Genentech A Discussion Winter 2018Joseph Milner, RSM54011

Issues to Consider To build or not to build? If build, what does one build? If build, when? If build, where? Winter 2018Joseph Milner, RSM54012

What to do? Evaluate the investment value Determine expected losses in each of the years. Compare the value of the lost sales to the cost of building capacity Everything else is details. Consider alternatives to investment Consider the implications with regard to the firm’s strategy Winter 2018Joseph Milner, RSM54013

An Approach to Estimating the Value Demand Estimation Sources of uncertainty Estimating the cost of loss sales ($/kg) Estimating the lost sales (kg) Finding the Expected NPV of the losses Winter 2018Joseph Milner, RSM54014

Demand estimation Trial Stage Probability of Success Told 50% chance in Stages II and III So likelihood a Stage II drug is eventually approved is 50% x 50% = 25% In reality, probability of transitioning from Stage II to III may be 40% In reality, probability of transitioning from Stage III to approval may be 60% But that implies likelihood from Stage II to approval is 40% x 60% = 24%. In reality, there are other considerations on the probability of success Winter 2018Joseph Milner, RSM54015

Probability of Success Examples Some are more clear: Breast, other: Phase III so 50% Pancreatic, front-line: Phase II so 25% Lung (NSCLC): Phase III or 50% (Stated on page 7 and Exhibit 5, though Exhibit 11 says II/III) Some are less clear: Breast, Front-Line: Phase II/III so 38%? Some are very unclear: Multiple Phase III colorectal Multiple Phase II Breast Winter 2018Joseph Milner, RSM54016

Issues on arriving at estimated demand in kg Number of cancer patients Estimated penetration Grams per dose Doses per year Winter 2018Joseph Milner, RSM54017

Estimating Demand Colorectal Other Total Avastin Demand Winter 2018Joseph Milner, RSM54018

Sources of Demand Uncertainty Winter 2018Joseph Milner, RSM54019

Sources of Supply Uncertainty Winter 2018Joseph Milner, RSM540110

Estimating the margin per drug: 2003 Product Sales2621 COGS480 Contribution2141 Margin %82% Production900kg Margin per gram $2,142M/900kg = $2,379/gram Winter 2018Joseph Milner, RSM540111

Estimating the margin per gram Avastin Price per dose $2,000 Margin per dose 82% x 2000 = $1,634 Grams per dose Margin per gram$1,634 / = $4,357 Winter 2018Joseph Milner, RSM540112

Options Winter 2018Joseph Milner, RSM540113

Estimating the lost sales (kg): Do nothing Consider 2012 If we do not build the capacity is 2808 kg Estimate demand for Avastin to be 743kg Other drug (not Lucentis/Omnitarg)1375kg Lucentis/Omnitarg149kg Total2267kg Capacity Utilization = 2267/2808 = 81% What does this imply? Winter 2018Joseph Milner, RSM540114

Demand vs. Capacity 2012 Winter 2018Joseph Milner, RSM % 83% of the time all demand is served. 17% of the time some demand is lost. Guess the conditional average loss = 300 kg So 83% x 0 loss + 17% x 300 kg = Expected Loss = 51 kg 83% 300

How many sales do we lose in 2012? Winter 2018Joseph Milner, RSM540116

Should we build? Losses Savings Do Nothing$1,070M Build 12 x 12$537M$533M Build 8 x 25$516M$554M Find the Expected Lost Sales for each of the years Multiply by the appropriate margin. Calculate the NPV of the Losses Observe that building a 12 x 12 plant is marginally valuable. Building an 8 x 25 plant has negative NPV. Winter 2018Joseph Milner, RSM540117

To build or not depends on the variability Variability = 20%Losses Savings Do Nothing653 Build 12 x 12332$321M Build 8 x 25327$326M Variability = 25%Losses Savings Do Nothing1070 Build 12 x 12537$533M Build 8 x 25516$554M Variability = 30%Losses Savings Do Nothing1555 Build 12 x 12799$756M Build 8 x 25747$808M Why is building more valuable when there is higher variability? Winter 2018Joseph Milner, RSM540118

What do else do we need to consider? Winter 2018Joseph Milner, RSM540119

Should we wait? Consider Lucentis. Expected Demand = 125kg. It is easier to consider expected profit instead of loss. If we build, expected profit is Expected Revenue - Lost sales - $500M $36,943 -$500 = $36,443 If we wait and Lucentis is approved, we would certainly build. Profit = $39,261 If we wait and Lucentis is not approved, we would not build. Profit = $33,724 Winter 2018Joseph Milner, RSM540120

A Decision Tree Winter 2018Joseph Milner, RSM Build $36,443 Wait Lucentis Approved p=0.5 Lucentis Not Approved, p=0.5 $39261 $33,724 Expected Value = $36,492

Annual demands are not independent In the model we assume that each year we see a different outcome. But there is strong serial dependency year to year. In particular, drugs that are approved tend to stay approved, and drugs that are denied, tend to stay denied. So we really should model the correlation of demand year to year. Doing so using a model such as the one we have is difficult. But one can simulate out many outcomes of the trials to estimate the value of an is an Excel add-on that allows us to do so. Winter 2018Joseph Milner, RSM540122

12x12000 Facility vs. Not Building Winter 2018Joseph Milner, RSM540123

8x25000 Facility vs. Not Building Winter 2018Joseph Milner, RSM540124