned subsidiary in Wisconsin.

That's likely to be cold comfort to Genentech staffers as they huddle around water coolers to discuss the recent offer. Wary about discussing job cuts and facility closures at this stage of the transaction process, Roche has been vague about specific plans, citing only in its initial press release that it sees $750 million to $850 million in potential savings as a result of the buy-out.

The company has focused instead on relaying a touchy-feely message designed to put the biotech's staffers at ease. "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 while announcing the deal.

But behind the corporate spin may be the realization that Roche's hands-off relationship with Genentech has already borne its best fruit. Indeed, despite Genentech's reputation for stellar science, even Genentech's management acknowledged a gap in the late-stage pipeline during the company's annual investor meeting earlier this year.

There are just two new molecular entities in Phase III development: a second generation anti-CD20 molecule for rheumatoid arthritis, and pertuzumab for metastatic HER2 positive breast cancer (See ² Also see "Pipeline Dreams: GSK’s Witty Outlines Plans To Lower Phase III Attrition" - Pink Sheet, 28 July, 2008.). Instead, much of Genentech's near-term focus has been on life cycle management of existing drugs, especially Avastin. The company is aiming to expand indications for the vascular endothelial growth factor inhibitor into areas like brain cancer and adjuvant colon cancer.

Until Roche's bid for Genentech, recent news flow has generally failed to excite investor interest. Some news has even left the biotech facing unflattering questions about drug pricing and efficacy, inquiries generally reserved for traditional pharmas, not biotech darlings. A high-profile story in The New York Times in July questioned the value of Avastin, which fails to extend life more than several months and comes with a price tag of $50,000 to $100,000.

Genentech has also faced criticisms for Lucentis (ranibizumab), the macular degeneration drug, which costs $2,000 per treatment, while Avastin can be used off-label for the indication for about $50.

Opportunity Knocks, Roche Opens The Door

Many in the industry were caught off-guard by the timing of Roche's offer. But the reality is that there may never be a more opportune time for the Swiss company to make such a bold move. Some former employees have quietly pointed out in the blogosphere than given Genentech's size, integration with Roche will be easier now then ever before.

Just as in 1990, when Roche took advantage of Genentech's undervalued stock to make an enormous profit, there is a potentially equally compelling arbitrage argument today: the strength of the Swiss franc relative to the dollar makes Genentech a comparatively cheap investment.

Moreover, Roche's dependence on Genentech's pipeline for its continued growth means it is absolutely paramount that the pharmaceutical company has unfettered access to the biotech's products. But Roche's option to ex-U.S. rights on Genentech products ends in 2015; if Roche were unable to successfully renegotiate this aspect of the deal, Genentech could conceivably partner with other drug makers.

Finally, new data on key Genentech drugs are expected later this year. Positive results - especially regarding the adjuvant use of Avastin - would likely send the biotech's stock on a strong upswing requiring Roche to significantly increase its offer price.

Strategically, there may be another reason for buying out the rest of Genentech now rather than waiting until later: Roche has made a significant bet on the importance of personalized medicine, building huge capabilities in both diagnostics and therapeutics. But at some point it has to marry the two ventures, and as it looks to integrate diagnostics into earlier stages of drug development there may be compelling reasons to fuse the pipelines of the two companies.

A Tempest Strikes; Will An Exodus Follow?

Once the transaction is completed, Roche plans to 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. Roche's Palo Alto, Calif., research center, which employs 1,000, would be shuttered.

Virology research and development activities would relocate to South San Francisco, while the Palo Alto Inflammation unit would move to Nutley. With Genentech's site in South San Francisco and Roche's New Jersey site - where there will still be R&D oncology and inflammation units - the U.S. would become the Swiss company's premiere spot for research and development.

Despite Roche's plans to maintain Genentech's autonomy as an independent subsidiary, these staff relocations will likely alter Genentech's research-driven culture, which encourages both competition and the pursuit of independent research projects.

This pervasive drive to understand is one of the primary reasons Genentech has been able to recruit A-list talent, including neurobiologist Marc Tessier-Lavigne, Executive VP Research Drug Discovery; Richard Scheller, Chief Scientific Officer; Susan Desmond-Hellmann, President Product Development; and David Schenkein, senior VP Hematology/Oncology.

Retaining these scientists and leaders - especially CEO Arthur Levinson - could be critical to Roche's successfully accomplishing its endeavor. But given their long-held Genentech options, many of the senior-level people don't have the financial incentive to stay.

"They've already got their nest eggs," says one former Genentech executive. And retaining Levinson could be the most difficult task of all. "This deal humiliates him," says one banker. "They didn't talk to him first." Adds the CEO of a competing big biotech: "Even if they let him run the pharmaceutical operations, do you think he'd want that?"

But the Swiss have no doubt factored the loss of these so-called "soft assets" into their deal calculus and are prepared to take that risk. And it may not even matter. One institutional investor that holds positions in both companies noted that Genentech's strong pipeline - even without the people - will allow Roche to generate significant profits for the next five to seven years.

Sell-side analysts do not necessarily agree but may have a vested reason for those opinions since Genentech is one of the most important companies they monitor in the industry.

"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."

If recent history is any example, convincing biotech leaders to remain onboard following a big pharma acquisition is no easy feat. MedImmune CEO David Mott announced his resignation just over a year after AstraZeneca's acquisition of that biotech for upward of $15 billion was made public (³ Also see "MedImmune’s CEO Stepping Down" - Pink Sheet, 26 June, 2008.).

Roche's handling of the situation doesn't seem to help matters. Levinson was apparently surprised by the announcement, learning of the deal on July 20, the day before it was announced, and gathering his management team at 5:15 a.m. on July 21 to discuss it.

No Near-Term Resolution on The Horizon

Indeed, Roche's bid is reminiscent of Roche's hostile takeover of the tissue-based test maker Ventana Medical Systems. That should not be too surprising. The Ventana deal was also orchestrated by CEO Severin Schwan, who headed the diagnostics unit before taking the helm at Roche in March. Schwan, with his vision of the pharmaceutical future as one in which large companies will compete on the basis of industrial efficiencies, could ultimately be the critical driver behind the deal.

"Why do it now? I think it may have to do with the new CEO coming in and him trying to take decisive action," Deutsche Bank analyst Michael Leuchten said.

Like the Ventana acquisition, a deal with Genentech's minority shareholders is unlikely to come about quickly. Roche and Ventana negotiated for seven months before shareholders eventually agreed to be bought out for $89.50 per share, or 3.4 billion in cash, an increase over the original offer of $75 per share (⁴ Also see "Roche Finally Gets A Nod With $3.4 Billion Bid For Ventana" - Pink Sheet, 22 January, 2008.).

Genentech's minority shareholders aren't likely to forget that Roche upped the ante for Ventana either.

Investors have already balked at Roche's initial offer, which represents only an 8.8 percent premium over Genentech's closing price of $81.82 on July 18 and a 19 percent premium over the price a month ago. On July 23, a lawsuit was filed in Delaware chancery court against Roche on behalf of minority shareholders, alleging the buyout proposal is unfair and inadequate and timed to take advantage of general market turmoil and the weak U.S. dollar.

The suit, which also names Levinson as a defendant, further claims that due to the control Roche holds over Genentech, Genentech's board of directors will be unable to independently negotiate a deal, despite appointing independent directors to review it.

Complicating matters further are the data that could be released later this year, including results from Phase III studies evaluating Avastin in adjuvant colon cancer and Phase III trials assessing Tarceva as maintenance therapy in non-small cell lung cancer patients.

Positive data would increase the marketing potential for the drugs, giving shareholders an incentive to hold out for a higher share price before finalizing a deal. JPMorgan analyst Geoff Meacham estimates Avastin in adjuvant colon cancer could bring in revenue upside of $1.3 billion by 2012 while Tarceva in NSCLC could bring in upside of $360 million.

"Genentech observers have felt that on a successful adjuvant trial, that day the stock breaks through $100," Deutsche Bank analyst Mark Schoenebaum added.

Final data from that C-08 study are not expected until 2009, but an interim look, if positive, could be released earlier.

Roche said the current offer already reflects future growth opportunities such as Avastin in colon cancer, but it is unlikely Roche will buy out minority shareholders without increasing the offer. According to most analyst expectations, Roche will need to adjust its offer to over $100 per share. At that price point, things could get sticky for Roche, which may need to make more significant cuts to the newly combined organization to avoid dilution.

Roche seems to be betting that the brinkmanship required to obtain Ventana will not occur - primarily because Roche has no intention of selling its majority stake in Genentech. Given this ownership structure, it's all but impossible to foresee another company stepping in to play white knight and make a competing offer for a minority stake in the company and US-only rights. Management also claims the deal with Genentech does not warrant a change of control premium that would be seen with a full-on acquisition.

For precedent and insight, there is Novartis' $5.4 billion acquisition of Chiron in 2006. The Swiss company owned 42 percent of the vaccines maker when it made a bid that was rejected by shareholders. As with Genentech, Novartis' stake in Chiron detracted third-parties from bidding. Novartis eventually increased its offer by 20 percent over the original bid of $40 per share before cementing a deal.

Genentech Signals Negotiating Leverage

Genentech is convening three independent directors - Herbert Boyer, Debra Reed and Charles Sanders - to review the offer, and has retained Goldman Sachs to assist as financial advisors to determine fair value.

The directors will return to Roche with a fair value, and if the parties agree on the price they will enter into an agreement and the proposal will be voted on by Genentech's minority shareholders. If shareholders reject the bid, two banks will be chosen by the independent board members to determine fair value.

However, Genentech issued a statement July 24 maintaining that it cannot be forced, under its affiliation agreement with Roche, to enter into a deal based on the estimate provided by the investment banks, a statement that appears to increase its negotiating leverage.

Don't expect the tale to wrap up anytime soon. It's a story with a long history that could take months to unfold.

- Jessica Merrill (j.merrill@elsevier.com)

Roche’s High Stakes Gambit For Genentech

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