Case study: Roche's Acquisition of GenentechMads Solberg Thomas, Luca Marmori, Rok Fer_jan la) Why is Roche seeking tobuy the 44% of Genentech it does not own? Roche is seeking to buy 44% of shares in addition to 56% that already owns. Main purpose of purchasing rest of shares is to merge two companies and exploit the synergies. Roche owned a majority stake in Genentech from 1990 and since then partnership was considered as one of the most successful in pharmaceutical industry. Every year less and less innovative products entered the market, so pharmaceutical companies were forced to deliver growth through mergers and acquisitions of other pharmaceutical companies. The old model, where Roche had a majority stake in Genentech but left the company to operate on their owill, did not work anymore for Roche, so they decided to do a horizontal acquisition and exploit Genentech potential. Acquisition would bring synergies, reduce risk and grow.The t\vo companies would not be competitive anymore between each other but would increase competitive strength towards other companies. All make sense if the synergies are lower than premium paid. 1b) From Roche's point of view what are adva11tages of owni11g 100% of Ge11e11tech? Owning 100% of Genentech would create the Largest biotechnology company in the world. (NY Times:http://www.nytimes.com/2009/03/ 13/business/worldbusiness/13drugs.html). Roche wou ld benefit from many of newly established synergies in total value of $Sb. The amount is a consequence of manufacturing, development and M&D cost reduction. Government and administration costs would reduce as well. Complete ownership would enable Roche to have a complete access to all technology, R&D projects and findings held by Genentech. Currently, the conflict of interest with Genentech's minority shareholders prevent them the access to desired information. Moreover I 00% ownership wou ld enable Roche to extract $9,Sb currently held by Genentech in form of cash and cash equiva lents. This cash could also be used to party repay the debt made by accusation. Finally there's an opportunity to create an affiliate contract extension allowing Roche to distribute Genentech best selling drugs and reducing or eliminating the risk of losing that right (sell Genentech'sproducts out of the US's market). le) What are the risks? losing the most important part of Genentech: the Human capital. so there is the bad chance that they change job or place to work. so the bidder pays higher premium than the value of synergies. there is a high risk of destroying the old culture and business practices in Genentech. Consequently the deal would be considered as bad and price of Roche's stock would drop.This company gives importance to the family environment in which they used to work. and Roche's doesn't have majority influence in board. By the fact that most of the minority shareholders are Genentech employees. After 2015 Genentech would be free to sell or auction the right which could be very expensive for Roche. Loss of selling rights for non US market During their 100% ownership of Genentech. Debt obligation risk One of risks that Roche is facing is also a debt obligation risk. it might be not ethical or in a certain way not according to rules of business. Is very risky to squeeze out minority SH that are working in that firm. they bear the risk oflosing the right. and that is something they wouldn't like to change in their work place. or the desire to acquire the company is too big. would not be successfully tested and will be banned from sale. Risk of complementary drug entering the market A lot of start-ups in biotechnological industry are working to develop new cancer drugs which represent a risk of sales drop of Avastin and other best selling drugs which would reduce Genentech growth prospects. . For the deal to be successful Roche would have to borrow around $30b of debt which could be more expensive due to financial crisis and consequently more difficult to get and repay. Roche would have to bear a risk that Avast in. Roche has signed affiliation agreement which gives them the right to sell Genentech on non US market. As contract expires in 2015.Run of human capital and destroying the company culture One of the main risks of seeking to buy the rest of the Genentech's shares is the Squeezing out consequences (hostile takeover). Risk of bad test results Furthermore if the acquisition would be successful before April 2009. Genentech's cancer drug facing test period. reducing Genentech 's revenues. Paying higher premium than the real value of synergies The value of synergies can be easily mispriced. a matrix using different levels of these two variables would give us a better range of possible values. Roche should try to explain them all positive effect of the merger and how would synergies benefit to employees.847 Dividing the equity value of the number of outstanding shares.58 436. losing power lo make decisions.36 Terminal value $ 5.890 Enterprise Value 72.2 share Discounti ng the Cash1flows with the WACC and treating the 2013 cash a flow as a perpetuity (not using a long-term growth of 2%).953 and 10.676 To find the equity value of the firm we need to subtract debt and add back cash (which is one of the incentives behind the acquisition) and securities.05 362.676 -500 -2329 +9000 78.785 NPV of Cash flow (2009-20 18) 29.431. According to Delaware law this wouldn't be necessary but only optional measure.953. FCF 4) Using the DCF technique on the Long-Range Plan (LRP) from 2009 to 2018. As we explained before. with a WACC of 9% and long-term growth of 2% and annual growth of 7%.47 138. minority shareholders are part of Genentech (workers) and it could be very risky to not have a good relation with them.2) As s minority shareholder of Genentech.92 NPV Shares to buy 463 $ l. By the fact.7 per share. I n case of hostile bid in which Roche would get 90% or more of the Genentech total shares and hold it for more than two months. we get value per share as a stand-alone company.9 Value per share Since the value per share is heavily affected by the annual growth and long-term growth. he was obliged to for squeeze-out the existing shareholders and merge the company.22 Discounted Shares $ 1052 3. 3) Using a WACC of 9% and calculating synergies that are dependent on the merger we get the following results: 2009 2010 2011 2012 2013 and thereafter $ 488. Enterorise Value Commercial Paper Long Term Debt 7? Cash And Securitisation E uit Value 72.7 $ 4. what responsibilities does Roche have to minority shareholders? According to the affil iation agreement signed in 1999 between Roche and Genentech the obligations to minority shareholders were clearly stated: In case of friendly bid. we get the following results: Terminal Value (discounted) 42. .81 $ $ $ $ 475. like losing job. the board approval would be sufficient and Roche would be able to buy all shares for the same price. we get a total value of 4. They should clear all Lhe fears of the employees.423.529.28 Total value Value per $10.052 74. Equity Value 78.847 Shares Outstanding 1. 055 1 *( l -0. The WACC has a substantial effect on value.744% 2.712 "the blume effect" Adjusted Beta 0.growt h/LT growth 5% 1% 1.5% 2% 2.658 Biogen 0.67% 5.21% 84.848*0.1% 0.5%-2.18% = 5.0618 7.01% 6.3066 4.767 Cephalon 0. We can then make the assumption that the Greenhi Uteam has used an industry Beta based on comparable firms.384 0. the WACC is quite different from the initial 9% used in the case. Let's have a look at the fundamentals behind the WACC Market risk premium Beta (as of Julv 2008) Beta of Equitv Treasury yield (as of July 2008. changing it to 8% or I0% gives ranging from 87 to 65. using long-term growth from 1.5% and annual growth from 6%-8% gives us a plausible range from S67 to $83 per share.761 WACC = 0.26 0.766 Genzyme 0.152 1+ 0.80992 Usmg the median Beta (the average 1s prone to outliers) and adjust mg 11 for "the Blume effect" we get an industry Beta of 0. Company Beta Average Median Amgen 0.8% As seen above.08% 5. Unlevered Beta is about 0.894 Celgene 0.829 Shareholders' equitv 15.454 Gilead 0.51% 15.5% 3% 61 63 66 69 72 67 70 6% 65 73 77 72 7% 82 75 78 69 8% 73 87 76 79 83 As seen above.A.68. . Implementi ng these variables into the cost of capital we get a new WACC of around 8%.10 years*) Cost of capital Commercial debt 500 Long term debt (AAA) 2329 Total debt 2829 Short and long term debt 2.80992.653833 0. A source of concern for the cash flow is the WACC of 9% initially used in our calculations. This seem to be in range with Greenhill's own calculations.35)*0. 1 59.2) 0. we should take a closer look at the characteristics of other firms in order to assess whether they are comparable or not.26) Gilead Sciences 24. P/E multipl es Tax 1834.1 76. Adding back debt and subtracting cash and securitization gives an enterprise val ue of about 74. EBITDA multiple .26) Average 17.396) and Gilead (G) (46.i or less capitalization than Genentech.7 1052 3. Despite these differences.52695 17.80208 EBIT Shares EPS Amgen Trailing EPS 5241 12.2) 0.48355513 40.073) come cl ose to Genentech 's (88.56879 As seen above. Before we start exploring the multiples.15102 25.7% ( 19.5% (19.894 (0.818.T growth Beta Am2en 10. Of similar size:in terms of capitalization. both companies should be taken into account as comparable's.98657 Gilead Average 19 61. Increasing the WACC rather than decreasing takes this into account as stand-alone valuation. This is a risky investment where future earn ings depend on the pipeline production of Genentech.The rather conserva tive outlook of a 9% WACC makes sense from Roche's point of view. Similar expected growth and risk: Company (Genentech) L. "A"'s low &rrowth prospects lowers it PIE multiple and makes it a poor comparison.1 42.3 Earnings 3406. These firms may be less liquid and have a higher default risk and should be left out the analysis.546).6% 0.option) to assess the riskiness in a better way.25182 22. Here we would recommend that future likelihood of successful drugs should be treated as real-options (put.674 "A" has a lower forecasted growth and lower Beta than "G"and the opposite 1s true for "G''. only Amgen (A) (57.454 (0.23826046 12. Companies in the same industry: all of the firms in exhibit 13 are Biotech companies as Genentech.98 which is in the same range as the DCF in question 4.4 82. although "G" seems to be the compa ny that resembles Genentech the most.35 Forward EPS 5638 1973.6 3664. The rest of the compan ies have around '/.65 1052 3. "G"'s forward PIE (better estimate of value) gives a pnce per share of 76. 3 13.2 12.5 106743. Th.3 16.9 4. This is especially true since the companies used in the calculations are not adequate in terms of size and risk. but the industry median multiple implied a value of 70. "A" and "G" shows total different forward values from the DCF evaluation . But looking closer at the industry median gives an enterprise value that is about 2.5 median The results show quite different enterpnse va lues.5 Average 81078.75 Il.5 The revenue multiple is poor comparable and wou ld not be taken i nto account.7 4.1 6. Despite these flaws. Using Gilead's P/E multiple (same expected growth) gave an enterprise value of 74.7 EBTTDA Multiple Amgen Gilead Average Industry median Enterprise value 100359 78986. 2008(trailing) 2009(forward) 5833 6195 9.6 79856.The EBITDA is capital-structure neutral and is thought to be a more robust measure for cross companies application.000.000 .7% different from the original calculations in the DCF model.818. PEG It is not recommended to use the PEG multiple. The big differences in valuation multiples high light the difficu lt task of using comparable's as a proxy for enterprise valuation.8 4 5. Average Industry median Enterprise value Average Industry median 89900.000. the .4 105573 Revenue Multiple Amgen .5 18. Enterprise Value/Revenue 2008(trailing 2009(forward) 13418 13535 4.3 Amgen 55013.676.9 12 9.5 64406.9 57613. The EBITDA multiple gave different enterprise values ranging from 57.is multiple is usually used for companies with no earni ngs. Summary: The DCF calculated in question 4 gave an estimated enterprise value of 72.I00.8 54140 Gilead 124787.3 Amgen Gilead 55413.25 Industry 69996 70003.4 58200. 88 Shares left to buy Value of offered price Value at closing price 41196.9% cumulative average growth rate assumed to prevail over the 16 year period. $13.30.7%).4b change reflecting the capitalized value on this expense.9%).2b positive adjustment to enterprise value reflecting the value of >>opt-in« rights to the product pipeline when the . The first year of forecast began from a higher base. Total revenue was $14. NFM DCF valuation included $l 1.8416 Value of synergies 3323. the differences in multiples also confirms the vast differences in Wall street's consensus about price targets (exhibit 14).52. 6. 2. In addition.82 Offer 89 462. and capital expenditures were all lower (3.118b in NFM vs.3%). WACC with which the companies' cash flows are discounted increase as well. 0. 3. and fell sharply from September on with bottom as low as $70 in October and November. However.205073 Syn.multiples confirm that the injtial valuation of Genentech as a stand-alone company seems to be witmn range. the stock price dropped in line with their industry. In this case the analysis should be adjusted and discounted with appropriate discount factor. This means that Roche 's Shareholders don 't lose value on the deal as the expected synergies of the acquisition is bigger than the premium paid.9% vs. From exhibit 15: Genentech stock has peeked in August 2008 (94$ per share) after the first Roche's offer. The specific cost (9.2%) and expense ratios differed but total cost was almost the same (52.726673 Value of premium There is excess over premium of 1629.1%). the offer of $89 per share for Genentech is within range of how much Roche would be recommended to pay: Iron law of Merger&Acquisitions Closing Price 81. In addition. changing in net working capital (1. 6a) how has thefinancial crisis affe cted Genentech's value? The demand oflife-saving drugs was not cycl ical.1% vs.b) What changes in valuation assumptions occured between June 2008 (LPR) and November 2009 (NFM)? There were many differences in NFM fi-om the LPR valuation assumptions.32 37872.535b in LPR. Crisis had an impact on Genentech's cost of capital and cost of debt: As cost of capital increased. More overly.The assumed tax rate (35% vs. 10.4784 4953. and that the offer of $89 per share is considered to be a "fair" price. In NFM valuation the period of the detailed forecast was extended from 2018 to 2024 with 6. depreciation expense (3. thus Genentech's near-term revenues and earnings were not much affected by the financial turmoil.3% vs.5% vs.7%).3% vs. NFM valuation included an $8. Excess of premium 1629. risky markets make borrowing more expensive as there is an »investor's flight« to safer assets. 329.91 117. in this case. But the committee announced that its members had unanimously determined to reject the 89$ per share proposal as substantially undervaluing the company.27 101. This is a substantial difference from the init ial LRP as a stand-alone company. Genentech decided to left the doors open to future offer.296 and a value per share of 101.83 $ Stock option expense 11. The committee quickly rejected Roche's offer and waited until November to put forward its own view of price: $112 to $115 per share.00 $ LT.000.04 113.04.5% 92.00 $ Enterprise value $ 103.676 to 103. The NFM was updated after Roche's offer and was concluded only five months after Genentech submitted its LRP to Roche in . Their first action was to recommend employees retention and severance plans. Roche quickly agreed.00 $ Investment and Sec.56 $ NPV 57. Goldman Sachs provided a new cash flow analysis based on new data.00 $ Value of equity $ 106. The value-matrix adjusted for different levels of annual growth and L.32 6. In addition.32$ to 117.T debt 500.069.355.T 1.current licencing agreement expired (2015). Terminal value $ 180.40 Shares 1.359. 9.296. The special board's appraisal of a price of around $112 per share seems.40 S.04 $ Annu al-Growth/L.58 Discounted 49. This can be seen as an extra value from Roche point of view and should be taken into account.052.00 $ opt in rights 8. Genentech's board of directors delegated responsibility for appraising the offer to a special committee (three independent directors). but we th ink that the opt in rights of 8. resulting in a valuation rrom 112$ to 115$ per share.69 109 8% 2% 2. the special committee retained Goldman Sachs as financial adviser and Latham and Watkins as legal counsel. Adjusting for debt and cash we get value of equity equal to 106.190 is a welcoming addition to the DCF model. is in the upper levels of the valuation. 7) How did Genentech 's board of and management respond to Roche's off er of USD 89per share? To protect the minority shareholders.T growth gives us a range rrom 89.420. In November Genentech senior managers presented a new financial forecast to Roche's senior managers (see 6b).58$.00 $ Value per share 101.190.debt 2.07 95.9% 97.5% 1!:rowtb 6% 89.515.68 104.355 in the new NMP plan. This plan may be a bit more biased than the in itial LRP plan.58 The new Enterprise value is up from 72. 000 to 35. the range between 90$. Given a normal ized tax-rate of 35% (as in the initial calculations). the base-case value per share drops from $101 to $94. Risks: •A tender offer would be viewed as hostile move and might solidify opposition to Roche among Genentech's managers and employees. Some person felt like it was a biased plan and that LRP was more reasonable and unbiased view of future prospects. and given that there is to be a tender offer. With synergies of $I 0. the premium wou ld be around 16$ per share and thereby substantially overpricing the synergies. Th is would make later integration of the two companies more difficult and costly. the cash-flow NPV changes from around 53. Moreover. where the value of synergies needs to be bigger than the premium. a bit biased. according to our assumptions. should he launch a tender offer for Genentech 'sshares? Humer has three alternatives: First he could raise the offer price close to 112$ even if there was no guarantee that special committee wou ld agree to any compromise.000. 8a) what should Franz Humer do? Specifically. even if they thought the price was fair: Risk of not taking over.June. and might drive some of Genentech's star scientists and managers into the arms of riva ls (loss of Human Capital). so take the issue of valuation directly to Genentech's shareholders. Since the min imum offer is the market price ($82-$84). . according with our calculations. As a result of this. The NMP plan is. the tender offer should be in the range of $82 to $93. •Roche wou ld be able to buy only shares actually tendered and wou ld need to comply with the terms of the affiliation agreement in order to squeze-out the remaining shareholders in a second step merger. With a current market price at 82-84 per share.7. we would recommend a price per share based on a base-case range of $70. the new tax rate at 30. bypassing the board and the special committee. The median rate of 36% clearly h ighlights the difference between the two assumptions. A tender offer would be made on the assumption that takes the LRP plan into account. Roche could make a tender offer for Genentech's shares. First of all. Raising the offer to 112$ per share would conflict with the Iron mle of Mergers & Acqu isitions. the proposed price of 112$ seems to be in the higher levels of our range matrix (see 6b). Given the LRP plan as a base case for our valuation. according to our own calculations.7% heavily conflicts with Genentech's own average tax rate of 63% over the last 11 years. In addition. In addition. the extended long term plan to 15 years from the original I 0 years is more prone to errors since uncertainty increases with each year of additional cash-flow projections. •Some shareholders might decide to not tender their shares.7 per share the maximum tendered offer should be in the range of $70-$93.55. 7 per share.117$ conflicts with the wall -streets own price targets.$83 per share.