Friday, May 27, 2005

Genentech's 1800% solution

With stunning speed, Genentech is gobbling up big pharma’s lunch.

Perhaps no statistic testifies more eloquently to this than Genentech’s $83 billion stock market value – which exceeds Merck’s by $12 billion – a company with five times Genentech’s revenues. At 18 times revenues, Genentech is valued more highly than any leading publicly-traded health care company in the eight sectors I analyzed recently. Its stock is up 12-fold in the last decade; in the last five years its revenues have climbed an annual average of 21% and in the last 12 months it earned a 21% net profit margin on $4.2 billion in revenues.

How does Genentech accomplish this? Although I doubt Genentech is familiar with them, the company happens to follow closely the
Four Sources of Advantage – introduced in my first book, The Technology Leaders: How America’s Most Profitable High Tech Companies Innovate Their Way to Success (Jossey-Bass, 1997).

The Technology Leaders’ key finding was that top performing technology companies share common organizational habits. The book selected 20 companies from 1,306 based on high R&D spending, superior return on investment, and a reputation for innovative products and services. These 20 companies grew six times faster, earned over twice the return on equity, were four times more productive, and increased shareholder value at four times the rate of their peers. They achieve superior return on innovation as a result of four sources of advantage:

  • Entrepreneurial Leadership. Attracting and motivating entrepreneurs who combine technology and business expertise;
  • Open Technology. Opposing the Not-Invented-Here (NIH) syndrome by obtaining the technology that customers want to buy regardless of source – whether through acquisition, licensing, or in-house development;
  • Boundaryless Product Development. Engaging all relevant business functions, from purchasing to early-adopter customers, in the new product development process; and
  • Disciplined Resource Allocation. Applying rigorous methods to deciding where to spend money on new product development and to spreading organizational learning.

Here’s how Genentech uses these four sources of advantage:

Entrepreneurial Leadership

  • Hiring top scientists. Genentech’s CEO, Arthur Levinson, studied with Nobel Prize winning scientists and could have had a successful academic career. Levinson created a university-like environment that attracted other top scientists including Marc Tessier-Levigne, a former neurologist at Stanford University, and Andy Chan, a former immunologist at the University of Washington;
  • Driving scientific initiative through self-selected projects. Genentech encourages its researchers to spend 25% of their time on projects of their choosing (compared to an industry average of 10%). In 1988, a Genentech scientist, Napoleone Ferrara, became interested in anti-angiogenesis, a process for choking off the blood supply to cancer tumors. His research led to Avastin which was approved as a colorectal cancer treatment in 2004 and is expected to reach $3 billion in peak sales;
  • Using peer recognition to motivate innovation. Levinson believes peer recognition is a key motivator for researchers, and he gives them the opportunity to build a reputation for themselves. Genentech, unlike pharmaceutical companies, encourages employees to publish in-house research work in scientific journals. Pharmaceutical companies don’t want any of their findings to get out until they’ve got a patent. According to Levinson, by that time the work is no longer ground-breaking; no one cares about it any more; and
  • Tapping into scientists’ desire to make the world better. Genentech creates a culture in which people believe they can make a big difference. There are 300,000 people who have been treated by Rituxan, a treatment for non-Hodgkin’s lymphoma. When someone comes up to a Genentech employee and says “you helped save my dad’s life” it creates a sense that Genentech has a higher purpose which further motivates Genentech scientists.

Open Technology

  • Partnering to obtain technologies customers want. Genentech has forged over 100 partnerships in which it licenses technologies which form the basis of significant revenue-generating products. For example, Genentech worked with Idec Pharmaceuticals, before that company merged with Biogen in 2003, to develop Rituxan – a blockbuster which generated $1.6 billion in 2004 sales.

Boundaryless Product Development

  • Using genomics to reengineer drug discovery. Genentech created the Secreted Protein Discovery Initiative -- that generated five exciting product leads, including a surprising antiviral molecule, and could spawn as many as 20 more within two years. The project -- called Speedy by company insiders – reengineered Genentech’s traditional approach to research, in which scientists worked alone or in tiny teams. Under the assembly-line-like Speedy process, 80 scientists -- a quarter of the Genetech’s research staff – search enormous gene-data warehouses. Traditionally, scientists chased drug leads, known proteins like insulin and growth hormone, by synthesizing them into marketable products. Today, drug prospects are more likely to lie within the human genome and are found with the help of computers. With Speedy, Genentech simplified the task by focusing on the 10% of all proteins that travel outside the cell, blocking or spreading disease. Those 10,000 proteins are identified by using high-tech screens called signal sequence traps (SSTs), and then run through tests to determine their therapeutic benefit.

Disciplined Resource Allocation

  • Focusing on areas of therapeutic expertise. Levinson analyzed the drug industry and concluded that companies with a therapeutic focus earned higher shareholder returns than less focused competitors. After Levinson became CEO in 1995, he concluded that Genentech could best profit from this insight by focusing primarily on cancer treatment;
  • Setting tight deadlines and beating them. In early 2005, Genentech was in a race against Novartis to complete Phase III trials for using Avastin to treat non-small cell lung cancer. Genentech worked so quickly that Avastin achieved its goals for the Phase III trials by March 2005 – effectively eliminating competition from Novartis which had moved much more slowly and ultimately found that its product was no more effective than chemotherapy. Genentech is not above using financial incentives to encourage workers to meet deadlines. In 1998, Levinson promised employees “Genenchecks” of $3,000 or more if they beat an FDA marketing application deadline for Herceptin, a breast cancer drug; and
  • Killing development projects which lack tight scientific justification. Levinson can be brutal in killing projects he thinks are going nowhere. His presence at the Genentech’s weekly science meetings is as much feared as appreciated, because the CEO takes pleasure in asking tough questions. Genentech will not move compounds into clinical trials – which cost between $30 million and $100 million -- until scientific arguments for pursuing the drug are able to withstand Levinson’s intense scrutiny. And unlike some competitors, Genentech routinely designs drug trials to prove that its therapies extend the lives of patients, an exacting standard that is arduous and time-consuming, but which tends to convince even skeptics when the results are positive.

For companies like Merck, Genentech’s success may drive big pharma CEOs to lose sleep over the following issues:

  • Why is Genentech doing better than us at getting new drugs to market?
  • What could we be doing differently to attract top researchers in the biggest disease and science categories?
  • How can we do a better job of building and motivating drug development teams to enhance our productivity?
  • How could we make smarter decisions about which research projects to cut and which to initiate?
  • Which technologies should we be licensing out to raise capital?
  • Which should we be licensing in to cut time-to-market?

No doubt the stock market will mete out its rough justice depending on how well CEOs respond. In the meantime, look for Genentech’s stock to keep climbing steeply -- unless it has trouble in a drug trial or the FDA pulls one of its products -- then look out below.

Thursday, May 26, 2005

Sell in May and go away?

With Memorial Day fast approaching, it is interesting to examine the wisdom of the old adage “sell in May and go away.” The adage, if followed, would help stock brokers by increasing commissions (assuming investors sold in May and then bought again in September.) Presumably, the logic behind the adage was that investors are vacationing in the Hamptons during the summer so stock market volume and price movement diminish.

And while “sell in May and go away” may actually work over the long run; over the last few years, a better strategy would be to “find the trend and bet on the end.” What I mean is that investors could profit more by assessing where the market has been heading during the first five months of the year and then betting on that trend accelerating during the summer and continuing throughout the fall.

The latest edition of the American stock traders Almanac suggests that “sell in May and go away” was profitable over a 54 year period beginning in 1950. Calculations conducted on a $10,000 investment in stocks and shares back in September 1950 and then sold in the May of every year until 2004, would have seen the initial investment of $10,000 evolve into $486,000. But by doing the opposite and selling in September and buying during May, that $10,000 investment would have actually been reduced to $9,640.

However, over the last three years “sell in May and go away” has not been such a good rule. For example, since 2002 the S&P 500 has accelerated the year’s dominant trend during the summer. In 2002, the summer accelerated the year’s downward trend; in 2003 and 2004, the summer accelerated the upward trend.

The trouble with this simple rule is that it is difficult to figure out 2005’s dominant trend. Until earlier this month, it looked like the market would be flat at best this year. The Amex was doing quite nicely, the S&P 500 was down, and the NASDAQ was down even more. But in the last week or so, the S&P 500 and NASDAQ have really come to life and the Amex has been treading water. I think a driving factor has been the declining price of oil which has recently fallen below its $58/barrel high.

If this trend continues, the summer could be a good time to own software and semiconductor stocks and a bad time to own energy, steel, and auto stocks.

Tuesday, May 24, 2005

End self-reporting

Today’s report that Guidant withheld for years the risk that its heart defibrillator was faulty is the latest in a string of problems caused by self-reporting. I think the societal costs of allowing companies to monitor and report on their own condition – whether product, plant, or worker safety -- are too high.

Something is deeply wrong when companies have the power to choose whether to sacrifice the lives of their customers in order to maintain their profits. But this is what Guidant did when it decided not to tell doctors that its Ventak Prizm 2 Model 1861 defibrillator would fail between 0.2% and 1.5% of the time – killing the patients who happened to be on the wrong end of that game of Russian roulette. And
potentially 100,000 lawsuits allege that Merck decided that it was OK for some of its Vioxx patients to double their risk of heart attacks and strokes in order to keep raking in the product’s $2.5 billion in annual revenues.

The fundamental problem these companies face is that their executives have a powerful financial incentive to boost share price. And when the interests of other constituents – such as customers or employees – are at odds with those of shareholders; these other constituents take a back seat. More specifically, customer deaths that might result from the products are thought of as finite costs which executives weigh against the greater cost to shareholders of pulling a lucrative product off the market.

Given this decision calculus, executives withhold from the public information that might hurt a product’s sales – even if that information pertains to the death of that product’s customers.

In my view, society has two fundamental choices for addressing this problem:

  • Raise the cost to executives and shareholders of withholding such information until this cost dramatically exceeds the lost revenue from pulling the product; or
  • Shift responsibility for monitoring and reporting on product safety from the company to the government.

While it would take an especially motivated, diligent, and aggressive government agency to perform this function effectively – I believe it’s time to make that shift.

Saturday, May 21, 2005

House for sale

Over the last five years, the bubble has shifted from tech stocks to real estate.

When it comes to warning signals, I am fascinated by a comparison between the two asset classes. Alan Greenspan’s prescient December 1996
comment on irrational exuberance preceded by about three years the collapse of tech stocks. But warnings about a real estate bubble have preceded Greenspan’s most recent one – here’s one from 2002 and another I made this April.

Is Alan Greenspan three years ahead of the bubble on real estate? My hunch is that he was wary of using his bully pulpit to take the air out of the US economy’s biggest growth driver in a presidential election year. Now that the end of his term in office is less than a year away, he is getting more conscious of his legacy. And realizing that he can’t do much to stop a real estate bubble from popping, he wants to at least go on the record as having warned about it just as he did with
hedge funds a few weeks ago.

But housing industry insiders have no such concerns about their public legacies. According to my analysis of insider selling by executives in 17 publicly-traded housing construction firms, over the last year insiders have been selling shares at 11 times the rate at which they have been buying them, taking advantage of the industry’s 53% average 12-month stock market appreciation.

As Barron’s Alan Abelson has suggested, there are many reasons why insiders might sell company stock – none of which is because they believe its price is going up.

For those who own real estate as an investment, now might not be a bad time to sell.

Friday, May 20, 2005

Bashing democracy's bulwark

A free press is the last bulwark of democracy. And Morgan Stanley is bashing away at its foundation.

On May 18th it was reported that Morgan Stanley would pull advertising from newspapers and magazines that report
“objectionable” stories about the company. Of course this is not the first time a company has tried to punish a newspaper. In April, GM pulled advertising from the LA Times after it wrote a negative story about the company.

And on May 20th, it became clear that Morgan Stanley was not only trying to use its money to control the media's message, but also the actions and words of its former employees. Morgan Stanley's $13 million carrot is designed to shut down its former executives' participation in the debate over CEO Philip Purcell's future with the firm. And with their silence, these executives have clearly decided that they are willing to give up some freedom in exchange for Purcell's money.

However, Morgan Stanley and GM may find that the media is less compliant. And through their efforts to shut down debate, they are doing themselves more harm than good. Let me count the ways:

  1. The advertising they pulled might have helped offset the negative impact of the stories
  2. The move displays a surprising naïveté about the way newspapers separate the business and editorial sides
  3. Whatever pressure the advertising side might bring to the editorial side to tone down criticism of advertisers will do nothing to minimize editors’ compulsion to scoop their competitors – and will probably annoy the editors
  4. The policy reinforces investors’ perception that their management is so weak that it would rather squelch discussion of their problems than solve them – adding to downward pressure on their stock

Morgan Stanley and GM are taking a cue from other parts of our society – if you don’t like what you read about yourself in the media, twist its arm until you do.

Sunday, May 15, 2005

Health care futures

Health care makes strange political bedfellows. But investors are of one mind when it comes to what they like and don’t like about this trillion dollar industrial complex. And investor’s clarity should guide the future of the health care industry.

Who would have imagined 10 years ago that Newt Gingrich and Hillary Clinton would ever agree on anything? Well, it turns out that both are now promoting
a bill that would modernize medical record keeping. Their bill may have merit if it cuts costs while protecting privacy. And both believe that working together may help their 2008 prospects. Perhaps Newt thinks that promoting Hillary helps increase the chances that the Democrats will nominate her for 2008 – making it easier for Rove & Co. to defeat the Democrats in the next election. And Hillary may believe that a rapprochement with her former nemesis may blunt the effect of such Rovian attacks.

While it is unclear how this political maneuvering will pan out, investors have expressed a far clearer message on health care. According to a Peter S. Cohan & Associates analysis of the largest companies in eight health care industry sectors, investors pay a premium for rapid sales growth. They are eager to own biotechnology, medical instruments and generic drugs – whose 5-year revenues grew an average 32%, 13%, and 19% respectively. And they dislike drug wholesalers, and hospitals – which grew a relatively tepid 15% and 7% respectively. Big pharmaceutical companies (7%) and managed care organizations (2%) are stuck in the middle. And Pharmacy Benefit Managers (PBMs) are an interesting case – while their rapid revenue growth (+34%) has propelled their stocks upward, their razor-thin 2% net profit margins lead investors to value them less highly.

The stock market performance in these sectors over the last decade helps explain the variation in investor preferences. For example, biotechnology (+1,186%), generic drugs (+713%), PBMs (+480%), medical instruments (+473%), and managed care (+394%) generated the top 10-year stock market performances. While big pharma (+140%), hospitals (+180%), and drug wholesalers (+193%) were among the weakest performers in the sector. All these sectors outperformed the S&P 500 which rose about 110% during the decade.

But the prices that investors are willing to pay now for a dollar of sales in each sector provide clues as to investor’s assessment of the sectors’ future prospects. Investors pay a significant premium for a dollar of revenues generated by biotechnology, medical instrument, and generic drug manufacturers ($8, $4.50, and $3.61 respectively). Whereas revenues of drug wholesalers, PBMs, and hospitals sell at a discount -- 21 cents, 49 cents, and 95 cents respectively. Big pharma trades at a premium of $3.31 – reflecting the sector’s 29% return on equity (ROE) offset by its tepid revenue growth compared with 32% growth (and -2.5% ROE) in biotechnology. Finally, investors pay a middling $1.27 for each managed care revenue dollar.

These stock market dynamics have important implications for health care executives. For example, big pharma’s enormous profits have attracted faster-moving competitors. Biotechnology companies, such as Genentech, have attracted the world’s best researchers and given them a chance to bring new drugs to market fast that help treat devastating diseases. Meanwhile, generic drug manufacturers like Barr Pharmaceuticals grab market share by cutting the costs of making off patent drugs and challenging on-patent drugs with clever patent strategies. Meanwhile medical instruments makers, such as Medtronic, focus their expertise in specific markets, such as cardiac care, that create enormous growth and profit opportunities.

Big pharma executives are now on the hot seat to figure out how best to compete. Should they jettison their R&D and just focus on sales and marketing of their own patented drugs and in-license new ones? Can they make their drug development more productive by learning from biotech leaders like Genentech? Can they improve their margins by borrowing generic drug makers’ cost cutting techniques?

The answers to these health care questions will probably remain in flux long after Hillary and Newt’s 2008 political ambitions have played themselves out.

Saturday, May 07, 2005

Morgan Stanley's blues

The temporary lull in the action at Morgan Stanley has helped me realize that the terms of the debate are off point.

Purcell and the gang of eight are fighting over who best can increase the price of
Morgan Stanley’s stock – which has declined 14% since the beginning of their imbroglio -- but they should be debating how to increase its value. Neither party has proposed compelling answers to the question of how to increase the stock price. And this is the key challenge facing Morgan Stanley’s CEO – regardless of who occupies the position.

Purcell has made several management mistakes. The biggest was merging his Dean Witter with Morgan Stanley. The companies served two very different groups of customers with very different kinds of employees. Dean Witter’s blue collar stock brokers sold stocks and mutual funds to the middle class. Morgan Stanley’s pedigreed blue bloods delivered investment banking to blue chip corporations and private banking to their executives. There was no way for the blue collars and the blue bloods to coexist.

Having executed a merger based on a flawed concept, Purcell compounded the mistake by creating a management structure in which his blue collar loyalists replaced the blue bloods from Morgan Stanley. By turning away Morgan Stanley’s talent, Purcell was securing his power at the expense of the company’s profit potential and shareholder value.

Purcell should do two things to increase shareholder value. First, he should analyze Morgan Stanley’s business units based on their profit potential and competitive position. Morgan Stanley should dispose of businesses with weak profit potential and lagging competitive position. Second, he should identify the businesses with the greatest profit potential and strongest competitive position and invest in them through strategic hiring and acquisitions.

My guess is that one way to increase Morgan Stanley’s stock price would be to return the company to its roots by making the following corporate strategy changes:


  • Individual Investor. This stock brokerage business – with 10,962 brokers and 525 expensive offices -- earns a paltry 8% pretax operating margin – well below the 28% pretax margin for the overall company. Prospects for this business look terrible with retail investors staying away from stocks in a year when the S&P 500 is down 5%. Morgan Stanley should sell it.
  • Credit Services. The Discover credit card business’s 46.2 million customers earn Morgan Stanley a 35% pretax margin – the highest earner in Morgan Stanley’s portfolio. I question the logic of spinning off to shareholders what looks to me like Morgan Stanley’s crown jewels. But this decision has already been made. However, if Morgan Stanley gets paid enough money for the business and can reinvest the cash wisely, the spinoff might end up making sense.


  • Institutional Securities. This corporate finance powerhouse earns a respectable 31% pretax margin. Unfortunately, Morgan Stanley is being forced to pay higher compensation to replace the bankers who have left and retain the ones that competitors are trying to poach. Higher pay will cut Morgan Stanley’s profit margins – particularly in segments such as Mergers & Acquisitions – where its market rank slipped from 2nd to 4th between 2002 and 2004. If Morgan Stanley gets the $9 billion in proceeds it expects from the Discover spin-off it should use the cash to bolster its position – particularly in its industry leading equity issuance business.
  • Investment Management. With $424 billion under management and 30% pretax margins, this business looks like it would be ripe for growth through acquisition. There are several asset managers which could be acquired to bolster Morgan Stanley’s position in this attractive industry which is likely to benefit from 77 million baby boomers making a last ditch effort to save money before they hit 65.

While I would like to refine this proposed change with better data, I believe that a debate over Morgan Stanley’s corporate strategy would be more fruitful for shareholders than the one about whose blood is bluer.

Thursday, May 05, 2005

WIN redux

In October 1974, President Gerald Ford decided that the way to defeat the then prevailing 7% inflation rate was to go on television and ask the American public to wear “Whip Inflation Now" (WIN) buttons.

Today, our 43rd President joined in that great tradition -- sending his spokesman to tell the media that “we want to continue to see oil prices come down and gas prices come down so that they are more affordable for the American people.”

After watching the President’s recent hand holding stroll through the bluebonnets with Crown Prince Abdullah of Saudi Arabia, which accounts for 20% of US oil imports and 95% of the 9/11 hijackers, today’s statement leaves a bit to be desired.

How serious can the President be when his corporate campaign contributors are so heavily tilted towards energy and defense? As I noted on
Wall $treet Week a few weeks ago, these companies have enjoyed a 101% increase in their stock prices during the President’s tenure while the S&P 500 has tumbled 13%.

To get lower oil and gas prices, the President will need to come up with something a bit better than coupling campaign- contributor-friendly policies with a WIN-redux campaign.

Merck's muddle

This morning’s announcement that Merck Chairman and CEO Ray Gilmartin – whose CEO contract was to expire in March 2006 -- is being replaced by Richard Clark, the head of Merck’s factory division, information systems and procurement operations, terminates Gilmartin’s disastrous CEO sentence with an odd punctuation mark.

Gilmartin, the first Merck outsider to become CEO in its 100 year history, came from medical device maker Becton Dickinson in 1994. He was preceded by Roy Vagelos, under whose tenure Merck earned a reputation as a leader with drugs for high cholesterol, hypertension, asthma and osteoporosis. Gilmartin made his mark, as I noted in The Technology Leaders (Jossey-Bass, 1997), by acquiring for $6.6 billion Medco Containment Services, a Pharmacy Benefit Manager (PBM) which manages pharmacy-benefit programs for businesses and health insurance companies.

Gilmartin’s misguided idea was that since PBMs were buying so many drugs Merck could better control the distribution of its wares if Merck owned the biggest PBM. Medco sales exploded from $4.1 billion in 1994 to $26 billion in 2001. But Medco’s low-margin business dragged down Merck’s overall net profit margin. In 2001, Medco accounted for 55% of Merck's revenue but only about 13% of profits.

Merck had other problems with Medco -- including charges of suspicious accounting – when it emerged that Merck had counted $12.4 billion of patients’ co-payments to druggists as revenue generated by Medco although Medco did not actually receive those co-payments. Merck disgorged the Medco mistake in August 2003 through a delayed spinoff.

Gilmartin will no doubt be remembered for the ongoing Vioxx scandal. Merck pulled Vioxx from the market in September 2004 after a study found it doubled patients’ risk of heart attack and strokes. Vioxx may have caused as many as 140,000 heart attacks in the U.S. between its 1999 introduction and the recall. Not only did Merck lose its second best-selling drug, whose sales totaled $2.5 billion in 2003 but it triggered over 2,400 lawsuits and analysts estimate Merck’s liability could reach $18 billion. To make matters worse, Merck’s top selling drug, cholesterol-lowering agent Zocor, loses patent protection in 2006.

But the most bizarre outcome of today’s announcement is the selection of a manager of manufacturing, IT, and procurement to head Merck which during Vagelos’s tenure was known for its invention of life saving drugs. It is hard to see how a manager lacking experience in drug development can help revive the critical pipeline of new drugs that contributed to the success of this once great company.