Comm 471 Section101

Case：Roche
Group 8

Phoebe Zhang, Yi Chen, Syed Huq, Jason Li, Bill Liu

 1. Advantages and risks of owning 100% of Genentech
As Genentech grows larger, it increasingly comes into direct competition with Roche because of the
increasing overlap and duplication between two firms. One of the key advantages of a full acquisition is
that there it reduces duplicating R&D efforts, gives Roche access to Genentech’s intellectual property
(which Roche currently could not share), and allows two companies to exchange information that would
stimulate R&D innovation, a factor critical to the sustainable growth of Roche. Combined operations
would also create economies of scale, thereby reducing manufacturing, G&A and other operational
expenses. In addition, as Genentech becomes one of the largest biopharmaceutical companies in the US,
a large percentage of Roche’s revenue and profit comes from Genentech-originated products. In fact,
Roche’s top three products in terms of sales come from Genentech. Furthermore, a full ownership
would give Roche access to Genentech’s cash, which Roche currently does not have access to directly
because cash paid to Roche would need to go to all Genentech’s shareholders equally and be subject to
taxation. Lastly, 100% ownership of Genentech means that Roche does not have to compete with other
bidders to renew the product licensing agreement expiring in 2015 that gives Roche the right to develop
and commercialize Genentech’s products, resulting in cost savings.
Despite the above advantages, there are several risks that must be considered. Genentech’s
management is not willing to accept the $89 price offered and may take moves to prevent a merger
from happening. This may eventually leads to a hostile takeover, which may have detrimental effect to
Genentech’s strong and positive culture. Genentech’s key scientists (Genentech’s “intellectual property”)
and management may leave the firm, making integration more difficult and costly. There is also
uncertainty in securing financing due to the financial crisis, and without financing, the deal would
collapse.

2. Responsibilities Roche has to the minority shareholders

As the majority shareholder of Genentech, under Delaware corporate law, Roche owes fiduciary duty to
Genentech’s minority shareholders. For instance, to protect minority shareholders, when the present
licensing agreement expired, a new agreement would have to be negotiated, possibly in competition
with other bidders. In addition, Roche could not share in Genentech’s intellectual property nor access
Genentech’s cash directly without distributing cash to all shareholders equally. Furthermore, the
proposed deal creates a clear conflict of interest between Roche and minority shareholders. To protect
itself from potential lawsuits, Roche has to acknowledge the role of independent directors who would
have to review and make a decision with respect to the offer. The terms and conditions of the
transaction would be determined through negotiations with the independent directors, not the Roche’s
appointed directors.

3. As of June 2008, the value of the synergies Roche anticipates from a merger with Genentech
Roche management expects $750 – $850 million in annual saving per year for five years from the
merger. However, based on our estimate, saving from solely the merger (excluding the portion that
Roche could achieve alone without the merger) is about $1.4 million in present value, which is
equivalent to synergy of $1.35 per share of Genentech (Appendix A). We included only the portion of
synergy dependent on merger with Genentech because the rest could be achieved by Roche
independently of the transaction.
 4. Range of values reasonable for Genentech as a stand-alone company in June 2008
Based on our DCF model, the appropriate range for Genentech, without taking into account of the
synergy from the merger, is $86 - $93 per share (Appendix B). The low end of our proposed range ($86)
is based on terminal value growth rate of 1.5%, mid value ($90) is based on a rate of 2.0%, and the high
end ($93) is based on a rate of 2.5%. We mainly used the assumptions from the LRP because we believe
that it is a more accurate prediction of Genentech’s future financial prospect than NFM. One reason is
that LRP is submitted to Roche in June before the management knows about a potential merger;
therefore, there is less incentive for the board to inflate the financial numbers. In addition, the NFM
extended the period of free cash flow forecast to 16 years with similar revenue growth rate as the one
from LRP (6.9% vs 7.0%). Longer period of revenue forecast tends to inflate the revenue numbers
because the terminal value growth rate is much lower than 6.9%, only at 2.0%. We have also examined
the historical financial ratios of Genentech, specifically the net working capital, capex, and depreciation
ratios, and have found the NFM significantly understates these three numbers. However, one
adjustment we added to the enterprise value is the $8.19 billion capitalized value of the 2015 “opt-in
rights”, because it is reasonable to assume that Genentech may sell the licensing agreement in the
market after it expires in 2015, thereby increasing the value of Genentech.

5. Analysis of comparable companies (Exhibits 12, 13, and 14) indication about Genentech’s
value within the range established in question 4
The average premium of precedent “squeeze-out” transactions is around 17% over price of previous
trading day. The $89 offer made by Roche represents 8.8% 1-day premium, much lower than the
average as seen above. Based on our valuation range of $86 - $93 per share, the 1-day premium ranges
from 5% to 14%, still lower than the average (Appendix C). We have also looked at the largest deal with
similar size as Roche’s acquisition (about $44 billion), ING C’s $32 billion acquisition of 45% Telecom
Italia, the 1-day offer premium is 36%. Overall, this implies that our estimated range of offer price is
lower than the average, and there should be more “squeeze-out” premium added to the offer price in
the Roche deal.
Our valuation range is higher than comparable companies and research analysts’ target price. For
example, the EV/EBITDA of average core comparable in 2009E 9.6x while that of our mid valuation is
12.1x. However, it is important to note that Genentech’s actual market valuation (based on July 18th
share price) is also higher than that of its peers. In addition, our low end estimate of $86 per share is
slightly higher than the consensus price among research analysts, while our high end estimate of $93
per share is lower than the highest four target prices.

6. How has the financial crisis affected Genentech’s value? What changes in valuation
assumptions occurred between June 2008 and January 2009?
As can be seen from the price chart, price of Genentech increased drastically, even above the offer
price of $89, after the announcement of Roche offer. However as the financial crisis hits, stock prices of
Genentech dropped in line with its industry. Despite near-term revenues and earnings were not much
affected by the financial crisis, market reacted negatively to the financial crisis. Therefore, Genentech’s
value dropped because of the financial crisis. The special committee’s valuation of $112 - $115 per share
now became more unreasonable. At the same time, bridge loan financing became increasingly difficult
to obtain and cost of debt for financing increased (which also results in the increase in the discount rate).
Even though that the risk free rates decreased, the triple B corporate interest rates rose, suggesting that
borrowing cost has gone up.

7. Genentech’s board and management response to Roche’s offer of $89 per share
To protect minority shareholders, the board delegated responsibility for appraising the offer to a
special committee made up of independent directors. The independent directors and special committee
regard the offer price negatively and quickly rejected the offer, saying that the price substantially
undervalues the company. However, they did not indicate which price range they would accept.
Eventually, they presented their valuation using NFM, instead of LRP they previously submitted in June,
that inflates the valuation of Genentech and valued the company at $112 to $115 per share. This price is
substantially higher than the valuation using comparable company analysis and any research analyst
target prices. It is very clear the the board and management does want the deal to go through, but have
not indicated the reason for not wanting a merger. Finally in 2009, the negotiations between the two
companies had reached an impasse.

8. What should Franz Humer do? Specifically, should he launch a tender offer for Genentech’s
shares? What are the risks of this move? What price should he offer? Should he be prepared
to go higher? How much new financing will Roche need to complete the tender offer?
The risk in launching a tender offer is that this viewed as a hostile move and might solidify
opposition to Roche among Genentech’s managers and employees. Because of the company’s
strong culture, this move may drive some of Genentech’s key scientists and managers into arms of
rivals and would make later integration of the two companies more difficult and costly. Another risk
is that loan for financing the acquisition is difficult to obtain during the financial crisis because few
banks are interested in arranging bridge loan. Thus, Roche may not be able to finance the deal, or
that the financing cost may be prohibitively expensive due to rising corporate interest rates.
Furthermore, even though share price decreased during the financial crisis, Genentech had many
committed and loyal shareholders rather than short-term traders, making it more difficult to
convince them to part with their shares. Despite the risks, we believe that the best option is to make
the tender offer because of management’s strong reluctance to agree on the offer price and the
favourable market condition – the decrease in Genentech’s share price means that the tender offer
price could be not as high to make it attractive for shareholders to tender. We think that tender
offer price should be below the value of Genentech as a stand-alone firm plus the synergy from the
merger, which is equivalent to $91.35 (mid-range valuation of $90 plus synergy of $1.35 per share).
Therefore, Roche could make a tender offer of $90 - $91 per share (implied equity value of around
$95 billion). He should be prepared to go slightly higher than $89 in order to decrease the risk of
shareholders not tendering. Overall, he needs a total of approximately $42 billion cash to finance
the deal. With the existing $20 billion cash Roche has on hand, the company needs to raise an
additional $22 billion loan to complete the tender offer.
Appendix A: Synergy

Synergies solely from Merger with Genentech

(i n mi l l i ons of US$) 2013 and
Year 2009 2010 2011 2012 thereafter
Ma nufa cturi ng 0 51 102.5 128 135
Res ea rch 0 0 0 0 0
Devel opment 38 98 109 111 112
Ma rketing & Di s tri bution 38 98 101 104 107
Roche G&A 47.25 77.25 84.75 92.25 93
Genentech G&A 14.8 38.11 39.22 40.33 41.81
Total 138.05 362.36 436.47 475.58 488.81
Di s count Fa ctor (9%) 0.9174 0.8417 0.7722 0.7084 0.6499
Di s counted Total 126.65 304.99 337.03 336.91 317.69
PV in 2008 1423.28
Sha res O/S (MM) 1053.00
Synergy/Share 1.35
Appendix B: Valuation using DCF

DCF
(in millions of U.S. dollars) 1 2 3 4 5 6 7 8 9 10
2008A 2009E 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E
Revenues
Product sales 7.0% 10,531 11,268 12,057 12,901 13,804 14,770 15,804 16,910 18,094 19,361 20,716
Royalties 7.0% 2,539 2,717 2,907 3,110 3,328 3,561 3,810 4,077 4,362 4,668 4,995
Contract and other 7.0% 348 372 398 426 456 488 522 559 598 640 685
Total Revenue 13,418 14,357 15,362 16,438 17,588 18,819 20,137 21,546 23,055 24,668 26,395

Costs and expenses

Cost of sales 9.5% 1,744 1364 1459 1562 1671 1788 1913 2047 2190 2344 2508
Research and development 18.5% 2,800 2656 2842 3041 3254 3482 3725 3986 4265 4564 4883
Marketing, selling, general
15.1% 2,405 2,168 2,320 2,482 2,656 2,842 3,041 3,254 3,481 3,725 3,986
and administrative
Profit sharing 9.0% 1,228 1292 1383 1479 1583 1694 1812 1939 2075 2220 2376
Other expenses 0.0% (88) 0 0 0 0 0 0 0 0 0 0
Total costs and expenses 8,089 7,480 8,004 8,564 9,163 9,805 10,491 11,226 12,011 12,852 13,752
Operating income 5,329 6,877 7,359 7,874 8,425 9,015 9,646 10,321 11,043 11,816 12,643
a
Less: Taxes -35.0% (2,004) (1,973) (2,575) (2,756) (2,949) (3,155) (3,376) (3,612) (3,865) (4,136) (4,425)
After-tax operating income 3,325 4,904 4,783 5,118 5,476 5,859 6,270 6,708 7,178 7,681 8,218
Plus: Depreciation and amortization 3.3% 592 577 507 542 580 621 665 711 761 814 871
Less: Increase(Decrease) in NWC 1.3% (705) 187 200 214 229 245 262 280 300 321 343
Cash flow from operations 3,212 5,294 5,090 5,447 5,828 6,236 6,672 7,139 7,639 8,174 8,746
Less: Capital expenditures -3.9% (751) (560) (599) (641) (686) (734) (785) (840) (899) (962) (1,029)
FCF 2,461 4,735 4,491 4,806 5,142 5,502 5,887 6,299 6,740 7,212 7,717
Equity-based Compensation -1.3% (187) (200) (214) (229) (245) (262) (280) (300) (321) (343)
FCF after Compensation 4,548 4,291 4,592 4,913 5,257 5,625 6,019 6,440 6,891 7,374
Discount Factor 9.0% 0.9174 0.8417 0.7722 0.7084 0.6499 0.5963 0.5470 0.5019 0.4604 0.4224

Valuation
TV Growth Ra te 1.5% 2.0% 2.5%
Present Values:
CF from 2009 - 2018 34,394 34,394 34,394
Terminal Value 44,113 47,497 51,401
Add: Adj “Opt-in Rights" 8,190 8,190 8,190
Enterprise Value 86,697 90,081 93,985

Less: Debt (2,829) (2,829) (2,829)

Add: Cash and Equivalent 7,000 7,000 7,000
Equity Value 90,868 94,252 98,156
Shares O/S 1,053 1,053 1,053
Implied Price per Share 86 90 93

Note: italics are assumptions made in the model

Appendix C: Squeeze-out and Comparable Company

Squeeze-out

Implied Valuation Price

July 18 Stock Price Low-end Mid High-end
Price 81.82 86 90 93
1 day Premium 5% 10% 14%

Comparable Companies
($ in millions, except per share data)
Long Enterprise Value /
Price Enterprise Term Revenue EBITDA Price / Earnings
Company 7/18/2008 Value Growth 2008E 2009E 2008E 2009E
All Comparables: Mean 20.1% 6.7x 5.6x 16.7x 14.0x
Median 17.7% 4.8x 4.3x 12.0x 11.3x

Core Comparables: Mean 13.5% 4.1x 3.7x 10.4x 9.6x

Median 13.2% 4.1x 4.0x 9.7x 9.3x

Genentech (Actual) $81.82 $84,570 19.2% 6.4x 5.9x 15.1x 14.1x

Implied Range $86.00 $86,697 6.5x 6.0x 14.6x 11.6x

$90.00 $90,081 6.7x 6.3x 15.2x 12.1x
$93.00 $93,985 7.0x 6.5x 15.9x 12.6x