Eli Lilly Goes Down The Hill As Patents Expire

Nov. 8.13 | About: Eli Lilly (LLY)

Loss of exclusivity whether by expiration or as a consequence of litigation typically results in a rapid and severe decline in sales for drug manufacturers like Eli Lilly and Company (NYSE:LLY). The company is currently facing the challenging situation where it will see some of its major revenue contributors lose their patents in the coming months.

Cymbalta - A gem of Eli Lilly's blockbuster product group

Cymbalta (duloxetine), a product for the treatment of major depressive disorder, diabetic peripheral neuropathic pain, generalized anxiety disorder, will see its patent expire in December, 2013. The drug was contributing as much as 31.82% of the company's revenue in the US market and 10.46% of the international segment's revenue in the fiscal year 2012. The graph below shows the company's increasing dependence on this patent with every passing year as it continued to penetrate in to the market. A sudden entry of substitute generic drugs could seriously dent the company's revenue base and profitability.

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Source: Eli Lilly's SEC Filings

Outside the US market, the company has data package protection for Cymbalta in major European countries up till August 2014.

Chances of Replacement

Several manufacturers have received tentative approvals to market generic duloxetine, and it is expected that generic duloxetine will be introduced in the market immediately following the loss of exclusivity.

While it is may be difficult to predict the precise impact on Cymbalta's sales, it can be safely assumed that the introduction of generics will result in a rapid and severe decline in the sales of Cymbalta. A similar incident took place in 2012 when the company saw the sales of Zyprexa, a treatment for schizophrenia, plunge to 7.53% of total sales in 2012 following the expiry of its patent that had once been a big hit on the market. It was contributing 19.03% of the global revenue in 2011. The expiration of Zyprexa's patent had an adverse effect on the results of operations and cash flows and the same is expected following the retirement of Cymbalta.

Evista - another expiry on the way

Under its Endocrinology segment, the company will see its patent retire for Evista on the treatment and prevention of osteoporosis in March, 2014. The drug contributed almost 4.47% of the total revenue in the fiscal year 2012. Although Evista was not a major contributor, the loss of exclusivity is likely to affect Eli Lilly. The patent's expiry will result in generic competition from other market players in the industry.

How is Eli Lilly Responding?

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Source: Morningstar

Seven major patent protected products, which together accounted for 68% of Eli Lilly's worldwide revenue in 2012, recently have lost or will lose in the following couple of years, their remaining US patent protection and data based protection, as well as their intellectual property based exclusivity in many countries outside the United States.

This is a major setback for the company and the management has been trying to replenish its drug pipeline by heavily investing in its research and development activity. This can be seen in the chart above that Eli Lilly has increased its research and development expenditure as a percentage of sales from 18.85% in 2008 to 23.73% to date. The company is making its efforts to come up with new drugs to replace the expiry of its existing patents.

The company will be back in the game. It has displayed its capability to absorb competitive pressures in the past when it saw its blockbuster antidepressant patent expire in 2001. However, it may take a few more years before the company is able to return back to its peak level as research, development, FDA approval and being finally on the shelf in the drug store takes a lot of time and is not a game of days or months.

Valuation Insight

The company's share price has come down in the past three months following the count down of its patent expiry. Although the company has been generating a superior return of equity "ttm" of 29% while the industry stands to offer only 19.9%, this high level of return may not persist for the next few years based on aforementioned facts and figures.

Also, the company has not raised its dividend from $1.96 since 2010, although, the shares have surged from around $30 to $50 causing a decline in its dividend yield to 3.92%. Furthermore, the dividend payout ratio has been consistently increasing as earnings are declining. Following the expiry of its major patents, Eli Lilly may be forced to reduce its dividend payout ratio of 46.33%. The norm that prevails in the drug manufacturing industry is a payout ratio of approximately 20%.

Conclusion

Based on my investment thesis and financial analysis, I expect Eli Lilly to underperform the high benchmark that it has set for itself during the past decade. Therefore, I recommend selling the stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.