Eli Lilly: Not Many Options Left

| About: Eli Lilly (LLY)

Like many pharmaceutical companies, Eli Lilly (NYSE:LLY) managed to report stronger-than-expected earnings by the end of January 2014. However, Eli Lilly managed to beat analysts' expectations for the quarter narrowly but the reported performance was way less than its performance last year. Eli Lilly was once known for converting R&D into profits now seems to fail across the board. Loss of patent exclusivity for major drugs followed by failure to replenish the drug pipeline casts doubts on the company's future profitability. In this article, I will delve into the reported performance of the company and glance at the future outlook and the company's ability to realize what it has forecasted for 2014 and ahead.

Top and Bottom Line Performance

The company reported mixed results. The annual results remained positive but patent expiration by the end of 2013 caused the last quarter results to demonstrate negative trend as reflected in the figure below:

Click to enlargeSource: Financial Workbook

Revenue Highlights By product

For the 4th quarter 2013 Eli Lilly's top line experienced a Y-O-Y decrease of 2% driven by lower volumes and unfavorable impacts of a weakening Japanese Yen that was partially offset by higher prices. A decline in the volume was the result of patent expiration of the company's bestselling anti-depressant drug Cymbalta in US that added almost 22.10% of the total revenue to the company's top line in 2012. Just after the patent expiry in December 2013 Cymbalta's sales plunged by -38% as several generic substitutes of the product have already been approved by the FDA for sale. All of the drugs offered by the company experienced a positive revenue growth Y-O-Y for the fourth quarter of 2013 as well as full year 2013 except for Cymbalta and Zyprexa both of which are facing generic competition after patent retirement. The following figure gives an insight into this information.

Source: LLY Financial News

Despite the 6% decline in US revenues, revenues from outside of the US increased by 1%. A major chunk of this revenue was hijacked by the continued softening of the Japanese Yen and the lower prices of products. For the full-year 2013 the company's top line climbed up by 2% driven by the strong sales of Cymbalta (pre-patent expiration) and other drugs.

Q4 gross margins decreased by 2.90% whereas the annual margins remained flat. During the 4th quarter of 2013, the net income for the pharmaceutical giant declined by 12.10% due to higher effective tax rates and a lower operating income. In contrast the company has tried to cut its marketing, selling and administrative expenses in the past quarter by 1.2%. This was achieved by reducing the marketing of Cymbalta after its generic competition hit the market. The effect was also evident in the quarterly EPS with a decline of 9.50% despite the decrease in the company's float driven by the share buyback program. On the other hand, the annual results were positive reflecting a 14.5% rise in net income and an 18% rise in per share earnings.

Click to enlarge

Source: Financial Workbook

Since the patents of the company's major drugs have expired and Evista and Cymbalta (EU data package) are going to lose their exclusivity rights in March and August of 2014 respectively, the drug pipeline revitalization is drawing more and more research and development expenditure as evident in the figure below. R&D as a percentage of revenue is showing an upward trend.

Source: Financial Workbook

The company is making an effort to come up with new drugs to replace its existing patents. Innovation acts as a passport for pharmaceutical companies to grow but requires a lot of resources. There are numerous drugs in Lilly's early and late stage product pipeline but it will take time to get back into the game. Since the complete revitalization of the product pipeline, FDA approval and finally shelving the product is a rigorous process and takes much time therefore, Eli Lilly can be expected to regain its lost status or position not any time soon.

2014 Guidance

After coming up with negative results in the last quarter of 2013, 2014 seems as though it could be worse because Eli Lilly is going to lose exclusivity rights for its bone- building drug Evista by March 2014. This will be accompanied by the Cymbalta data package exclusivity expiration in the European Union that will cause a dent in the company's top line. However, in its 2014 guidance, Eli Lilly claims to be well positioned for growth and margin expansion beyond 2014 on the basis of potential regulatory approvals and various product launches. But the plan has been flawed at the outset of 2014 because of the legalities involved in the regulatory approvals that further delayed the company's recovery in the industry.

Source: Q-4 2013 Slides

As far as the company's expectations are concerned, revenues for 2014 will be in the range of $19.2 to $19.8 billion plunging by 15.2% from a total revenue figure of $23 billion in 2013. Due to the 4% margin decline, the net income will experience a decrease of more than 34% and the EPS will experience a decrease of 35%. These deteriorating figures are indicative of the company's weakening position following major patent expirations and lack of products to offset the revenue loss from the retirement of Cymbalta and Evista patents.

FDA Approval for Insulin Drug Halted

Eli Lilly along with its partner Boehringer Ingelheim filed a new drug application to the FDA for permission to sell a biosimilar version of Lantus. This was an effort made by Eli Lilly to grab a major chunk of the US diabetes market. This generic substitute of the anti-diabetes treatment was expected to inject strong revenues for the company as the diabetes market is likely to grow from $35 billion in 2012 to $58 billion in 2018 due to obesity and sedentary lifestyles.

French drug-maker Sanofi Aventis currently holds the patent rights of Lantus and it is the world's top selling patented anti-diabetes drug. As a response to the new drug application, Sanofi sued Eli Lilly alleging infringements of Lantus' patent. Sanofi alleged the company violated its patent rights despite the fact that Eli Lilly had announced that it would not launch its generic version before the patent expiration of the active ingredients in Lantus in 2015. This has caused a 30-month stay of approval by the FDA, or until a court finds in favor of the Eli Lilly. This will delay the company's plans to market its own version of the product till mid-2016.

This will push back the company's previously expected launch date to market the biosimilar drug that is able to generate $1 billion in sales annually by 2020. By the time Eli Lilly's case is resolved and the generic version of Lantus comes to the market, Sanofi aims to get its new long acting follow up product U300 that will enable the company to switch its patients from Lantus to the new arrival. If this plan comes to fruition, Sanofi will be giving Eli Lilly tough competition for its investigational basal insulin that is currently awaiting approval. As a worst-case scenario, Eli Lilly will not receive approval from the FDA to launch its drug if the case is ruled in Sanofi's favor. If this happens the company will end up generating no revenue from its own version of the drug.

Final Take

Following the loss of exclusivity rights for its major revenue contributors, Eli Lilly needs to replenish its drug pipeline. However, in order to accomplish this, the company increased its R&D expenses over the past 2-3 years. Unfortunately the outcome was not a drug or a product but expense addition to the income statement due to late stage trial failures. The current court case initiated by Sanofi has halted the company's entry into the diabetes market and its efforts to produce a generic version of Lantus. The only option left for the company is to make acquisitions in order to bolster its product pipeline once again. This whole scenario casts doubt on the company's ability to meet its earnings forecasts for 2014 and 2015. Eventually the dire situation of the company makes me believe it will underperform in the market and it won't be able to achieve the high benchmark it set for itself throughout the past decade. Therefore in my opinion a long position should be avoided on the stock in order to avoid losses in case of further price depreciation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by a Blackstone Equity Research research analyst. Blackstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Blackstone Equity Research has no business relationship with any company whose stock is mentioned in this article