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The Buy Signal You've Waited For

By Rob Fannon, editor Phase 1 Investor
Friday, July 25, 2008

Genentech has reigned as king of the biotech industry for more than three decades.
A three-hour chat in a San Francisco pub launched the company in 1976. On its first day of trading in 1980, the stock tripled – and has risen 20-fold since. Today, Genentech's portfolio includes three of the world's top-selling biotech drugs – Avastin ($2.5 billion per year), Herceptin ($1.7 billion), and Rituxan ($2.5 billion).
But the king of biotech is now a buyout target. While I don't believe the takeout bodes well for buyer or seller, the deal should mean big profits for biotech investors. Let me explain...
In 1990, Swiss drug company Roche acquired a majority stake in Genentech. Roche became Genentech's exclusive European distributor. Today, Genentech's drugs represent 30% of Roche's pharmaceutical sales. And as Genentech's largest shareholder, Roche has multiplied its money about 40 times in two decades.
As part of the deal, Roche allowed Genentech to maintain the entrepreneurial spirit so critical to its early success. In return, the Big Pharma's financial backing allowed Genentech to focus on making drugs, not meeting Wall Street's quarterly numbers.
The win-win relationship thrived for nearly two decades. But this past Monday, Roche launched a bid to acquire the 44% of Genentech shares it didn't already own.
Apparently, the takeout move caught Genentech executives off-guard. Roche insists it's interested in boosting its research engine... not downsizing. But our inside sources tell us many employees are dusting off their resumes in preparation for a post-merger shakeout. Whether it's voluntary or not, a mass exodus of the Genentech talent pool won't help Roche.   
And I think the minimum $40 billion outlay is a mistake. Roche's new trigger-happy CEO, Severin Schwan, led the diagnostics division on several hundred-million-dollar buyouts. Now he's courting another acquisition when the money could be better spent on research.
As I wrote earlier, Genentech is more like a Big Pharma player than the tiny biotech it once was. It focuses on expanding its existing drugs in new indications, rather than discovering new drugs. Since Roche already reaps the benefits of Genentech's portfolio, gobbling up the rest of the shares adds little value.
And Roche is going to have to pay up. The company's initial $89-per-share offer gave a measly 9% premium to Genentech's shareholders. The market thought it was a low-ball bid and pushed shares as high as $94.50. My guess is the bidding will stop around $100 per share, valuing Genentech at $100 billion.
While I believe the bid is a bad move for Roche – and not a great proposal for Genentech shareholders – this mega-deal is actually good for the entire biotech industry... and its investors.
With Genentech gone, the top of the biotech food chain is empty. Many investors will be searching for new spots to park their biotech cash. And sector valuations are on the rise. Both major biotech indexes – the Nasdaq Biotech Index and AMEX Biotech Index – are up more than 7% in just a few weeks.
And as my colleague Steve Sjuggerud recently noted, the proposed acquisition has propelled the biotech sector from the back pages to the front pages of every major newspaper.
Small-cap biotechs are cheap right now. So I'd be willing to bet the sector could jump 25% or more in the coming months. And big-cap names like Biogen (BIIB), Genzyme (GENZ), and Elan (ELAN) have jumped to the top of Big Pharma's short list of buyout candidates.
If you're thinking of dabbling in the biotech sector, Roche's bid for Genentech just may be the buy signal you're waiting for.
Good investing,
Rob Fannon

Market Notes
Novartis leads medical stocks higher... Vital Signs, Owens & Minor, Alcon, Varian Medical, and ConMed hit new highs.
Stretched consumers rent-to-own... Rent-A-Center hits a 52-week high.
Mexican fast-food restaurant Chipotle misses numbers, hits all-time low.
Earnings today... Legg Mason, Alexander & Baldwin, Honda, T. Rowe Price.
Market Watch
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S&P 500 1221.53 +1.3% +10.1%
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S. Africa 70.85 +3.9% +22.9%
China 45.06 +1.4% +0.1%
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Sector ETFs
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Oil Service 136.18 +1.5% +14.8%
Big Pharma 64.13 +0.6% -3.3%
Internet 72.13 +0.7% +22.3%
Semis 16.03 +2.1% +28.9%
Utilities 31.21 +0.3% +1.6%
Defense 18.51 +1.3% +10.1%
Nanotech 9.99 +1.3% +0.0%
Alt. Energy 9.95 +1.4% -4.4%
Water 18.31 +1.1% +12.2%
Insurance 16.07 +1.2% +18.3%
Biotech 20.58 +1.1% +27.1%
Retail 19.65 +0.1% +28.4%
Software 24.59 +0.9% +24.1%
Big Tech 53.73 +1.0% +21.9%
Construction 12.99 +2.1% +13.3%
Media 13.57 +1.1% +25.0%
Consumer Svcs 67.26 +0.8% +23.3%
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Health Care 64.22 +0.7% +1.3%
Industrials 63.25 +1.6% +19.7%
Basic Mat 73.57 +1.6% +21.6%
Real Estate 55.24 +1.4% +23.8%
Transportation 91.17 +1.4% +25.6%
Telecom 22.48 +1.1% +17.1%

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