Early in 1997, Genzyme Corporation began negotiations with Geltex Pharmaceuticals in an attempt to launch a joint venture to market Geltex’s first product, RenaGel. Geltex was a young biotech research company with only two products in its pipeline, and they didn’t have the resources necessary to launch RenaGel on their own. Genzyme, on the other hand, was a quickly growing company that experienced revenues of $518 million in 1996. They were attracted to the joint venture with Geltex because of the likelihood of increased earnings, as well as the joint venture being an excellent fit for Genzyme’s specialty therapeutics. Genzyme also felt that the joint venture would lead to a similar deal in launching Geltex’s second product, CholestaGel. Before cementing a deal with Geltex, Genzyme managers had to ask themselves three questions:
What is the likely enterprise value of the joint venture?
How much of the venture should Genzyme acquire?
How much should Genzyme pay for its interest?
We will attempt to answer these questions by first giving a brief overview of the two companies involved, and then by calculating the Net Present Value of the joint venture based on expected cash flows. Because we were given no operating history of the two companies, this is the only method we will use to determine what interest Genzyme should take in the joint venture. We will provide answers in three different scenarios: Genzyme’s estimates, conservative, and worst-case.
Launched in 1981 by Henry Blair, Genzyme Corporation is the fourth-largest biotech company in America. What differentiates Genzyme from its competition is that it uses living organisms or their products to generate drugs, rather than chemicals. Genzyme made its name in the industry with Ceradase, a treatment for Gaucher’s disease. This drug was approved for sale in March of 1991 and had a market of 3000 people. Two years later a recombinant form of Ceradase was released and the company began to enter new markets through alliances, joint ventures, and acquisitions. Genzyme quickly became a leader in its industry.
The broad array of products and services Genzyme provided gave the company an ample platform to work with in achieving medical breakthroughs. However, the company decided to outsource innovations through partnerships rather than focusing on developing the next miracle drug. They felt this strategy would lead to higher quality products in late-stage development, which increased the likelihood of the product being approved by the FDA.
Geltex is a company founded in 1992 by George Whitesides, Dr. James Tananbaum, Bob Carpenter, and Henry Blair. The company was started to develop Whitesides’s ideas involving using polymers as drugs. Eight initial investors generated $875,000 to fund the startup, which lasted a year. One year later, $6.8 million was raised from venture capitalists, and the company moved into a new facility in Lexington. In 1994, $10 million more was raised in another round of financing.
Geltex went public in November of 1995 by selling 2,875,000 shares of common stock for $26.2 million. Geltex kept costs down by employing a handful of experts to oversee development and then by outsourcing the actual work. The possible joint venture deal with Genzyme would affect only the American and European markets. The joint venture planned on rolling out the drug in 1999 in the U.S. and a year later in Europe. Genzyme was expecting to take a large interest in the joint venture, so in our analysis we will assume they want anywhere from 30-50%.
RenaGel, a drug for chronic kidney failure, is the focus of the joint venture. Healthy kidneys are maintained when there is a balance of phosphorus and calcium in the blood. In patients with chronic kidney failure, the kidneys were unable to maintain this healthy balance. Bone demineralization could result if untreated. RenaGel works by absorbing excess phosphorus and maintaining the healthy calcium and phosphorus balance.
There are many factors involved in this case that will affect the final numbers. Our analysis takes into effect the following variables: product launch delay (years), peak market penetration rate, price per patient, market compliance, gross profit, life of the drug, U.S. growth rate, European growth rate, and the discount rate.
In this section we show how Genzyme went about their analysis and what values they used for certain variables. These numbers were generally found by settling somewhere near the average of the range provided by market research.
One factor that must be considered is that the drug had not yet been approved by the FDA, but was in phase III trials. Historical data shows that 65% of drugs in this phase eventually get approved for sale to the market. It was felt that approval of the drug would occur late in 1998.
It was expected that 90% of the U.S. market would be eligible for the drug, while this number was lower for the European market, at 70%. The U.S. growth rate was based on the historical rate of 8%, while the European rate was found similarly at 6%.
Analysts’ reports provided a range of 20-59% for a peak penetration rate into the market. As with most new drugs, the penetration rate was expected to start low, grow to a peak, and then begin to slowly decline again. Analysts estimated a peak penetration rate of 43%
Not all patients would continue to regularly use the new drug, even if recommended to do so by their doctor. The compliancy range was felt to be 75-94%, with an average of 87% expected.
The annual price paid for the drug per patient depended on several factors, including how many pills the patient used as well as competitive pressures on how much could be charged for the pill. A range of $600 to $1300 per patient per year was possible, with $1000 as the average. Because the drug had yet to enter the market, variable costs were difficult to estimate. Genzyme decided to use the industry average of 70% of revenues to estimate gross profit to keep their analysis accurate.
One very important variable in this analysis is the life of the drug. There were currently no competitors to RenaGel on the market, but several were under development. It was estimated that the life cycle of the drug could last anywhere from 10-20 years, with a likely life span of 14 years. It was projected that RenaGel would reach its peak penetration within five years of entering the market.
The joint venture planned to market the drug to doctors with the largest patient populations instead of concentrating solely on patients with chronic renal failure. Using this approach, it was decided that a sales force of 45 people would be enough to distribute the drug. Each sales representative would cost $200,000, rising at 5% yearly. General and Administrative costs were assumed to be 40% of the cost of the sales force.
To forecast the cash flows, the joint venture would comprise a 45-day collecting period for receivables, a 90-day period for inventory, and a 45-day period for payables. Capital expenditures were expected to be $14 million, which were split over the first three years of the venture. Receivables were estimated to be 12.3% of revenues. It was estimated that payables would be equal to 30% of receivables, and that inventory would maintain a level at 60% of receivables. Depreciation was expected to be $400 thousand for the first two years of the venture and $950 thousand every year following that.
Based on these assumptions, we can answer the three questions proposed to us by forecasting the income statements and cash flows resulting from the joint venture. The joint venture does not become profitable until 2001. Following this, however, net income quickly rises and reaches more than $89 million in 2012, the final year in the life of the drug.
By projecting cash flows from our net income numbers, we are able to calculate the net present value of the joint venture at $89,792,891. Genzyme was highly interested in this joint venture and wanted a large stake in the business. A 50% interest would give their interest in the joint venture a value of nearly $45 million. We feel it is reasonable to expect to realize about 40% of this net present value when the initial investment is factored in, so an estimate of $27,500,000 was determined as how much Genzyme should pay for their 50%
interest in the joint venture. To summarize:
What is the likely enterprise value of the joint venture? $89,792,892
How much of the venture should Genzyme acquire? 50%
How much should Genzyme pay for its interest? $27,500,000
Calculations for these numbers can be found in Appendix A, Exhibits 1 & 2.
To determine our answers in the conservative scenario, we used what we felt were the most likely numbers from the ranges provided by market research, and adjusted accordingly if we thought necessary.
The first change we made was to reduce the life span of the drug to 13 years. We felt that it would still peak within five years of reaching the market, but we gave it a peak penetration rate of 40% to be on the safe side. A compliance rate of 90% could be reasonably expected, as there are currently no competitors on the market. We also factored in a one-year launch delay in the U.S. and a two year delay in Europe, based on the idea that it was possible the FDA would not approve the drug before the end of 1998. The annual price per patient was left at $1000 as we felt this was an accurate estimate. The discount rate was left at 20%, as this number had been found using the industry historical average.
All other factors were left the as they were in the previous analysis. These factors are based mostly on historical data and are likely to be accurate, so we left them alone.
When using these numbers, we get a very different answer. First off, the joint venture would not become profitable until 2002. Its net income would peak in the final year of the joint venture at more than $85 million. The net present value of the joint venture is $64,156,817. Our analysis shows that a 50% interest in the joint venture is not very profitable for Genzyme unless their initial investment decreases. To maintain the approximate 40% realization of net present value after factoring in the initial investment, Genzyme could pay $19,000,000 for a 50% interest in the venture, $15,500,000 for a 40% interest in the venture, or $11,500,000 for a 30% interest. The net present values associated with these three situations are $13,078,409, $10,162,727, and $7,747,045, respectively. Thus, a 50% share is most beneficial for Genzyme. To summarize:
What is the likely enterprise value of the joint venture? $64,156,817
How much of the venture should Genzyme acquire? 50%
How much should Genzyme pay for its interest? $19,000,000
Calculations for these numbers can be found in Appendix B, Exhibits 1 & 2
Worst Case Scenario
For the worst case scenario, we adjusted the variables to the low end of the ranges provided by market research. This scenario was analyzed to see if it was possible to profit from the joint venture in the event that all market conditions made it unlikely.
Our first adjustment was to lower the life of the drug to 10 years. Its peak penetration rate was limited to 20%, but would still be reached within 5 years of the drug hitting the market. Compliance dropped to 75%. We factored in a 2 year launch delay in America, thus a 3 year delay in Europe as well. The annual price per patient was lowered to $600. Once again, any other factors not mentioned here were left as they were in the original analysis. The discount rate was left at 20% because Genzyme was confident this would be the rate based on historical data.
When looking at the results of this scenario, it is obvious that Genzyme would not want to go through with the joint venture with Geltex. The venture does not become profitable until 2003, and net income peaks in 2007 at almost $22 million. The present value of the future cash flows doesn’t look any better. The net present value of the joint venture is ($29,513,370). No matter what share of this Genzyme took, it would provide a negative net present value, and thus the project should not be undertaken. To summarize:
What is the likely enterprise value of the joint venture? ($29,513,370)
How much of the venture should Genzyme acquire? 0%
How much should Genzyme pay for its interest? $0
Calculations for these numbers can be found in Appendix C, Exhibits 1 & 2