Eli Lilly: Cheap With Good Reason

| About: Eli Lilly (LLY)

A high dividend yield, high earnings yield and a share price that is cheap relative to the market – these are all things we like at YCharts and which our proprietary valuation model looks for.

But when those numbers look too good, as is the case with Eli Lilly (NYSE:LLY) (and some other Pharma stocks), we’re alerted that the shares hold special risk. In Lilly’s case, it’s because many of its best-selling drugs are to lose patent protection in the next few years, meaning generic drug makers can begin competing with far cheaper offerings. In the industry, it’s known as facing a patent cliff.

So at Lilly, a p/e ratio below 9, earnings yield above 11%, and a dividend yield chart that looks like this are actually warning signs.

LLY Stock Chart

As the saying goes, if it looks too good to be true, it probably is.

Here are Lilly’s top drugs, each one’s 2009 sales, and soonest patent expirations:

  • Zyprexa: $4.9 billion/2011 (Oct.)
  • Cymbalta: $3.1 billion/2013
  • Humalog: $2.0 billion/2013
  • Alimta: $1.7 billion/2016
  • Cialis: $1.6 billion/2017
  • Gemzar: $1.4 billion/2010 (Nov.)

With total sales in 2009 of $21.8 billion, it’s clear that the loss of patent on Zyprexa (a treatment for schizophrenia) alone could blow a big hole in Lilly’s finances; Lilly’s 2009 profit was $4.3 billion, or $3.94 a diluted share, and even though investors can see trouble ahead, 2010 results are shaping up as even better. Lilly said in reporting second-quarter profit (up 16%) that per share net income for all of 2010 would be between $4.44 and $4.59. Heavy clover out there near the cliff.

What investors want to see are some new drugs to replace Zyprexa and the others. There may be a wait. As Lilly’s CEO, John C. Lechleiter, noted in his letter to shareholders earlier this year, “Our industry is suffering a dry spell.” It’s not for lack of trying. Lilly shelled out $4.3 billion on R&D last year, and is spending apace in 2010. (The spike below is related to an acquisition.)

LLY Stock Chart

Even with the rising dividend …

LLY Stock Chart

… Lilly has lots of cash to fund R&D.

LLY Stock Chart

And Lilly has been aggressively cutting its operating costs and axing about 5,000 workers to free up still more money for R&D.

Lilly has about 70 new medicines in clinical development. Getting one all the way through the process can take more than a decade and cost $1 billion. Lilly had to pull the plug on one promising drug, semagacestat, an Alzheimer’s disease treatment, in August. During Phase III trials, Alzheimer’s patients taking the drug worsened more than those taking a placebo, and there was also an increased risk of skin cancer.

A decade ago, Lechleiter noted in his recent letter, Lilly faced a similar problem when its giant drug Prozac lost its patent protection. “Up to that time, no pharmaceutical company hit with a loss of that magnitude had survived intact. We became the first by launching nine innovative products in five years.”

At best, Lilly received faint praise from investors for that trick.

LLY Stock Chart

A major drug discovery, with regulatory approval, would surely send Lilly shares rising, and its p/e, dividend yield and earnings yield sinking. Until then, Lilly’s cheap with good reason.

Disclosure: No Positions