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Shares of Eli Lilly And Co (NYSE:LLY) only saw a modest sell-off on Friday after the pharmaceutical producer received a big downgrade from Jefferies.

Unlike Jefferies I don't see compelling downside to Eli Lilly's valuation. The dividend seems safe for now, despite major patent expirations in the near term as Eli Lilly has a solid balance sheet.

The strong pipeline should provide some visibility for growth going forwards into next year, warranting the current valuation.

The Downgrade From Jefferies

Analyst Jeffrey Holford at Jefferies downgraded Eli Lilly from "Hold" to "Underperform", while cutting the price target quite aggressively from $49 to $40 per share. The price target suggest shares have some 18% downside from current levels.

Jefferies sees further disappointments in the pipeline, and this will put an increased strain on future cash flow allocations required to maintain the current dividend.

Jefferies is disappointed with the pipeline, notably with ramucirumab targeting breast cancer. Holford sees Eli Lilly as a bond proxy, expecting pressure on the valuation once the tapering likelihood increases in the coming year. He notes that Eli Lilly is the least preferred US stock within his investment universe.

Valuation

Eli Lilly ended its second quarter with $4.7 billion in cash and equivalents. The company operates with $5.3 billion in total debt, for a net debt position of $0.6 billion.

Revenues for the first six months of the year came in at $11.5 billion, up 3% on the year before. Thanks to one-off income of $495 million from exenatide commercial rights, net earnings rose by 42% to $2.75 billion.

The company guided for annual revenues of $22.6 to $23.4 billion, and non-GAAP earnings of $4.05-$4.15 per share, or roughly $4.6 billion.

Trading around $49 per share, the market values Eli Lilly at $55 billion. This values the firm at around 2.4 times annual revenues and 12 times annual earnings.

Eli Lilly pays a quarterly dividend of $0.49 per share, for an annual dividend yield of 4.0%.

Some Historical Perspective

Long term holders in Eli Lilly have seen very poor returns. Shares peaked around $100 per share at the turn of the century and have steadily fallen to lows in their mid-thirties between 2009 and 2011.

Shares have gained ground in recent times, peaking at $58 in April of this year, before falling back some 20% to current levels at $49 per share.

Between 2009 and 2013, Eli Lilly is expected to grow its annual revenues by a cumulative 5% to around $23 billion. Net earnings fell from $4.3 billion to an expected non-GAAP earnings of $4.1 billion this year. Despite recent share repurchases, the outstanding share base remained roughly the same over the past four years.

Investment Thesis

Eli Lilly looks cheap on the back of the guidance for this year and the essentially flat net cash position. Yet the company is facing two big patent expirations at the end of this year, and start of next year, which will create a lot of headwinds in 2014.

Most important is the loss of expiration on Cymbalta, which generated revenues of $1.50 billion in the second quarter, up 22% on the year before. Following the expiration, sales will most likely collapse which will have a huge impact given that Cymbalta made up roughly a quarter of total second quarter revenues.

With average gross margins for Eli Lilly approaching 80%, losing a drug with an annual run-rate of $6 billion in revenues will take a huge toll on revenues, but also on earnings. Yet recently, Eli Lilly confirmed its goal of $20 billion in revenues for 2014, and net income of $3 billion. To me these targets, notably the earnings target, seems quite far stretched.

While 2014 will become an extremely difficult year, Eli Lilly is quite upbeat for the longer term prospects given continued expense controls and a maturing Phase III pipeline. This should rejuvenate revenue growth and margin expansion after 2014.

The company stresses that it has the strongest pipeline in its history with 13 potential medicines in Phase 3, the final stage of clinical studies, or in regulatory review. The company has another 26 candidates in phase 2 testing, all putting a strain in the R&D budgets at the moment, but something which could create strong tailwinds in 2015 and beyond. Note that such an extensive pipeline will result in the occasional disappointments. In recent times the company pulled the plug on the development of enzastaurin, LY2886721 and Alimta, among others.

Back in August of this year, I last took a look at Eli Lilly's prospects. I concluded that unexpected positive research results of SQUIRE highlight the potential within the firm's pipeline. At the time, Eli Lilly announced the successful competition of the SQUIRE Phase III program.

At the time of writing, I thought the overall valuation was appealing enough despite a very difficult 2014, as the pipeline should drive the visibility into 2015 earnings and beyond. While the earnings multiple will increase towards 18 times next year, things should improve going forwards.

To lessen the pain for shareholders, Eli Lilly is using its strong balance sheet to maintain its 4% dividend yields, supplemented by a $5 billion share repurchase program. At current prices this should be enough to retire 9% of the company's shares outstanding in the coming years.

I am not sure why Jefferies is so negative on the prospects for Eli Lilly. I agree that the company had a relative poor past performance and execution issues, but the relative strong balance sheet and solid pipeline should provide some appeal to shares after a difficult 2014. I will await the third quarter earnings report on the 23rd of October before making up my opinion on which position to take.

Source: Eli Lilly And Company - Jefferies Is Unnecessarily Bearish Amid Patent Expirations