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Genentech’s (DNA) slowing growth does not support the current share price. Recommendation: Buy at $59 or below (current price $70)

Venture capital investments in companies seeking to cure cancer with either Biological or Small Molecule therapeutics have kicked into high gear. There have been 14 new deals announced during the last three months, investing $318 million in new capital. The VC funds have not given up on finding a cure for cancer, and as growth stock investors we shouldn’t either.

Globalization is the Big Driver

There are two long-term drivers for growth in the global cancer drug market — the greying of the world population and the increase in affluence among developing nations. Let me explain the small driver first, which is the greying of the world population.

The incidence of cancer is sharply tilted toward the elderly, as can be seen in the following table (pulled from the American Cancer Society’s publication, Cancer Facts and Figures - 2007).

As an aside, please note that 45% of all men and 38% of all women in the US are expected to get cancer at some point in their lives.

Cancer occurs more often as we get older, and, unfortunately, we are getting older — both individually and on average. Here in the US, we are expected to move from having 13% of our population over the age of 65 in 2010 to 20% of our population over the age of 65 in 2030. All in all, the number of cancer patients in the US should increase at over twice the rate of population growth during the next 20 years — 2.00% growth per year for cancer patients versus an expected population increase of 0.84% per year.

A much more important driver to cancer drug revenues over the next five years is the rapid increase in global affluence. China offers a good example — China’s population has benefited from a sharp rise in living standards and income over the last several years. For example, China had a higher growth rate in new millionaires during 2006 than any other country in the world.

Onyx Pharmaceuticals quotes a startling statistic: while the US has approximately 14,000 deaths annually due to liver cancer and Japan has approximately 30,000 deaths, China is estimated to have 300,000 deaths annually. China is therefore a huge new target market for Onyx, whose drug Nexavar is approved for liver disease in the US and Europe. Onyx expects their partner Bayer AG to complete the necessary regulatory clearances and launch Nexavar in China during the second half of 2008.

Where Are the Opportunities?

Here is a list of six cancer drug companies that are potential investment opportunities:

I will try to value each of these companies individually over a series of reports, starting with Genentech.

How did I decide to focus on these six companies while excluding over 30 others? All of the companies above have at least two abstracts being presented at the American Society of Clinical Oncology (ASCO) meeting, which runs from May 31 through June 3 this year. The competition to present an abstract is fierce because of the publicity attendant upon the ASCO event. Accordingly, I figure that all six of these companies have strong new drug efforts ongoing in oncology.

Genentech’s Slowing Revenue Growth

Genentech Inc. (DNA) is by far the largest cancer company, with four top cancer drugs — biologics Avastin, Rituxan and Herceptin, and the small molecule drug Tarceva. 55% of Genentech is owned by Swiss drug giant Roche AG, who in turn has an exclusive license to sell Genentech’s cancer drugs outside the US.

Genentech does a great job on cancer drugs, and their growth over the last couple of years reflects their success. Revenues were up 40% in 2006 and 26% in 2007. Growth in 2008 revenues, however, is expected to slow to 10.7%, and 2009 revenue growth is expected to come in at 8.4%.

There are a couple of things going on here. First, Genentech’s cancer drugs are already blockbusters, and they are starting to saturate their target markets. Second, the fastest growth is coming outside the US, and the international markets are controlled by majority shareholder Roche.

To get a full picture of Genentech’s global drug sales, you have to read through Roche’s annual report (Genentech does not report their international drug sales, representing those sales as a “royalty” from Roche’s sales). The following table shows Genentech’s worldwide drug revenues in 2007, along with annualized revenue from the March quarter (annualized in that I multiplied the March quarter’s revenues by four). The key observation is that Genentech’s annualized revenue growth rate slowed to 2% in the March quarter.

That annualized 2% growth number overstates the weakness, as growth was stronger on a year-over-year basis comparing Q1 2008 to Q1 2007. Genentech reported a 7.7% growth in year-over-year quarterly revenues. No matter how you slice it, however, Genentech’s revenue growth is slowing.

Most of the growth Genentech can claim is coming from overseas. The bright spot in Genentech’s March report was a year-over-year jump of 47% in Royalties , the line item showing participation in Roche’s international sales.

Genentech at the American Society of Clinical Oncology (ASCO) Meeting

So what is Genentech doing to address their slowing growth going forward? Nothing that is likely to kick their revenue growth rate much beyond 10%. My valuation analysis has them growing revenues at 10.3% annually over the next five years.

Genentech has six abstracts being presented at ASCO next month, more than any other cancer drug company. Exelixis, Inc. (EXEL) is second, by the way, with four abstracts being presented.

Examining Genentech’s six abstracts, we see that three of the reports analyze ways in which Avastin (one of their fastest growing blockbusters) can be used to treat different types of cancer — specifically, colon, brain and breast cancer. Two of the abstracts look at the effectiveness of combining Herceptin, another Genentech top seller, with a new drug called Pertuzumab.

Only one of the abstracts is directed at a new drug targeting a new market — “a phase I study evaluating the safety, pharmacokinetics, and efficacy of ABT-263 [an in-licensed small molecule cancer drug from Abbott labs] in subjects with refractory or relapsed lymphoid malignancies.”

Five of Genentech’s six ASCO abstracts are focused on extending their current cancer drugs into tangential cancer markets. The economics of drug research seem to favour extending a drug already having been approved for some usages by the FDA rather than looking for an entirely new drug. I found this to be true not only with large companies such as Genentech and Celgene, but also with mid sized companies such as Imclone, Medarex and Onyx. The only companies focused on blue sky drugs are the ones with no currently approved drugs — Exelixis and Array BioPharma.

Genentech - Buy at $59 or Below

View the spreadsheet used for this valuation analysis.

You can click the spreadsheet above to see the details, but basically I have developed a December, 2012 target price for Genentech of $91. The stock is trading for $70 right now, which would imply a 5.8% annualized return over the next five years. I require a 10% annualized return to buy Genentech, so the stock is not a buy for me above $59. For readers who disagree with that 10% risk rate, the spreadsheet above includes a table showing annualized internal rate of returns delivered at various price points given the $91 target price.

I’ve made several assumptions in developing this five year target value of $91.

• I have projected domestic drug revenues growing at 8% per year and international royalties growing at 16% per year to arrive at a blended annualized revenue growth rate of 10.3% over the next five years. Total revenues as reported by Genentech are expected to grow from $11.7 billion in 2007 to $19.2 billion in 2012.
• I am projecting operating margins of 50% in 2012, up from 36% in 2007. Driving this operating margin improvement are my expectation of continued declines in R&D and SG&A, along with relatively good growth in non-US drug revenues. Non-US drug revenues have no costs of goods sold, as Genentech accounts for them as Royalties from Roche.
• I am projecting a 2% reduction every year in shares outstanding.
• I place a 7 multiple on 2012 estimated sales and a 15 multiple on 2012 estimated earnings.

The projection of 2% annual share shrinkage is one of the most important and also most tentative of my suppositions above. I am expecting Genentech’s management to apply reductions in R&D and SG&A to share buybacks over the next five years. I note that Genentech has a relatively small option plan of 8.6% of outstanding shares and that they have kept shares outstanding flat since 2005.

See also: Cancer - Celgene (CELG)

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