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Can Genentech Stage a Recovery?

Biotech Firm's Shares May Languish in Sick Bay
Unless Pipeline, Tanox-Deal Prospects Improve

By KAREN RICHARDSON
July 23, 2007; [WSJ] Page C1

Genentech Inc.'s stock could use a shot in the arm.

The once-healthy stock of the San Francisco biotechnology company could languish for months as sales growth slows for its key cancer drug, Avastin. And new revenue opportunities for its existing stable of medicines likely won't materialize until at least the end of the year.

What investors once viewed as a potential catalyst -- Genentech's first acquisition -- also has turned out to be more of a pain than a salve. Stumbles over regulatory issues have delayed the closing of the agreement to buy Tanox Inc., a small biotech company that makes an asthma drug. And some bearish investors have speculated that the $919 million transaction might never get done.

Since hitting a high of nearly $100 in 2005, Genentech shares have drifted lower. In 4 p.m. New York Stock Exchange composite trading Friday, the stock closed down two cents at $75.15, giving the company a market value of $79 billion. The shares are down 7.6% this year and off 19% since the end of 2005, while the Dow Jones Wilshire Biotechnology Index is effectively flat over both time periods.


Having traded in 2003 at more than 200 times earnings, Genentech, whose majority owner is Swiss drug maker Roche Holding AG, is now priced at about 25 times estimated per-share earnings for 2007, while the broader biotechnology sector is trading at 53 times, according to Thomson Financial.

While Genentech is inexpensive on a historical basis, "a cheap-looking valuation can be a trap before new growth drivers emerge," warns Jim Reddoch, an analyst at Friedman Billings Ramsey & Co., which doesn't provide banking services for Genentech. Mr. Reddoch has a "hold" rating on the stock. In investing parlance, a "value trap" is a stock that has gotten cheap but will languish at that valuation.

High biotech-stock valuations are "like a fire that needs more wood to keep it going," says Tom Vandeventer, portfolio manager at Tocqueville Asset Management LP, which manages about $7 billion. Tocqueville recently sold some Genentech shares, which Mr. Vandeventer bought a few years ago. "A lot of the catalysts that might move the stock higher are visible but aren't close at hand before year's end."

Avastin's second-quarter sales in the U.S. were flat from the previous quarter for its approved treatment for colon cancer. But Genentech expects Avastin's U.S. sales, which at $1.75 billion last year accounted for 23% of its total product sales, will be buoyed since the drug has been approved to treat lung cancer. Approval for the treatment of breast cancer is expected in mid-2008, which the company also expects to boost revenue.

Some analysts aren't so optimistic about Genentech's near-term growth prospects, however, and lament investors' fixation on Avastin as a driver of earnings and stock price. Instead investors need to look at Genentech's whole array of treatments.

"People need to come back to a more fundamental story, which is a portfolio of products," says Michael King Jr., an analyst at Rodman & Renshaw, a small investment bank that specializes in biotech stocks. Mr. King has a "hold" rating on Genentech. He doesn't own the stock and his firm doesn't have a banking relationship with Genentech.

One concern for investors is a study last month that indicated Avastin works marginally better when used in half the standard dose. Expecting that doctors will prescribe lower doses, investors bet sales would slow. Within three weeks of the study's disclosure, Genentech shares had fallen 6%.

Meanwhile, results of trials for Genentech's lymphoma drug, Rituxan, for treatment of rheumatoid arthritis and other diseases aren't due until the end of 2007 or later.

Even Genentech's first acquisition since it was founded 31 years ago has failed to inspire investors, save for short sellers betting that its stock price would decline and merger traders focused more on the target, Tanox.

The November announcement that Genentech would buy Houston-based Tanox for $20 a share caps an 11-year collaboration on Xolair, an injectible asthma drug. Last year, Genentech paid $187 million in royalties for Xolair, mostly to Tanox, and recorded Xolair sales in the U.S. of $425 million.

In January, Genentech said the review of the deal by the Federal Trade Commission would take longer and delay its closing date. Then, in February, the Food and Drug Administration said Xolair required a "black-box warning," the industry's most stringent, because it found Xolair caused a severe allergic reaction and even death in some patients, which could occur hours after an injection.

This month, Genentech said the strengthened warning label leaves the length of post-injection observation time to the discretion of doctors rather than mandating it, which could have been an inconvenient put-off for doctors and patients.

Still, sales growth of Xolair, which costs as much as $40,000 a year, had already been slowing. Sales grew 14% in the second quarter, compared with 31% in the same period in 2006.

"A lot of physicians and primary-care specialists aren't so comfortable administering it," says Jonathan Field, director of Pediatric Allergy & Immunology Clinic at New York University Medical Center. He adds, however, that he has 24 patients on the drug with no sign of any problems.

Other doctors and investors in Genentech and Tanox say the label issue was a temporary setback and that it will continue to be profitable for Genentech. By applying the new label and addressing the FDA's concerns, "we expect continued good growth in Xolair use," David Ebersman, chief financial officer of Genentech, said in an emailed response to questions.

With $1.75 billion in cash on its balance sheet in the second quarter, when it generated $760 million in cash from operations, Genentech won't be burdened by the financial cost of buying Tanox. Nor, however, would it necessarily hurt to walk away, since Genentech would only have to pay a relatively small $5 million break-up fee to Tanox to do so. Last month, about 20% of Tanox's shares were sold short.

Genentech's Mr. Ebersman said the company still expects the deal to close in the third quarter, subject to customary closing conditions, FTC approval and "the absence of a material adverse event," which the company defines as something that could hurt the sales, future value or revenue of Xolair -- a caveat so vaguely worded that it leaves both short sellers and long-term investors feeling queasy.

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