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Shares of Eli Lilly (NYSE:LLY) started the week on a bad note after the pharmaceutical company received a downgrade from analysts at Goldman Sachs.

I think that Goldman is too aggressive at this point. The earnings guidance into 2014 brings comfort as the full pipeline should drive incremental improvements going forwards.

Goldman Becomes More Cautious

Analyst Jami Rubin at Goldman Sachs (NYSE:GS) downgraded Eli Lilly from "Neutral" to a "Sell," while reducing the price target by four dollars to $48 per share, suggesting some 4-5% downside potential from current levels.

Rubin is cautious given the lack of differentiation at the company's pipeline. The primary care business of Eli Lilly is declining amidst patent expirations, while the new product portfolio becomes increasingly more important to earnings after 2014.

Rubin notes that the new products of Eli Lilly for diabetes and oncology portfolios, which are the majority of the pipeline going forwards, face a lack of differentiation. Rubin sees flat earnings per share between 2013 and 2018, assuming the patent of Alimta prevails, and limited potential in other parts of the pipelines.

Given the flat earnings per share growth, the premium valuation at 16 times 2015 earnings versus the likes of AbbVie (NYSE:ABBV), creates more downside risk on a relative basis.

Valuation

Eli Lilly ended its third quarter with $5.4 billion in cash, equivalents and short-term investments. Total debt stood at $5.3 billion, for a modest net cash position of roughly a $100 million.

Revenues for the first nine months of the year came in at $17.3 billion, up 4% on the year before. Net earnings rose by 21% to $3.96 billion, resulting in 25% growth in earnings per share, totaling $3.64 per share.

Annual revenues are seen around $23 billion as reported GAAP earnings are seen between $4.33 and $4.38 per share. Non-GAAP earnings, which are more meaningful in this case are seen around $4.10-$4.15 per share, or $4.5 billion.

Trading around $50 per share, the market values Eli Lilly at $57 billion. This values operating assets of the firm at 2.2 times annual revenues and 11-12 times earnings.

Eli Lilly currently pays a quarterly dividend of $0.49 per share, for an annual dividend yield of 3.9%.

Some Historical Perspective

Long-term investors, those who invested in the company around the turn of the century, have lost nearly half their value. Shares fell to lows of $30 in 2009 and 2011, but have recovered quite a bit in the meantime.

Shares rallied to $58 in April of this year, before falling back to current levels around $50 per share, for flat year-to-date returns.

Between 2009 and 2013, Eli Lilly is guiding for a cumulative 5% revenue growth to $23 billion. Net earnings are seen roughly flat, increasing slightly from $4.3 billion to $4.5 billion.

Investment Thesis

Three weeks ago Eli Lilly reported its third quarter earnings, and shares have been tied around the $50 level ever since. Financial results for now are stable as the expiration of blockbuster Zyprexa at the end of 2011 depressed returns in 2012, allowing organic growth rates to dominate into 2013.

The announced $5 billion share repurchase program, combined with the $20 billion sales target of 2014 are creating some support for the shares. While 2014, will become very difficult, the company has 4 potential diabetes drugs going for sale in 2014 and the year after, assuming all will be approved by regulators.

It is this focus or which Goldman Sachs is warning about, as competition from the likes of Merck (NYSE:MRK), Pfizer (NYSE:PFE) and Johnson & Johnson (NYSE:JNJ) in the area could result in fierce competition. For now, Eli Lilly claims the broad appeal of its drugs, supplying all segments is a key advantage in differentiating the drugs to doctors.

The biggest short-term threat is the expiration loss of Cymbalta, which generated $1.38 billion in third quarter revenues, nearly a quarter of total revenues. Following the expiration, sales will most likely collapse, which will have a huge impact on the overall results.

Losing the patent on the drug with $5-$6 billion in annual revenues will take a huge toll on earnings and revenues given the gross margins of 80%, reported by Eli Lilly. The 2014 targets of $20 billion in revenues and earnings of $3 billion should provide a lot of comfort to investors.

Halfway through October, I last took a look at Eli Lilly's prospects. I concluded that the visibility into 2014 is comforting and that a strong pipeline with 13 potential drugs in Phase 3, is comforting in 2015 and beyond. While 2014 will be disappointing, the pipeline should drive visibility into 2015 and beyond.

The price-earnings ratio should peak around 18-19 for 2014, and then fall on the back of earnings improvements. Furthermore, Eli Lilly is paying out a nearly 4% dividend yield, while buying back 9% of its shares in the newly announced repurchase program. These combined cash flows to shareholders should soften the pain for shareholders in the meantime.

The past performance over a long-term horizon has been poor, but shorting the company at these levels seems aggressive. Eli Lilly has a strong balance sheet and solid pipeline. A short position seems too aggressive, I remain on the sidelines.

Source: Eli Lilly - A Short Position Seems Too Aggressive