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Roche-Genentech: Lack of Deal Is All Goldman Sachs' Fault

Roche's offer document for purchase of outstanding shares of Genentech is worth a look -- it gives a day-by-day, sometimes hour-by-hour explanation of what exactly happened between the two boards of directors since last summer, when Roche first proposed buying Genentech.

It also explains why Roche is now low-balling its bid at $86.50; and why Genentech thinks it's worth $115(!) a share. It turns out Goldman Sachs was using a wildly optimistic method for estimating Genentech's value -- a method that has a number of well-known flaws.

Roche initially proposed an $89 bid; Roche rejected it. Roche then went hostile and is offering $86.50. Shareholders now have to decide whether they want to accept the money from Roche -- which is still a nice premium on the price before the bid -- or sit tight. They have until March 12 to decide. Genentech said it will respond to the new offer in 10 days.

Given the history described in the Roche offer document, it's a fair bet that Genentech will say "no thanks." You can read the offer document here. The crucial difference between Roche and Genentech seemed to emerge in December:

On December 12, 2008, representatives of Greenhill [Roche's bank] and Goldman Sachs [Genentech's bank] met in New York City. The Goldman Sachs representatives made a presentation on valuation based on the November Financial Model that included a discounted cash flow analysis ... yielding a valuation range of approximately $112 to $115 per Share.
The document then uses especially prim language to describe what happened next:
On January 23, 2009, Dr. [Franz] Humer [chairman of Roche] and Dr. [Charles] Sanders [lead director of Genentech] spoke by telephone. On the call, Dr. Sanders stated that he believed that the $112 per Share price proposed by the Special Committee was fair and that the $89 per Share price proposed by Roche was not an appropriate starting point for negotiations. In response, Dr. Humer responded that he believed the $89 per Share price was fair for a negotiated transaction and that the $112 per Share price proposed by the Special Committee was not an appropriate starting point for negotiations.
And then talks fell apart. (Clearly, it has been a long time since this pair negotiated anything. Anyone who has ever haggled over the price of a bootleg DVD on the street would have done better at getting Roche to increase its bid.)

Nonetheless, the crucial words in that mess are "discounted cashflow analysis."

Put simply, a DCF starts by looking at current cash flows generated by the company. It then makes some assumptions about whether those flows will grow or decline in the future., and estimates that with a percentage, the A "discount" percentage rate is then applied to convert those flows into "today's" dollars. The calculation is extended several years into the future and is sometimes capped with a final, estimated value.

One need not be a math genius to realize that DCF takes current, accurate information (current cashflows) and then pollutes that information by adding in levels of uncertainty (next year's estimated cashflow). The more years you telescope into the future, the more uncertain the information you're creating becomes.

And because those estimates are calculated with exponentials and multipliers, any error you've made in your estimate is magnified in the calculation, downward or -- as in Genentech's case -- upward.

The result is that unless you've got it exactly right, your analysis is most likely to be off the mark. Which is how Goldman believed that Genentech is worth $115 a share even though it has never broken $100 at any point in the last 10 years.

So what is the correct price for Genentech? There's a simple answer if you're a Genentech stockholder: The correct price is the price being offered by the highest bidder in the market. DNA traded at $80 before the bid, and is now at about $83. Roche is offering $86.50. There are no other bidders. That's the price of Genentech stock.

Side note: Here's an interesting story about Roche's lack of financing for the deal. Apparently, it's currently looking for a $27 billion bridge commitment which it will then turn around and float off as bonds. Layoffs will follow like night follows day as Roche cuts expenses to make those payments.