task 829 - Must be Post graduate level, No plagiarism acceptable

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9-210-040 R E V : S E P T E M B E R 2 8 , 2 0 1 1

________________________________________________________________________________________________________________ Professors Carliss Y. Baldwin and Bo Becker, together with Vincent Dessain, Executive Director, Europe Research Center, prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2010, 2011 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545- 7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

C A R L I S S Y . B A L D W I N

B O B E C K E R

V I N C E N T D E S S A I N

Roche’s Acquisition of Genentech

Late on the wintry afternoon of January 29, 2009, Franz Humer, chairman of Roche, looked out on the spires of Basel and the fast-flowing Rhine and thought about Genentech, Roche’s biotech subsidiary in California. Roche’s offer to acquire the remaining 44% of Genentech’s stock that Roche did not own had been open for six months, with little progress toward a deal. Humer wondered if it made sense to make a tender offer for the shares.

Since 1990, Roche, a global pharmaceutical company headquartered in Switzerland, had owned a majority stake in Genentech, a successful pioneer in biotechnology. Although technically a subsidiary of Roche, San Francisco–based Genentech operated with a great deal of latitude and had a fiercely independent culture. Many in the industry viewed the arrangement as one of the most successful partnerships ever.

On Monday, July 21, 2008, in a surprise move, Roche had publicly offered to pay $89 per share in cash for all the shares of Genentech it did not currently own. This offer represented an 8.8% premium over the previous Friday’s close and valued Genentech at approximately $100 billion. (Exhibit 1 presents a time line of major events.)

To protect Genentech’s minority shareholders, Genentech’s board of directors delegated responsibility for appraising the offer to a special committee made up of Genentech’s three independent directors. The committee quickly rejected Roche’s offer as “inadequate,” but then waited until November to put forward its own view of Genentech’s value: $112 to $115 per share. Meanwhile, the global financial system entered a period of severe crisis, and the share prices of most companies (including Genentech and Roche) declined significantly. Given these events and its own valuation of Genentech, Roche’s management team believed the special committee’s valuation was unreasonable. In January 2009, the negotiations between the two companies had reached an impasse.

Roche’s investment bankers, Greenhill & Co., suggested that Roche should consider making a tender offer for Genentech’s shares. Humer was concerned that such a move might alienate Genentech’s managers and employees, many of whom were shareholders. At the same time, he felt that the current uncertainty about Genentech’s future would soon begin to damage morale and its ability to hire and retain key employees. Humer was also not sure that Roche would be able to raise the required debt funding, given the state of the financial markets and feedback from many bankers.

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Humer, Roche CEO Severin Schwan, and a few other senior managers were scheduled to talk by phone later that afternoon with Bob Greenhill and his team in New York. Based on the bankers’ advice, Humer and Schwan had to decide whether to initiate a tender offer for Genentech’s shares and, if so, at what price. Before making the final decision, Humer wanted to review the strategic reasons for the acquisition, Genentech’s stand-alone value, the synergies expected from the deal, and the probable response of Genentech’s board, employees, and shareholders to a take-over bid.

As twilight approached, Schwan joined Humer in his office. The two chatted briefly as they waited for the teleconference to begin.

The Roche Group In 1896, Fritz Hoffmann-La Roche founded F. Hoffman-La Roche & Co. (Roche), a pharmaceutical

company based in Basel, Switzerland.1 Hoffmann was among the first to realize that the industrial manufacture of medicines with standardized dosages and effects would be a major advance in the fight against disease. The company’s strategy was to develop new products through cooperation with academics. By 1914, Roche was a global company, with offices in Milan, New York City, Saint Petersburg, London, and Yokohama as well as Basel. Although it suffered heavy losses during World War I, after the war ended, the company resumed its growth, becoming primarily a maker of synthetic vitamins.

After World War II, Roche intensified its pharmaceutical research to avoid becoming too dependent on vitamin sales. The company successfully introduced the antimicrobial drug Gantrisin and the first effective treatment for tuberculosis. Roche also launched the first cancer chemotherapy drug, Fluoro-Uracil, in 1962 and, the following year, began selling the tranquilizer Valium, which was the first sedative not to cause drowsiness.

In 1965, Adolf Jann became chairman of the board. He was convinced that scientific medicine would soon expand into areas beyond mere treatment with synthesized substances. Thus, in 1967, the company founded the independent Roche Institute of Molecular Biology in New Jersey and, a year later, the Basel Institute for Immunology. These institutes provided major breakthroughs, such as development of a process for producing monoclonal antibodies in the 1970s.

In 1978, Fritz Gerber was appointed CEO. He rationalized the structure of the company and made a number of strategic investments and alliances. During the 1980s and 1990s, biotechnology, which used living cells to make therapeutic proteins (as opposed to traditional drugs, which were made from chemicals found in plants or molds), was just beginning to emerge as a new method of synthesizing drugs.2 In 1990, Roche bought a majority of the stock of Genentech, a pioneer biotechnology firm (see the section “Genentech” below). Roche also bought the nonprescription drug company Nicolas in 1991 to strengthen its over-the-counter portfolio, the U.S. bioscience company Syntex in 1994,3 and diagnostics leader Boehringer Mannheim in 1998, to become the world leader in in-vitro diagnostics.4

Humer, former head of Roche’s pharmaceuticals division and chief operating officer, became CEO in 1998 and chairman of the board in 2001. Humer initiated a strategy to focus on innovation-driven businesses by divesting the company’s nonpharmaceutical divisions, increasing its R&D spending, and managing the company’s core and new drug pipelines. Under Humer, Roche also made a number of strategic acquisitions, buying companies in the fields of biotechnology, histopathology, and diagnostics. Humer commented: “I believe a company should focus on what it excels at. Roche

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excels at innovation and at identifying, developing, and commercializing innovative medicines and solutions for patients in need.”

Roche went through a period of intense financial stress in 2001 and 2002. In 2001, Roche’s cross- town rival Novartis bought 21.3% of Roche’s voting shares. It increased its stake to 32.7% (voting shares) in 2003 with a view to an eventual merger. However, the Hoffmann and Oeri families (who owned 50.1% of the Roche voting shares) and the Roche board stated that they had no intention of agreeing to an acquisition by Novartis.5 Despite its shareholding, Novartis had no participation on the board of directors and functioned much as any other shareholder.

After recording a $2.9 billion loss in 2002 after significant write-offs, Roche recovered in 2003 and went on to outgrow the market in subsequent years. Its financial success was based on strong sales of a diverse portfolio of drugs such as Neorecormon (anemia), Rituxan (non-Hodgkin’s lymphoma), CellCept (an immune-system suppressant), Herceptin (breast cancer), Avastin (several cancer types), Tamiflu (flu), and Pegasys (hepatitis). Humer explained how Roche’s strategic position had changed: “Our focus on innovation started to pay off. Our balance sheet grew stronger by the day, and I realized that we had regained strategic flexibility. That was critical to be able to address new and important challenges facing Roche and the industry at large.”

In 2008, the Roche Group generated revenues of CHF (Swiss francs) 45.6 billion ($43.2 billion) and net earnings of CHF 10.8 billion ($10.3 billion). (Exhibit 2 presents consolidated financial data for the Roche Group for 2007 and 2008.)

Genentech Genentech was founded in 1976 by venture capitalist Robert Swanson and scientist Herbert Boyer,

who one night in a bar each agreed to put $500 toward forming a partnership.6 They raised their initial financing from the venture capital firm Kleiner, Perkins, Caulfield & Byers: Tom Perkins was the first chairman of the board. The company was a trailblazer in biotechnology: it produced the first human protein in a microorganism (E. coli bacteria) and cloned human insulin and human growth hormone for the first time.7

While Boyer encouraged Genentech scientists to publish in academic journals and to become renowned in the science world, Swanson made sure to patent their discoveries. Early on, the company used licensing deals with big pharmaceutical companies to finance new product development. From the start, Genentech combined scientific excellence with business acumen.

Genentech turned its first profit in 1979 and became the first biotech company to go public in 1980, raising $35 million. On the day of its IPO (with the ticker symbol “GNE”), its share price went from $35 at the opening to $88 within the first hour of trading.

In 1990, Roche acquired 60% of the equity of Genentech for $2.1 billion. In total, Roche purchased 50% of the outstanding shares (41.7 million shares) for $1.5 billion and 8.3 million newly issued shares for $492 million. It also spent $100 million to retire related stock options and warrants.8 As part of this deal, Roche obtained an option to buy the remaining shares of common stock at escalating prices, starting at $38 in 1990 and growing to $60 per share in 1995. Roche was also permitted to purchase additional shares on the open market at any time to raise its ownership up to a maximum of 75%.9

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The alliance with Roche benefited Genenetch in several ways. It provided a stable source of financing for Genentech’s R&D, but allowed Genentech to remain a public company and to continue compensating employees with stock options. It also gave Genentech access to Roche’s extensive marketing and distribution channels, especially outside the U.S. Steve Krognes, Roche’s head of mergers and acquisitions, described the relationship in the early 1990s: “In Europe we say it’s good to have a rich uncle in America. Genentech had a rich uncle in Switzerland.”

In 1995, Roche did not exercise its option to buy the balance of Genentech’s shares, but instead obtained approval from the biotech company’s shareholders to extend the maturity of the option. Under the new terms, Roche could purchase shares at $63.75 each, with the price increasing each quarter, up to $82.50 per share in the second quarter of 1999. If Roche did not exercise its option by the end of June 1999, Genentech’s other shareholders could “put” their shares back to the company for $60 per share during a 30-day period commencing July 1, 1999.10

In July 1995, Arthur Levinson, Genentech’s chief scientist, was appointed president and CEO.

By 1998, Genentech’s revenues exceeded $1 billion, and under the leadership of Levinson, the Genentech R&D pipeline grew stronger by the day. (Exhibits 3 and 4 show Genentech’s income statement and balance sheet data and selected ratios from 1998 to 2008). On June 14, 1999, the trial of a 21-year patent infringement suit with the University of California ended with a hung jury, saving Genentech from a potential billion-dollar legal liability. (The case was settled in November 1999, with Genentech agreeing to pay the University of California $200 million.) That same day, Roche exercised its option to purchase the remaining Genentech shares at the price of $82.50 per share. After a brief period of 100% ownership, during which time an affiliation agreement between the companies was instituted, Roche sold 19% of Genentech shares and relisted the company under the ticker symbol “DNA.” The shares opened at $97 and closed at the end of the first day’s trading at $127.11 Four months later, Roche made an offering of a further 20 million shares, constituting 15.6% of common equity, at $143.50 each.12 In March 2000, Roche sold further Genentech shares through a public offering at $163 per share, yielding proceeds of $2.8 billion and reducing its ownership to 59%.13

Although it owned the majority of shares, Roche had decided to maintain a minority representation on the board, appointing three of the seven directors. Levinson, the CEO, served as chairman of the board, and there were also three independent directors. (Exhibit 5 shows the composition of Genentech’s board in July 2008.) However, the 1999 affiliation agreement gave Roche the contractual right to obtain majority representation on the board through the appointment of new directors. This could be done through a governance notice and be effective within days. The Roche directors also had to give their approval before Genentech made certain decisions, such as acquisitions, issuance of capital stock above 5% of the total, and licensing, leasing, or sales outside the course of ordinary business. In a separate commercial agreement, Roche’s exclusive rights to commercialize Genentech drugs outside the U.S. were extended until 2015.14

The affiliation agreement also outlined how a Roche merger of Genentech would be organized. In case of a friendly deal, board approval would be sufficient and all shareholders would be paid the same price. (The Roche representatives on Genentech’s board would not participate in the decision.)

However, in case of a tender offer, the affiliation agreement had additional implications. In the most likely case, Roche would have to buy the nontendered shares at an appraised value equal to or higher than the tender offer price. Furthermore, if Roche owned 90% or more of Genentech’s total shares for more than two months, it was required to merge the two companies. (Delaware law made “squeeze-out” mergers optional for 90% owners, but the affiliation agreement made such a merger mandatory.)

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Between 1998 and 2008, Genentech’s operating revenue increased to $13.4 billion, and its share price increased nearly tenfold. (Exhibit 6 shows Roche’s and Genentech’s stock prices, adjusted for splits, from June 30, 1998 through June 30, 2008.) By 2008, Genentech had become a vertically integrated pharmaceuticals company, researching, producing, and selling its own products in the U.S. It had also started to develop small chemical molecules alongside its traditional large biological ones. In terms of revenue, it was second largest among biotech companies in 2007, behind Amgen, with more than double the sales of its third-place competitor. (See Exhibit 7 for financial data on selected biotech and pharmaceutical companies in 2007.) In the meantime, Roche’s ownership stake in Genentech had been reduced to about 56%, largely due to Genentech employees exercising their options.

Genentech had become an important part of Roche’s business, representing 24% of Roche’s pharmaceutical product sales in 2008. Several of Genentech’s pioneering products achieved very strong market positions due to their medical differentiation, commanding high prices. Products originating from Genentech represented 46% of total sales of Roche’s 20 top-selling drugs on a worldwide basis. (See Exhibit 8 for a list of Roche’s top-selling drugs in 2008, showing which originated from Genentech.) Avastin, for example, accounted for 14% of Roche’s total pharmaceutical sales in 2008. Also, from 1990 to 2008, Genentech’s workforce had increased from approximately 2,000 to more than 11,000 staff.15

Genentech operated in most respects as a fully independent company, and many Genentech employees were not aware that Roche actually owned a majority of the shares. Levinson’s leadership style and focus on science and patients resonated with employees, and he was universally liked and respected throughout the company. Genentech had become famous for its strong culture: “We are committed to excellent science and doing what is right for the patient. Our talented employees work hard, are willing to go the extra mile and work together to achieve results. But we also have fun at work,” said Levinson.

Roche Considers Buying Out Genentech’s Minority Shareholders By 2007, the global pharmaceuticals market was enjoying rapid growth. Total industry revenues

were expected to exceed $767 billion by 2010. However, the market had many “me-too” drugs, which were similar in composition and treatment to existing products, and relatively little innovation. The U.S. Food and Drug Administration (FDA) considered only 14% of drugs introduced between 1998 and 2002 a “significant improvement” over available products.16

Given a lower rate of product introductions and less-innovative products, the trend among major pharmaceuticals companies was to grow through mergers and acquisitions. Pfizer was particularly active on this front, initiating a hostile acquisition of Warner-Lambert in 2000 and a merger with Pharmacia in 2003. Cost cutting after these deals contributed to Pfizer’s earnings growth between 2001 and 2006, but analysts felt that such savings could not make up for a dearth of products in the pipeline.17 Given the lack of success in bringing new and innovative drugs to market, many pharmaceutical companies were also seeking to diversify from the prescription drug business by acquiring generic-drug companies, which sold cheaper version of drugs that were no longer under patent protection, and other adjacent businesses such as medical devices, diagnostics, etc.

The biotechnology sector was much smaller and less mature than pharmaceuticals, but was growing much faster. In 2008, the sector generated $89.7 billion in revenues in the U.S. alone and showed an aggregate profit for the first time.18 The industry was dominated by Amgen and

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Genentech (see Exhibit 7), but there were several hundred smaller biotechnology start-ups engaged in research and development. Many of these were focused on potential cancer medicines.

In 2007, Roche’s managers began to question the structure of the Roche-Genentech relationship. According to Schwan, “The old model that had served both companies so well was beginning to show signs of wear.” As it grew, Genentech was increasingly coming into direct competition with Roche in several U.S. markets. Genentech had also established emerging R&D activities and production facilities outside the U.S. Additionally, in developing small molecular products, Genentech had begun to encroach on Roche’s traditional territory, while Roche was preparing to launch products in the U.S. that would compete with existing Genentech products. Through its phenomenal success, Genentech had grown from a nimble biotechnology firm to a fully integrated biopharmaceutical company, but the existing ownership and operating model left Roche few alternatives in addressing the increasing overlap and duplication between the two firms. A merger of the two companies would create new opportunities, including “the ability to collaborate on a worldwide scale,”19 according to Humer.

Roche’s managers were also aware that the product licensing agreement, put in place in 1999 during the period when Genentech was 100% owned by Roche, was due to expire in 2015. This agreement gave Roche the right to opt in to development and to commercialize Genentech products outside the U.S. This right had given Roche access to many important products from Genentech’s innovative R&D efforts (see Exhibit 8 for Roche’s top-selling products in 2008). To protect Genentech’s minority shareholders, when the present licensing agreement expired, a new agreement would have to be negotiated at arm’s length, possibly in competition with others. Thus, in effect, after 2015, Genentech’s product pipeline could be sold to the highest bidder.

Again, to protect Genentech’s minority shareholders, Roche could not share in Genentech’s intellectual property. Concerns about property rights blocked the flow of information between researchers at the two companies, which might facilitate product development and research. If Roche and Genentech merged, this constraint on possible cross-fertilization between Roche’s and Genentech’s R&D efforts would disappear. However, this benefit had to be balanced with the desire to maintain unique and innovative R&D efforts at Genentech and maintaining a diversity of approaches to research and early development efforts.

Outside of R&D, Roche managers believed there was increasing duplication of effort and facilities at the two companies and, thus, opportunities to create value by cutting costs and streamlining operations. This was largely within manufacturing, G&A, and commercial operations. To see what could be achieved, in the first half of 2008, Roche managers conducted a detailed, strategic analysis of synergies obtainable if Roche’s and Genentech’s operations were combined. They identified $750 million to $850 million in annual savings realizable over five years. (Exhibit 9 presents the results of the study, showing the breakdown of anticipated savings by expense category and by year.) Krognes noted that about 40% of these savings were achievable by Roche alone, even without a merger with Genentech: “Our planning uncovered these opportunities, and we found that we could pursue many of them independently of the transaction.”

Finally, beginning in 2007, Genentech began to generate large amounts of free cash flow. (See Exhibit 10 for estimates of Genentech’s free cash flow for 2006 through 2008 and the company’s forecast for 2009.) Genentech did not pay dividends; thus, cash was building up inside the company. Its cash and marketable securities increased from $4.3 billion in 2006 to $9.5 billion in 2008 (see Exhibit 4). Under the present ownership structure, Roche could not access Genentech’s cash directly, even though it appeared on Roche’s consolidated balance sheet (see Exhibit 2). Cash paid to Roche as a dividend would need to go to all Genentech’s shareholders equally and would be subject to

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dividend taxation; cash obtained through the repurchase of shares held by Roche would decrease Roche’s equity stake; and cash transferred via intercorporate loans would raise questions about potential conflicts of interest. If the two companies were merged, Roche would have unfettered access to Genentech’s cash. Erich Hunziker, Roche’s influential CFO, explained: “We saw that Genentech’s cash flow was set to grow and remain high for some time, and securing full access to this cash would have many advantages to Roche.”

In late 2007, Roche approached Genentech’s directors about the possibility of Roche increasing its ownership stake in the company. Genentech independent directors were reluctant, and Roche’s management did not press the issue.

In March 2008, Humer retired as CEO of Roche and was succeeded by the 40-year-old Schwan. Humer remained as chairman of the board and was actively involved in the strategic management of the company: “Severin and I were fully aligned in our view on a potential transaction with Genentech, and despite me retiring as CEO of Roche, we worked closely together to complete and execute our plans.”

Roche Makes an Offer to Genentech’s Board

In May 2008, Roche retained Greenhill & Co., Inc., to advise the company about a potential acquisition of the outstanding Genentech shares. Greenhill formed a team led by its chairman, Bob Greenhill, and included head of U.S. M&A, Jeff Buckalew, and vice president, Ashish Contractor, all of whom had worked with Roche on its prior acquisition of Ventana Medical Systems. Roche also worked closely with trusted legal counsel Davis Polk, whose team was headed by Arthur Golden, an experienced Wall Street lawyer.

Greenhill stated, “Given our past experience with minority squeeze-outs, we and Davis Polk recognized very early that this could evolve into a protracted and possibly antagonistic process. This was especially true in the case of Genentech, given its iconic status and roster of long-time blue chip shareholders.”

On Monday, July 21, 2008, before the stock market opened in Zurich, Roche announced publicly an offer for all outstanding shares of Genentech that it did not already own. The offer was for $89 per share, in cash, representing an 8.8% premium over the previous Friday’s close, and valuing Genentech at $100 billion.20 Humer had placed calls to Levinson and Charles Sanders (Genentech’s lead director) on Sunday night (California time) to advise them of Roche’s intention. He simultaneously arranged to send a letter to Genentech’s three independent directors (see the section “Genentech’s Response” below).21

Roche planned to finance the transaction through a combination of its own funds and debt financing,22 but many key market players were skeptical that Roche would be able to secure the financing on reasonable terms. On the announcement, Genentech shares jumped $12.06, or 15%, closing at $93.88. In late Monday trading in Zurich, Roche shares dropped CHF 8.6, or 4.8%, to CHF 171.

Analysts immediately expressed concern that Roche’s potential purchase of Genentech would result in vital “intellectual property” walking out of the door with some of Genentech’s scientists, who would leave the company because of fear that Genentech would lose its independence and entrepreneurial spirit. However, Humer stated, “We intend to keep Genentech’s research and early

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development efforts autonomous; they will be able to continue to make their own decisions on which projects to bring forward, which projects not to bring forward.”23

As the majority shareholder of Genentech, under Delaware corporate law, Roche and its appointed directors owed fiduciary duties to Genentech’s minority shareholders. The proposed acquisition created a clear conflict of interest that had to be addressed to protect Roche from potential lawsuits. Thus, simultaneously with the announcement of the offer, Humer sent a letter to Sanders, Debra Reed, and Boyer, acknowledging their role as independent directors who would have to review and make a decision with respect to the offer and urging them to retain independent financial advisers and legal counsel. In the press release announcing the bid, Roche stated that “the precise terms of the transaction, as well as the conditions to its consummation, will be determined through negotiations with the independent directors.”24

Genentech’s Response On the afternoon of July 21, Genentech issued a press release stating that it had received Roche’s

offer and that it expected a special committee of independent directors to be appointed to consider the offer. The independent directors would decide whether to recommend that Genentech’s minority shareholders accept or reject the $89-per-share offer. Several legal considerations were pertinent to their work. Directors of corporations owed their companies duties of care and loyalty. Board members must exercise judgment and care in the operation of the business and could not put their own interests ahead of those of the corporation (or in this case, the minority shareholders). On July 24, Genentech’s board (including the board members Roche appointed) formally appointed the special committee and gave it extensive rights to determine the board’s position regarding the Roche offer. Specifically, the board resolved that “it would not recommend any possible transaction with Roche without the prior favorable recommendation of such transaction by the special committee. The outcome of the process has not been pre-determined, and there can be no assurance that the special committee will approve any transaction with Roche.”25

The special committee retained Goldman Sachs as financial adviser and Latham and Watkins as legal counsel. Their first action was to recommend employee retention and severance plans; Roche quickly agreed, and the plans were enacted and publicly announced on August 13. In the same press release, the committee announced that its members had unanimously determined to reject the $89- per-share proposal as substantially undervaluing the company. However, the committee left the door open for a future offer, saying it “would consider a proposal that recognizes the value of the company and reflects the significant benefits that would accrue to Roche as a result of full ownership.”26

The financial representatives of Roche and Genentech had several meetings and conversations during the fall to discuss the valuation methodology behind the $89 offer and other aspects of the bid. At the first meeting of financial representatives, on August 21, 2009, the Greenhill team presented Roche’s views of the value of the company and the basis on which the $89 price had been determined. As discussed in the section “Valuations of Genentech” below, at the core of Roche’s analysis was Genentech’s own long-range plan (LRP).

On September 12, Humer and Levinson met to discuss operational matters. They agreed that the longer the acquisition process continued, the more likely it was to negatively affect morale and Genentech’s ability to attract and retain key employees. However, Humer reiterated that Roche remained committed to the acquisition and was not prepared to continue the existing arm’s-length

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relationship. In a subsequent discussion between Humer and Sanders, no counterbid or different valuation was presented, however, and the special committee did not indicate what price might change its response. For its part, Roche indicated that it would not be willing to change the price unless the special committee and its advisers explained and justified the basis for a different valuation, thus convincing Roche that the business was worth more. Genentech’s board of directors, apart from the special committee, continued to operate as usual during the fall.

Valuations of Genentech Prior to the offer in July, Greenhill & Co. used several methods of analysis to assist Roche in

estimating a fair value of Genentech’s shares. First, it estimated Genentech’s stand-alone value based on the forecast contained in Genentech’s most recent long-range plan. As was customary practice, this plan had been approved by Genentech’s board in December 2007 and transmitted to Roche in June 2008 (with adjustments to reflect certain important interim events). This so-called June LRP contained detailed projections of revenues, expenses, capital expenditures, and changes in net working capital for 10 years (2009 through 2018). Traditionally, the information provided to Roche included the year-by-year numbers, but excluded the more detailed supporting assumptions and data in the plan itself.

Greenhill used the June LRP and worked with the Roche internal M&A team to estimate Genentech’s free cash flow for 10 years and thereafter in perpetuity. (Exhibit 10 shows the first year of this projection.) Greenhill adjusted these summary numbers to incorporate an assumed tax rate of 35%, but made no other changes in the forecast. Although the LRP provided for changing growth and cost ratios for the first 10 years, its results were closely approximated by the constant rate and ratio assumptions shown in Exhibit 11.

Given the forecast based on the June LRP, Greenhill used a 9% weighted average cost of capital and a 2% long-term growth rate (after 2018) to estimate Genentech’s enterprise value. The weighted average cost of capital was based on interest rates and betas as of June 2008 and a market risk premium of 7.1%. From the estimated enterprise value, Greenhill subtracted Genentech’s short- and long-term debt, added back its cash and marketable securities, and divided by shares outstanding to obtain a value per share. Allowing for different long-term growth rates, they obtained a valuation range of $73.94 to $81.54 per share. Greenhill used a similar DCF-WACC methodology to value the synergies anticipated from the Roche-Genentech combination (see Exhibit 9).

Roche’s managers’ view was that because Roche already owned a majority of Genentech’s shares, the acquisition of the remaining shares did not constitute a change of control. Thus, Roche did not include a control premium in its offer. “Based on the fact that Roche already had paid a control premium to acquire a majority of the Genentech shares, we felt that no control premium was required or appropriate in our current offer,” said Krognes.

In addition to the DCF valuation, Greenhill presented three additional analyses: (1) an overview of offer premiums paid in similar “squeeze-out” transactions; (2) a comparison of EBITDA and earnings multiples for selected comparable companies; and (3) a review of the consensus price target of Wall Street analysts as of July 2008, before the Roche offer was announced. These analyses, shown in Exhibits 12, 13, and 14, tended to confirm the valuation range of $70 to $80 per share. According to Buckalew:

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210-040 Roche’s Acquisition of Genentech

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The proposed offer price of $89 was above anything that standard valuation methodologies would justify, based on the detailed information that was available to us at the time, and given the lack of a control premium due to Roche’s existing majority ownership. Roche was well aware of this but was willing to reflect the benefits of the combination in its offer price in order to gain the recommendation of the Special Committee and achieve a consensual outcome.

Although Greenhill provided valuation analysis to support Roche’s offer, the investment bank did not appraise the value of Genentech, nor did it give an opinion as to the fairness of the offer price.

In November, at a meeting in New York, Genentech’s senior managers presented a new financial forecast to Roche’s senior managers and Sanders, representing the special committee, as well as their financial advisers and legal counsel. The forecast assumed higher future prices of existing drugs, a higher likelihood of success for drugs in the pipeline, lower investment needs, and a lower effective tax rate. This forecast came to be called the November financial model (NFM) to distinguish it from the June LRP on which Roche had based its offer. On December 12, Goldman Sachs provided Greenhill with a new discounted cash flow analysis based on the NFM, resulting in a standalone valuation of $112 to $115 per share. That same day, Sanders called Humer to say, on Goldman Sachs’ advice, the special committee would be willing to recommend the sale at $112 per share.

“I am not sure what was more surprising; the $112 counteroffer, or the assertion that there was not much room for negotiation. We were deeply disappointed,” Humer said.

The NFM, which became the basis for the special committee’s valuation, differed from the June LRP in a number of ways, both large and small. The first year of the forecast began from a higher base: total revenue was $14.118 billion in the NFM vs. $13.535 billion in the LRP. The period of the detailed forecast was extended from 2018 to 2024, with a 6.9% cumulative average growth rate assumed to prevail over the 16-year period. The specific cost and expense ratios differed, but average total cost as a percent of revenue was virtually unchanged. The assumed tax rate, depreciation expense, change in net working capital, and capital expenditures were all lower. There was no charge taken for equity-based compensation in the NFM, but Goldman Sachs’s DCF analysis included a $11.4 billion charge reflecting the capitalized value of this expense. Goldman’s analysis also included an $8.2 billion positive adjustment to enterprise value reflecting the value of “opt-in” rights to the product pipeline when the current licensing agreement expired in 2015. (Exhibit 11 presents a comparison of averages approximating the June LRP and the NFM.)

Roche’s managers felt that the NFM and Goldman’s assumptions significantly overstated Genentech’s prospects with respect to pipeline productivity, development costs, subsequent applications of Avastin (Genentech’s most valuable drug), the tax rate, and other operating assumptions. In their view, it could not serve as the basis for a reasonable valuation of Genentech.

“The NFM was updated after Roche’s offer and was concluded only five months after Genentech submitted its LRP to Roche in June 2008. We felt it was a biased plan and that the LRP was a more reasonable and unbiased view of the future prospects,” commented Krognes.

The Collapse of the Financial System from September 2008–January 2009 On the weekend of September 13-14, 2008, the global financial system went into a tailspin. Merrill

Lynch was sold to Bank of America, and the Federal Reserve provided a credit lifeline to the insurance giant, AIG. On Monday morning, Lehman Brothers declared bankruptcy, and banks throughout the world stopped lending to each other. In the weeks that followed, banks in the U.S.,

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Roche’s Acquisition of Genentech 210-040

11

Europe, and Japan announced major losses from their exposure to subprime mortgages and other bad loans and derivative contracts. Numerous large banks received capital injections from their governments, and the International Monetary Fund (IMF) provided emergency assistance to Iceland, the Ukraine, and Hungary. Virtually every economy in the world was in recession or suffered substantially diminished growth in the fourth quarter of 2008.

The demand for life-saving drugs was not cyclical; thus, Roche’s and Genentech’s near-term revenues and earnings were not much affected by the financial turmoil. However, the stock prices of the two firms dropped in line with their industry. (Exhibit 15 shows the daily price movements of Genentech and Roche as well as the S&P biotech and pharmaceutical indexes from July 1, 2008 through January 29, 2009.)

Of greater concern to Roche’s management was the availability of credit to finance a $44 billion purchase of Genentech’s shares. In normal times, such an outlay would be financed via a bridge loan from a consortium of banks. The bridge loan would be replaced over time by long-term financing in multiple currencies. But in the midst of the financial crisis, few banks were interested in arranging bridge loans to finance acquisitions.

Roche’s managers were concerned that bridge loan financing might not be available or would be prohibitively expensive. Indeed, the concern that Roche might not be able to finance the deal was one possible reason for the special committee’s reluctance to engage in serious negotiations. Thus, in December 2008, Roche’s CFO Hunziker and Karl Mahler (Roche’s head of investor relations) opened a dialogue with large fixed-income investors. They held discussions with major investors in the U.S. 144A bond market, the Eurobond market, and the Swiss franc bond market.a

“We felt that the banks had lost touch with the market in their quest for survival. I decided that we needed to listen to the lenders directly, and that gave us important insights into what was really happening in the financial markets,” said Hunziker.

The talks had been cordial, but as of the end of January 2009, Roche had not obtained nor asked for any financing commitments. Clearly, both investors and Roche felt it would ideally be better to wait for a deal with Genentech to be struck before setting the terms of the necessary financing agreement. (Exhibit 16 shows selected interest rates by month from January 2007 through January 2009.) Hunziker was responsible for the financing, and he wrestled with a fundamental question: should and could Roche follow industry practice in these unusual times?

The Decision Facing Humer In early January 2009, the senior managers of Roche and Genentech (including several R&D

managers) together with their financial and legal advisers met in New York to discuss the assumptions underlying the NFM. On January 15, Greenhill provided Goldman Sachs a detailed list of the key areas of disagreement between the two companies with respect to the forecast and the valuation. The special committee, responding through Goldman Sachs, refused to revise their assumptions in a meaningful way. a Securities issued in the U.S. under SEC Rule 144A did not have to file a public registration statement with the Securities and Exchange Commission, but could be sold only to qualified financial institutions. Eurobonds were international bonds denominated in currencies not native to the country in which the bond was issued. London was the center of the Eurobond market. Because of the stability of the Swiss franc as a currency, Swiss franc bonds had traditionally been attractive to investors seeking to protect their fixed-income assets against inflation.

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210-040 Roche’s Acquisition of Genentech

12

In a phone conversation between Humer and Sanders on January 23, Sanders stated that he believed $112 was a fair price and $89 was not an appropriate starting point for negotiations. Humer responded that he believed $89 was a fair price and $112 was not an appropriate starting point for negotiations. It appeared that Roche and the special committee had arrived at an impasse.

At this point, Humer faced three alternatives, none of which was ideal. First, he could concede to the special committee’s position and raise the offer price, bringing it closer to $112 per share. For example, if Roche offered $100, the two parties might split the difference, leading Roche to pay $106 per share. Of course, there was no guarantee that the special committee would agree to any compromise; they might simply hold to the $112 price. And their actions to date had clearly showed that they were willing to let the negotiations drag on for a very long time; all pressure for a quick resolution had come from Roche.

Second, on Greenhill’s advice, Roche could make a tender offer for Genetech’s shares. A tender offer would take the issue of valuation directly to Genentech’s shareholders, bypassing the board and the special committee, although the committee would have to issue a recommendation within 10 days of the offer.27 However, there were several drawbacks to this course of action. A tender offer would be viewed as a hostile move and might solidify opposition to Roche among Genentech’s managers and employees. This would make later integration of the two companies more difficult and costly, and might drive some of Genentech’s star scientists and managers into the arms of rivals.

Also, Roche would only be able to purchase the shares actually tendered, and it would still need to comply with the terms of the affiliation agreement in order to “squeeze out” the remaining shareholders in a second-step merger. Unfortunately, because of the specific provisions of the affiliation agreement, some shareholders might decide not to tender their shares, even if they thought the price was fair. Instead they might gamble on a squeeze-out transaction, in which two investment banks, both chosen by the special committee, would provide higher valuations than the tender offer price. This game-playing strategy would be most attractive to investors who perceived that their tendering decision would not affect the likelihood of the tender offer’s success.

As indicated, Roche did not have firm commitments for funds to finance the acquisition, and in January 2009, global markets were still extremely fragile. If Roche desired, its tender offer could be made contingent on obtaining the necessary financing on acceptable terms. However, the more caveats attached to the offer, the less attractive it would be to Genentech’s shareholders. The most effective tender offers were the simplest: all cash for all outstanding shares with no such contingencies.

If Roche decided to go ahead with a tender offer, it had to decide at what price. Following Roche’s offer in July, Genentech’s shares had risen above the offer price, trading as high as $98 in August (see Exhibit 15). As the financial crisis unfolded amid speculation that Roche would not be able to finance the purchase, Genentech’s shares fell, reaching the low $70s in October and November. Humer was informed that during the last week of January, Genentech’s shares had recovered and were trading in the range $82 to $84. But he knew that the price on any trading day reflected the valuations of marginal investors, many of whom were short-term traders. Genentech had many committed and loyal shareholders who demonstrably thought their shares were worth more than the current trading prices. Roche had to convince the majority of these investors to part with their shares, if the tender offer was to have any chance of success. A plan for a tender offer should include a strategy for convincing important investors about the merits of the bid.

Finally, Humer could simply wait. The results of an important set of clinical trials of the extension of Genentech’s blockbuster cancer drug, Avastin, to the treatment of additional forms of cancer could

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Roche’s Acquisition of Genentech 210-040

13

be announced as early as April 2009. Early test results had been inconclusive, and there was substantial uncertainty about the likelihood of a positive outcome. Publication of the new results would reduce uncertainty as to Genentech’s future performance and might bring Roche’s and the special committee’s valuations closer together. On the other hand, if successful, the results would likely have a large, positive impact on the stock price, making a deal substantially more expensive and potentially out of reach from a financing perspective.

Humer wondered what his next steps should be. How could he bring Roche’s acquisition of Genentech to a successful conclusion?

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Roche’s Acquisition of Genentech 210-040

15

Exhibit 2 Roche Historical Consolidated Financial Data As of December 31, 2008 (in millions of CHF, except amounts per share and nonvoting equity security of parent, which are expressed in CHF, and ratio of earnings to fixed charges) (1 CHF = €0.6720 and $0.9473)

Years Ended 2008 2007

CHF USD CHF USD Income Statement Data

Sales 45,617 43,213 46,133 43,702 Royalties and other operating income 2,287 2,166 2,243 2,125 Cost of sales (13,661) (12,941) (13,743) (13,019) Marketing and distribution (9,170) (8,687) (9,327) (8,835) Research and development (8,845) (8,379) (8,385) (7,943) General and administrative (2,332) (2,209) (2,453) (2,324) Major legal cases 271 257 -- -- Changes in group organization (243) (230) -- -- Operating profit 13,924 13,190 14,468 13,706

Operating profit before exceptional items and cumulative effect of a change in accounting principle 13,896 13,164 1,187 1,124

Associated companies 1 2 Financial income 1,123 1,064 1,805 1,710 Financing costs (887) (840) (971) (920) Profit before tax 14,161 13,415 15,304 14,497 Income taxes (3,317) (3,142) (3,867) (3,663)

Net income 10,844 10,273 11,437 10,834 Cash Flow Statement Data

Net Cash Provided by (Used in): Operating activities 12,177 11,535 11,728 11,110 Investing activities (1,722) (1,631) (5,788) (5,483) Financing activities (9,442) (8,944) (5,270) (4,992) Currency translation 147 139 (125) (118) Increase (decrease) in cash 1,160 1,099 545 516

Balance Sheet Data

Cash and marketable securities 20,771 19,676 24,202 22,927 Current assets 38,604 36,570 42,834 40,577 Property, plant, and equipment, net 18,190 17,231 17,832 16,892 Noncurrent assets 37,485 35,510 35,531 33,659

Total assets 76,089 72,079 78,365 74,235 Total short-term debt (1,117) (1,058) (3,032) (2,872) Current liabilities (12,104) (11,466) (14,454) (13,692) Total long-term debt (2,972) (2,815) (3,834) (3,632) Noncurrent liabilities (10,163) (9,627) (10,468) (9,916)

Total liabilities (22,267) (21,094) (24,922) (23,609) Total equity 53,822 50,986 53,443 50,627

Other Information:

Ratio of earnings to fixed charges 53.10 45.48 Capital expenditures 3,596 3,406 4,697 4,449 Net income per share and nonvoting equity security of parent -- --

Basic 10.43 9.88 11.36 10.76 Diluted 10.23 9.69 11.16 10.57

Book value per share and nonvoting equity security of parent 62.58 59 --

Source: Roche Annual Reports and Greenhill & Co.

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G en

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ttp :/

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.

Do N

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or P

os t

This document is authorized for use only by Andrianos Tsekrekos at Athens University of Economics & Business until January 2014. Copying or posting is an infringement of copyright. [email protected] or

617.783.7860.

210-040 Roche’s Acquisition of Genentech

18

Exhibit 5 Genentech’s Board of Directors, July 2008

Arthur D. Levinson, PhD Chairman of the Board, Chief Executive Officer, Genentech

Herbert W. Boyer, PhDa Cofounder of Genentech and Professor Emeritus of Biochemistry and Biophysics, University of California, San Francisco

William M. Burns Chief Executive Officer of the Pharmaceuticals Division and Member of the Corporate Executive Committee, F. Hoffmann-La Roche Ltd.

Erich Hunziker, PhD Chief Financial Officer and Deputy Head of the Corporate Executive Committee, F. Hoffmann-La Roche Ltd.

Jonathan K. C. Knowles, PhD Head of Group Research and Member of the Corporate Executive Committee, F. Hoffmann-La Roche Ltd.

Debra L. Reeda President and Chief Executive Officer, San Diego Gas & Electric and Southern California Gas Company

Charles A. Sanders, MDa Lead Director of Genentech and former Chairman and Chief Executive Officer, Glaxo, Inc.

Source: Genentech Annual Report 2008.

aSpecial Committee Member.

Do N

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or P

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This document is authorized for use only by Andrianos Tsekrekos at Athens University of Economics & Business until January 2014. Copying or posting is an infringement of copyright. [email protected] or

617.783.7860.

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This document is authorized for use only by Andrianos Tsekrekos at Athens University of Economics & Business until January 2014. Copying or posting is an infringement of copyright. [email protected] or

617.783.7860.

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b

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617.783.7860.

Roche’s Acquisition of Genentech 210-040

21

Exhibit 8 Roche’s Top-Selling Pharmaceutical Products in 2008

Product Active Substance Indication

Sales (in millions

of CHF)

% Change in Local

Currencies vs. 2007

MabThera/Rituxan rituximab non-Hodgkin’s lymphoma, chronic lymphocytic leukemia, rheumatoid arthritis

5,923 16

Avastin bevacizumab colorectal cancer, breast cancer, non- small cell lung cancer, kidney cancer

5,207 37

Herceptin trastuzumab HER2-positive breast cancer 5,092 12

CellCept mycophenolate mofetil

transplantation 2,099 13

NeoRecormon, Epogin epoetin beta anemia 1,774 -13

Pegasys peginterferon alfa-2a

hepatitis B and C 1,635 6

Tarcevaa erlotinib advanced non-small cell lung cancer, advanced pancreatic cancer

1,215 23

Xeloda capecitabine colorectal cancer, breast cancer, stomach cancer

1,211 13

Bonviva/Boniva ibandronic acid osteoporosis 1,108 35

Lucentis ranibizumab wet age-related macular degeneration 960 7

Tamiflu oseltamivir treatment and prevention of influenza A and B

609 -68

Xolair omalizumab asthma 560 10

Valcyte, Cymevene valganciclovir, ganciclovir

cytomegalovirus infection 553 10

Xenical orlistat weight loss, weight control 502 -13

Pulmozyme dornase alfa/DNase cystic fibrosis 496 12

Nutropin somatropin growth hormone deficiency 413 -2

Neutrogin lenograstim neutropenia associated with chemotherapy

404 -3

Rocephin ceftriaxone bacterial infections 344 -10

Activase, TNKase alteplase, tenecteplase

acute myocardial infarction (heart attack)

342 -1

Madopar levodopa + benserazide

Parkinson’s disease 311 4

Source: Roche Group, Annual Report 2008.

Note: Genentech-originated products are shaded.

a Roche and Genentech separately contracted with Tarceva’s developer, OSI, hence, shared credit for origination.

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617.783.7860.

210-040 Roche’s Acquisition of Genentech

22

Exhibit 9 Roche Estimates of Achievable Synergies by Expense Category and Year (in millions of US$)

Year 2009 2010 2011 2012 2013 and

Thereafter

% Dependent Merger with Genentech

Manufacturing 0 102 205 256 270 50% Research 44 114 118 121 125 0% Development 38 98 109 111 112 100% Marketing & distribution 38 98 101 104 107 100% Roche G&A 63 103 113 123 124 75% Genentech G&A 40 103 106 109 113 37%

Total 223 618 752 824 851         

Source: Roche Group.

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617.783.7860.

Roche’s Acquisition of Genentech 210-040

23

Exhibit 10 Genentech’s Actual and Forecast Free Cash Flow, 2006–2009 (in millions of US$)

2006

Actual 2007

Actual 2008

Actual 2009

Forecast Revenues

Product sales 7,640 9,443 10,531 10,868 Royalties 1,354 1,984 2,539 2,409 Contract and other 290 297 348 258

Total Revenue 9,284 11,724 13,418 13,535 Costs and expenses

Cost of sales 1,181 1,571 1,744 1,792 Research and development 1,773 2,446 2,800 2,644 Marketing, selling, general and administrative 2,014 2,256 2,405 2,058 Profit sharing 1,005 1,080 1,228 1,403 Other expenses 159 142 (88) 0

Total costs and expenses 6,132 7,495 8,089 7,897 Operating income 3,152 4,229 5,329 5,638

Less: Taxesa (1,290) (1,657) (2,004) (1,973)

After-tax operating income 1,862 2,572 3,325 3,665 Plus: Depreciation and amortization 407 492 592 577 Less: Increase (decrease) in net working capital (741) 894 (705) (457)

Cash flow from operations 1,528 3,958 3,212 3,785 Less: Capital expenditures (1,214) (977) (751) (672)

Free cash flow 314 2,981 2,461 3,113 Less: Charge for equity settled equity

compensation 0 0 0 (1,567) Free cash flow after equity settled equity

compensation 314 2,981 2,461 1,546

Source: Actuals from casewriter estimates based on Exhibits 3 and 4. Forecast based on Genentech, June 2008 long-range plan summary, prepared by Greenhill & Co. for Roche.

a Actual equals income tax provision from Genentech Income Statements. Forecast assumes a 35% tax rate.

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617.783.7860.

210-040 Roche’s Acquisition of Genentech

24

Exhibit 11 Comparison of Assumptions Approximating the June Long-Range Plan (LRP) and November Financial Model (NFM)

Growth LRP NFM Annual growth rate of total revenue (2010–2018) 7.0% 6.9% Period of year-by-year free cash flows 2009–2018 2009–2024 Operating Ratios (2010–2018)

Cost of sales / Revenue 9.5% 10.2% R&D / Revenue 18.5% 19.9% Marketing, G&A / Revenue 15.1% 14.3% Profit sharing / Revenue 9.0% 7.8% Other costs / Revenue 0.0% 0.0% Total costs / Revenue 52.1% 52.3% Operating income (EBIT) / Revenue 47.9% 47.7% Tax rate 35.0% 30.7% Depreciation / Revenue 3.3% 2.9% Ch. net working capital / Revenue 1.3% 0.7% Capex / Revenue 3.9% 3.1% Equity-based compensation

1.3% of Revenue

2010-2018

0%

Adjustments to Enterprise Value

Capitalized equity stock option (ESO) expense $0.00 -$11.42 billion Capitalized value of 2015 opt-in rights $0.00 $8.19 billion

Source: Casewriter estimates.

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617.783.7860.

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617.783.7860.

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