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Summary

Eli Lilly and Co. (LLY) is a global pharmaceutical company that has a strong presence in the central-nervous-system market with products such as Cymbalta and Strattera. It also has a strong presence in the oncology, endocrinology and cardiovascular markets with key products that include Alimta, Evista, Humalog/Humulin, Erbitux and Cialis. The company faces a number of key patent expirations through 2015. Among the drugs facing patent expiration are Zyprexa, Evista, Gemzar and Cymbalta (Duloxetine), which accounts for a significant portion of Lillly's earnings. It is estimated that Lilly shares will fall 20% in 2014 because of generic competition due to expired patents for antidepressant Cymbalta and osteoporosis drug Evista.

Failure After Failure

Lilly's experimental drug Ramucirumab failed to meet expectations for treating breast cancer in a late-stage trial, which sent Lilly's share price spiraling down. Lilly shares fell 3% to $51.04 on Sept.26 after the company announced the trial results. Lilly's therapy solution didn't help patients live longer without their tumor progressing, according to a study known as Rose. However, the compound did meet its primary goal in a separate late-stage trial, called Rainbow, for the treatment of people with advanced stomach cancer. Lilly had been counting on Ramucirumab and other experimental drugs for Alzheimer's and diabetes to help revive growth in 2014. Tim Anderson, a Sandford C. Bernstein analyst, said analysts had been expecting $1B in annual sales from Ramucirumab by 2020.

Lilly gained the rights to Ramucirumab when it acquired ImClone Systems Inc. in 2008. But, based on the breast-cancer study results, Lilly said it does not intend to seek regulatory approval for the compound as an initial breast-cancer treatment. This is unfortunate as the American Cancer Society estimates that, in the U.S., cases of breast cancer outpaced those of gastric cancer by a factor of 10 in 2013.

Despite its failure with Ramucirumab, Lilly continues to press forward with the testing of drugs for other types of malignancies, although breast cancer had been one of its top target markets.

Lilly has also received disappointing news from the Centers for Medicare & Medicaid Services (CMS), which decided to deny patient access to beta-amyloid imaging agents such as Amyvid (Florbetapir F 18 Injection). CMS made the judgment despite expert opinion and published appropriate use criteria previously recommended by the Alzheimer's Association, the Society of Nuclear Medicine and Molecular Imaging. By denying patient access, CMS is also in conflict with the National Alzheimer's Project Act, passed unanimously by Congress in December 2010. CMS participated in creating this plan aimed at developing new and innovative ways to diagnose, support and treat patients suffering from Alzheimer's disease. The upshot is that CMS has decided to reject the only technology currently approved by the Food and Drug Administration (FDA) for evaluating beta-amlyoid neritic plaque density in brain and for aiding doctors in making a more accurate diagnosis of Alzheimer patients. Eric Dozier, senior director of Lilly's Alzheimer's Business Division, recently said, "Coverage with evidence development as proposed by CMS does not provide patients appropriate access to these amyloid-imaging brain scans. Instead, it creates additional complexity for the broader community in determining the best path forward for patients." He added, "As we continue to review the final decision memo, we will be evaluating all available options to ensure patients and physicians can gain access to this innovative diagnostic tool as soon as possible." His remarks caused company shares to drop an additional 1.06% on Sept. 27, following the 3% decline the day before.

Patent Expirations

Since Lilly will undoubtedly hit a patent cliff in 2014, who will be the lucky generic manufacturers to profit from Lilly's loss? Cymbalta, which goes generic in December, will be the first of Lilly's patent expirations. Multiple generic manufacturers - including Impax Laboratories Inc. (IPXL), Teva Pharmaceutical Industries Ltd. (TEVA), Momenta Pharmaceuticals Inc. (MNTA) and Sunesis Pharmaceuticals Inc. (SNSS) - have acquired competitor exclusivity on Cymbalta. Subsequently, these companies will take a piece of Lilly's $5B in annual sales of the drug. This will have a notable impact on Lilly's portfolio, resulting in a significant loss of market share. Evista will go generic in March 2014, with Teva being one of two companies holding 180 days of exclusivity in the U.S. market. With the Affordable Care Act (also known as Obamacare) going live for regulatory insurance to U.S. citizens in January, we can expect Cymbalta and Evista to increase their rate of sales due to the availability of health insurance and the reduced price of the drugs. Estimated sales of Cymbalta by Lilly are expected to fall to $1.5B, a 72% drop in sales, while Evista sales are estimated at about $417M, a drop of 54%. This is a bleak outlook for Lilly, although it is an encouraging reason to focus on Teva.

Fundamental Overview

Currently, Lilly's yearly performance rates at 10.58%, with a YTD figure of 5.19%. Its RSI rating of 31.38 could indicate that Lilly is close to being oversold. Lilly currently averages quarterly growth of 2.5%, and has a P/E of 11.32, which is expected to rise to 18.2. Even if the company's P/E does rise, it is estimated that its share price will still drop by 32.95% next year. The estimate is based solely on patent extension and doesn't factor in recent news about Ramucirumab and Amyvid. As a result, from a fundamental aspect, the company's prospects don't look too hot over the next couple of years.

You would think that, based on recent news and the exclusivity loss of Cymbalta and Evista, analysts would rate the company negatively. However, rating distributions are currently 35.7% positive, 35.7% neutral and 28.6% negative, showing that 11 of 14 firms rate Lilly above negative. The current estimated average target price is $54.41, with a maximum target price of $65 and a minimum target price of $44. The estimates do not take into account recent developments with Lilly's trial-phase failures.

Sales of Cymbalta and Evista are expected to produce significant income in Q3 and Q4. It is estimated that Cymbalta sales will average $5.2B in 2013, and $960M for Evista, although this represents a 72% loss in Cymbalta sales and 54% loss in Evista sales. This is disappointing for Lilly, although it has other drugs that are performing well, with their sales estimated to increase over the next five years. These drugs include Strattera (2% - 5YRE), Cialis (6% - 5YRE), Axiron (42% - 5YRE) and Erbitux (5% - 5YRE).

Options Suggestions

Lilly recently began trading for a Dec. 21 expiration. I would recommend a sell-to-open PUT for a strike of $49.50, currently priced at about $1.90. This commits you to purchasing shares at $49.50, but you would also collect a premium representing about a 1% discount compared to the current share value. If the contract expires worthless, you would collect a premium and call it a day. The current odds of this occurring based on Greeks is 54%. Should the contract expire worthless, the premium would represent a 3.68% return on your cash commitment, or about a 15% annualized yield. This is considered a yield-boost. If you prefer the bear side of the options chain, I would recommend a sell-to-open CALL for $53.00. I would also recommend having the cash available to cover the position, making it a covered call instead of a naked call. Should the option expire worthless, you would collect a 5.5% premium on your cash commitment. If you would like to maximize on the short side of Lilly, I would also recommend purchasing a $49.50 PUT. This would be the most appropriate position based on current fundamentals news, although the position could potentially be overshadowed by Q3 and Q4 earnings, and create a large loss. I believe the bull side will be more effective in the next four months of trading. According to current Greeks, the bear side has a 64% potential of occurring, improving the odds that this would be an extremely intelligent position. It would also provide a 2.20% yield-boost, should the bear-side options expire worthless, or a 9.01% annualized yield based on your cash commitment. You could also go with a well-placed strangle, straddle or butterfly, if you expect the shares to remain in the current price range.

Conclusion

With the company's current trial failures and patent expirations, I would recommend staying short in the long term. I do not expect Lilly to produce any significant news within the next year. Even with its successful trial of Ramucirumab for use as a treatment for gastrointestinal cancer, I do not believe this will be enough to outweigh Lilly's coming portfolio losses. If you did not enter Lilly at the beginning of 2013 or earlier, I would highly recommend changing your position and outlook. The company is very innovative, and drug companies have a reputation for gaining momentum quickly on the back of successful trials and potential drug releases in new and innovative fields. However, I do not believe Lilly will have a breakout until the end of 2014 or mid-2015.

Source: 2014 Isn't Looking Too Good For Eli Lilly And Company