Description

Roche Holding AG (“Roche”) is a Switzerland-based pharmaceutical company that develops and manufactures pharmaceutical and diagnostic products. In addition to these two core businesses; Roche also holds large stakes in 2 public biotechnology companies: a 55.3% majority stake in Genentech Inc. (Ticker: DNA) and a 50.6% majority stake in Chugai Pharmaceuticals (BB Ticker: 4519 JP.)

The Roche/Genentech relationship began in 1990 when Roche took an initial 60% stake in Genentech for $2.1Bn. Most importantly, the two companies entered into a marketing agreement by which Roche would have rights to all Genentech products outside the U.S. net of a royalty payment to Genentech. Subsequently, Roche acquired a similar stake in Chugai in order to gain a distribution platform in Japan, and gave all rights to Genentech’s products in Japan to Chugai.

We believe the current enterprise value of Roche is undervalued particularly when you take into consideration the value of its ownership stake in Genentech and its rights to Genentech’s products ex U.S. To isolate the undervalued “stub” position you deduct from Roche’s enterprise value:

1) Roche Pharmaceutical, (their Non-Genentech drug portfolio),
2) Roche Diagnostics, and
3) Roche’s ownership in Genentech

This net result is in essence what you are paying for Roche’s rights to Genentech’s non-U.S. products.

Valuation:

Roche Pharmaceuticals is one of the largest pharmaceutical companies in the world with a strong portfolio of drugs including CellCept, Recormon and Pegasys. We have examined the Roche portfolio drug by drug and applied what we believe to be conservative market multiples to each product based upon future growth potential, market size, and competition (generic or otherwise.) Through this process we arrive at a blended sales multiple range of 2.6x to 3.7x sales for the portfolio. Applying these multiples to Roche- only (Non-Genentech/Non-Chugai) drug sales of $12.7Bn we arrive at a valuation of $33.0Bn to $47.2B. Public market comps for Roche Pharmaceutical trade in a range of 4.0x to 6.0x sales, thus we believe our valuation is conservative.

Roche Diagnostic is a leading provider of medical testing products and services generating sales and EBITDA of approximately $6.3Bn and $2.0Bn, respectively. Using a valuation range of 8.0x to 9.0x 2005E EBITDA, we arrive at a valuation of $16.2Bn to $18.3Bn. Public comps trade at slightly north of 10.0x forward EBITDA and Quest Diagnostics recently announced its acquisition; albeit, much smaller, of LabOne for just north of 12x forward EBITDA, thus we believe our valuation is conservative.

We outline the price we are paying for Genentech’s products Ex U.S. below:

Low High
Roche Enterprise Value $126,783.8 $126,783.8
Estimated value of Roche Pharma (47,166.5) (33,334.4)
Estimated value of Roche Diagnostics (18,272.0) (16,241.7)
Value of Genentech Stake (53,063.5) (53,063.5)
Value Paid for Roche Ex-US DNA Business $8,281.9 $24,144.2

Value of Chugai Stake(1) (5,237.6) (5,237.6)
(1) We do not deduct since we elected not to short this component.

We believe that the best way to value Roche’s rights to Genentech’s products Ex U.S. and Japan is to adjust Genentech’s current enterprise for: 1) drugs that Roche does not have Ex U.S rights for, 2) Royalties paid by Roche to Genentech and 3) Japanese market sales that Roche does not own through its stake in Chugai.

As we did for Roche, we examined each Genentech proprietary drugs and applied appropriate sales multiples to each arriving at a blended peak sales multiples of 3.5x to 5.2x and a valuation range of $6.1Bn to $8.8Bn.

Roche pays Genentech a blended royalty of 15-20% of sales. However, not only does Genentech receive a royalty from Roche on Ex-US sales, but also avoids royalties on its own US sales. Thus, we believe to properly adjust Genentech’s value, we must double the adjustment to 30-40%. We reduce enterprise value by 30-40% since biotech companies tend to trade on a multiple of sales.

Lastly, we reduce the value of Genentech for the Japanese market Roche does not own or approximately 49.4% of Chugai’s enterprise value (100%-50.6%, Roche’s ownership stake in Chugai), so we deduct that portion from the valuation.

Value of Genentech Drugs to Roche

Low High

Market Value of Genentech 95,955.7 95,955.7
Value of DNA Only Drugs (8,781.2) (6,097.9)
(not licensed by Roche Ex-US)
Net Value of DNA Cancer Franchise 87,174.5 89,857.8
Haircut for Royalty Income (20.0%) (15.0%)
Haircut for Royalty Payments (20.0%) (15.0%)
Haircut for 49.4% of Chugai (5,113.4) (5,113.4)
not owned
Net Value of Ex-US DNA/Roche $47,191.3 $57,787.1
Price Paid $24,144.2 $8,281.9
Net Upside $23,047.1 $49,505.2
% Upside from Stub Price 95.5% 597.8%

Two principal assumptions are that the market ex-US and ex-Japan is approximately equivalent in terms of product pricing and market size. Our due diligence has confirmed that on a net basis after rebates, pricing appears to be in line. Certainly from a pure population stand point, ex US and ex Japan is greater than the US Market. Additionally, Europe alone seems to be a bigger market due to longer duration of drug and the higher incidence rate of lung cancer, an area targeted by Genentech’s drugs. Thus we believe market size is at least as large and most likely larger for Roche than Genentech.

Trade:

We believe the right way to play this trade, is to isolate the “stub” by acquiring Roche shares and shorting Roche’s ownership in Genentech. Shorting Genentech rather than maintaining the exposure through the long position in Roche makes sense in large part because the Roche position already gives exposure to the same drugs, only in different markets. As detailed above, it creates this “stub” at an attractive discount. In contrast to the “stub” valuation, the Genentech short strips away a stock that appears over valued, trading at 41x 2007 EPS and 2.0x P/E/G, a significant premium to the overall market, the biotech index and, most importantly, the Roche “stub”. Also, most of the good news on Genentech is out and any additional upside overtime should be reflected in Roche’s stock price.

Shorting Chugai we believe poses risks because we believe it is potentially undervalued and given the size of Roche’s ownership, it represents only 4.2% of Roche’s enterprise value, the likelihood of this translating into upside appreciation in Roche is limited.

Below, we have simplified our analysis to show the stub creation price, and the implied valuations of the stub components. As shown, we believe there is 30-70% upside in this trade. Further leverage could be provided if one were to create a short for the Roche Diagnostic and Pharmaceutical components.

Price Paid for Stub
Roche Enterprise Value $126,783.8
(Value of Genentech Stake) (53,063.5)
Price Paid for Stub $73,720.3

Stub Components and Valuation Low High
Value of Roche Diagnostic Business $16,241.7 $18,272.0
Value of Roche Pharmaceuticals Business 33,334.4 47,166.5
Value of Chugai Stake 5,237.6 5,237.6
Value of Genentech Ex-US Franchise 47,191.3 57,787.1
(Value of Chugai Not Owned) (5,113.4) (5,113.4)
Implied Value of Stub 96,891.6 123,349.7
Price Paid 73,720.3 73,720.3
Percentage Upside 31.4% 67.3%

Catalyst

While Genentech’s stock has doubled in the last 6 months, Roche’s stock has only increased 42%. We believe this increase reflects mostly the appreciation in market value of its Genentech stake and that the market is failing to recognize the value of Genentech’s Ex-US business that Roche owns. We believe that over time people will recognize this disparity and the spread will close, or, if nothing else, investors will buy Roche stock to own Genentech’s strong portfolio at a much lower valuation.