Roche/Genentech: When Independence Costs Too Much

It's already Tuesday but that won't stop us from our penchant for Monday morning quarterbacking--especially when it comes to the biggest deal we're likely to see all year: Roche's unsolicited bid for the remaining 44% of Genentech it didn't already own. So why do it?

Certainly, Roche’s earnings are slowing and buying the remainder of Genentech will allow it to consolidate 100% of Genentech’s profits, not merely 56% of them. And there may be, as one banker noted, obscure tax reasons pushing a deal: Roche has always had a complex financial structure.

But ultimately Roche’s acquisition rationale must out-argue the one big reason not to do the deal: this has been the most successful relationship in pharmaceutical history. Neither company would likely exist as an independent entity without it. Genentech was an acquisition waiting to happen back in 1990 when it managed to keep at least managerial independence by selling Roche 60% of its shares. Without Genentech, the Swiss giant would most likely be part of another Swiss giant, Novartis (which still owns a small stake in the pharma.)

It's worth remembering that in 2007, Roche got 28% of its sales from Genentech-sourced products, which include the large molecule trifecta Herceptin, Rituxan, and Avastin. Moreover, one third of its Phase II and III pipeline is comprised of Genentech programs. Meanwhile, Roche's 56% ownership of Genentech accounts for roughly a third ($55.2 billion) of its $154 billion market cap, the second biggest in Pharma after Johnson & Johnson.

In case you aren't getting it, let's be clear: Roche’s success is largely due to Genentech.

By buying Genentech – and no one we spoke with figures this deal will end up any other way, as we noted yesterday the only question is the ultimate price tag– Roche is betting that this unique relationship has already borne its best fruit. The independence that kept Genentech productive has simply become too expensive.

Sure, the Roche press release made the obligatory soothing noises about Genentech’s independence and culture. Severin Schwan, Roche's CEO even went so far as to say “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” on a same-day conference call announcing the news. “We have sent very, very strong signals to Genentech [about] how much we appreciate the strength Genentech brings into our organization," he said.

I'll say. Actions, as your mother taught you, speak louder than words. And the manner of Roche's bid does much to destroy any future positive collaborations between the two companies. Apparently, Genentech CEO Art Levinson only learned of the deal on Sunday, July 20th, the day before it was announced.

If the intent was to preserve the Genentech culture, wouldn't Schwan's team have first outlined the positive rationales for the deal to Levinson and his board, and allowed them a window of time in which to suggest alternative governance structures that might have preserved Genentech's independence? Instead the announcement was sprung upong Genentech as a fait accompli.

The deal, in short, has more of the hostile flavor of the Ventana takeover. That shouldn't be too surprising: the Ventana acquisition, which took seven months from start to finish, was also spear-headed by then diagnostics-leader Schwan. Moreover, Greenhill & Co., the boutique bank that advised Roche in that high stakes gambit, is also advising on the Genentech tender offer.

Few people we talked to figure that Genentech’s best scientists will stick around. In the first place, most of those responsible for the marketed and later-stage products are already gone or wealthy enough, thanks to Genentech options, to chance a start-up. “They’ve already got their nest eggs,” says one former Genentech executive. “I suspect most would stay if Art Levinson does,” says a senior Genentech executive. “But they won’t if he doesn’t.”

And the early betting is that he won’t. “This deal humiliates him,” says one banker. “They didn’t talk to him first.” Adds a Big Biotech CEO: “Even if they let him run the pharmaceutical operations, do you think he’d want that? I certainly wouldn’t.”

Perhaps David Hamilton of bNet Industries is correct when he writes that Roche "has vastly underestimated both the difficulty of managing biotech operations and the risk that Genentech’s scientists will simply walk away at their first opportunity." They certainly aren't the first Big Pharma to take the biotech plunge that's faced significant cultural issues--MedImmune, anyone?

But Roche is populated by extremely smart folks, so our guess is Schwan's team has probably figured the likelihood of mass exodus into its deal calculus. Instead, it’s betting that the strategic and financial flexibility complete ownership permits are more valuable than the theoretical continued R&D productivity achieved by keeping Genentech at arm’s length.

Indeed, a financially strong Roche is buying Genentech at a time “when the house of Pharma is burning,” says one Big Biotech CEO. With Genentech, Roche will be be much larger by market cap than all of its pharma rivals and far out of reach of its Swiss nemesis, Novartis, ensuring freedom from takeover threats.

Which gets to what we suspect is the real point of the deal: industrial efficiencies. Roche’s last major pharmaceutical acquisition– of Syntex, in 1994, for $5.3 billion– worked out quite well, if not exactly as the pharma company imagined. Roche cut massive costs out of the operation, saw their shares rewarded for the expense reductions, and netted themselves, in the transplant drug CellCept, one of their most important products outside of the Genentech collaboration.

Today, Genentech is one of the few large companies Roche could buy without angering Wall Street, which has come to see the large cost-cutting horizontal mergers characteristic of the 1990s as value destroying. But the aura of the Genentech pipeline allows Roche to make a horizontal acquisition–with plenty of opportunities to cut significant expenses and thus increase earnings (Roche’s PR estimates savings of $750 - $850 million a year).

And while a number of analysts were angry over the deal’s terms, Roche shares were up on the announcement. “It may not create value long term,” says the Big Biotech CEO, “but it lets Roche do what these deals used to do – cut costs – and live to fight another day.”

Indeed, Schwan’s vision of the pharmaceutical future is one in which large companies will compete on the basis of industrial efficiency, not the kinds of innovations Genentech is known for. The value of such innovation is too unpredictable and perhaps growing more so as payors increasingly question the high prices charged for a cancer drug like Avastin which provides, on average, only a few extra months of life.

It's likely Roche took a look at the price of its current Genentech relationship--with its manufacturing transfer prices, up-front fees and royalties, and most importantly no ability to leverage its investment in the US marketplace where the economics of oncology marketing look more and more like primary care--and figured those costs outweighed the innovation it would lose if Genentech's world class talented departed as a result of a takeover. Just as no primary-care force can afford to sell a single product, Roche can’t afford a US oncology operation selling only Xeloda.

Moreover, Roche is clearly not convinced that Genentech’s productivity would have continued at the rates it has in the last decade. And there are plenty of people who agree. “We all know that Amgen is now a Big Pharma. We talked about it eight years ago. But I think Genentech has now sneaked over that line too,” says the CEO of one of Genentech's peer Big Biotechs.

Without having spoken with him for this story, we suspect Severin Schwan’s vision of the pharma future looks a lot more like the cost-constrained world he knew at Roche Diagnostics – where innovation was rare and rarely paid for; where extraordinary business acumen counted for more than outsized research capabilities. Roche’s first gamble on Genentech was all about R&D. Its new gamble: business synergies will drive the next wave of pharmaceutical success.

--By Roger Longman