Right off the bat, I'll acknowledge that I have not been a fan of Eli Lilly (NYSE:LLY), nor has it been one of my preferred picks in Big Pharma. That didn't keep the stock from doing well in 2012, though, and perhaps the one saving grace to my anti-Lilly stance was that it didn't stand out from others I liked better like Roche (OTCQX:RHHBY), Sanofi (SNY) and Pfizer (NYSE:PFE).
Taking Lilly's financial performance at the end of 2012 into account, particularly the strong cost performance, and factoring in the company's deep bench of Phase 3 candidates, it's fair to say that Lilly could have the best chance of carrying that 2012 momentum through 2013. Although I'm still not a Lilly fan on balance, investors who have more faith in this company's pipeline could have a lot to look forward to in the coming 12-18 months.
Closing On A High Note
Lilly delivered an inspiring close to 2012 with a quarter that beat on the two places that matter most - revenue and operating profits.
Revenue did fall 1% as reported, but that was good for a slight (3%) beat versus sell-side estimates. Pharma sales were down 3% (also better than expected), while animal health sales jumped 18%. Lilly's biggest drug, Cymbalta, saw 20% revenue growth (a 7% beat), while Alimta (up 7%) and Zyprexa (down 49%, due to generic competition) were also better than expected. Evista was a little weak (and down 10%), and performance in Lilly's insulin business (down 5%) was likewise disappointing.
Lilly did quite well on expenses and margins. Gross margin improved nearly a point from last year (and even more on a sequential basis), while adjusted operating income rose 3% and beat the average sell-side estimate by an impressive 15%. Gross margin drove the beat, but SG&A expenses were also a bit lower than forecast.
The Next Two Years Will Be Tough Operationally, But Rich In Data And Possibilities
Lilly has some of the highest patent cliff exposure in Big Pharma, and a large chunk of that comes home to roost at the end of 2013 when Cymbalta goes off patent and takes more than one-quarter of the company's revenue with it. Evista (worth close to $1 billion in revenue) goes relatively soon after, and 60% of 2013's estimated revenue could be lost to generics by 2017.
On the positive side, Lilly has a large number of Phase 3 programs that will deliver go/no-go data over the next 12 to 18 months. In particular, investors will find out whether the company's more than $6 billion deal for ImClone really pays off, as necitumumab, ramucirumab, and cixutumumab all come forward with pivotal data.
Ramucirumab is probably the biggest unknown at this point, at least in terms of its ultimate revenue potential. While the fact that the antibody binds to the VEGF receptor and not the ligand could be a differentiating factor versus Roche's Avastin, I'm not so sure that the drug is going to show the necessary overall survival advantage to make a real mark. The company decided to go forward on a ramu filing in gastric cancer despite mediocre results from the REGARD study, but the efficacy in breast cancer (with data on the way) is the real driver. Absent a meaningful OS advantage, I don't know if this drug goes much above $300 million or $400 million, but if the data's strong enough the drug could be worth over $1,000 million in revenue in five or six years.
Going over all of Lilly's near-term pipeline would make for a very long column, but there is a common theme - quite a lot of potential, but also a lot of risk. I don't believe solanezumab has much likelihood of making it to market, but the potential for any approved drug for Alzheimer's disease is large. Elsewhere, I question whether the data will show a real and meaningful difference in efficacy and safety for drugs like dulaglutide (diabetes), edivoxetine (depression), or ixekizumab (rheumatoid arthritis and other auto-immune diseases) and allow those drugs to stand out from generics or branded drugs from Bristol-Myers (NYSE:BMY), Sanofi, or Pfizer.
If I'm wrong, the addressable markets are all measured in the billions and Lilly could have multiple future blockbusters hitting in a relatively close window. Of course, the odds are not equal for all of the drugs - I think ixekizumab is more likely to be a real threat to Pfizer's Xeljanz and a commercial success than edivoxetine is in depression - but the point is that these are not binary outcomes.
I think it's also worth noting that Lilly's diabetes franchise is likely to come under more stress. Lilly has done a very good job of acquiring/developing new medications for Type 2 diabetes, but the insulin franchise is looking more vulnerable to Novo Nordisk (NYSE:NVO) and Sanofi. With this business providing a legacy of rich (and relatively secure) cash flow and a potential per-share value of $20, I suggest investors keep an eye on these developments.
Shooting For Growth
Lilly has several drugs in Phase 3 testing with $1 billion-plus potential, but also a heavy overhang of upcoming patent expirations. If everything goes right, the company could post some of the best revenue growth in Big Pharma across the next five to 10 years. But if the pivotal trial data don't come in as expected (and/or the company cannot sell doctors on the differentiating features), this could be another AstraZeneca (NYSE:AZN) situation where the company is scrambling for revenue.
I'm incrementally more positive on Lilly than I was six months ago, and I believe the company can produce low-mid single-digit long-term free cash flow growth with definite upside to those numbers if key clinical/marketing programs break right for the company.
The Bottom Line
Solid cost-cutting and a prospectively rich pipeline are typically things Big Pharma investors like, so it's not hard to understand the optimism on these shares. I still have my issues with Lilly's management, and that keeps me from a full buy-in at this point.
Based on the aforementioned cash flow growth, Lilly looks basically fairly valued today. After the run in 2012, though, it's hard to find cheap pharma stocks in the U.S. right now unless you're willing to get very aggressive with pipeline success and revenue contribution assumptions. Along those lines, I'm sure Lilly bulls will think that $55 is much too low for these shares. For my part, this looks like one of the bigger risk/reward opportunities in Big Pharma. If you feel like taking on the risk, these shares may offer the best sector outperformance over the next two or three years.