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Summary

  • The company's earnings will fall in 2014 and rise again in 2015 as it works through the major portion of its patent cliff.
  • The company is relying on its animal health division to smooth out its earnings while its pharmaceutical earnings recover.
  • The company is rewarding its shareholders with an over 3 percent dividend while it moves its new drugs towards the approval process.
  • A $1 million insider purchase in 2014 is a positive sign that Eli Lilly shares will rise further.

Eli Lilly and Company (NYSE:LLY) is one of our favorite major American pharmaceutical investments. In recent years, there have been many headlines regarding the "patent cliffs" faced by the major pharmaceutical companies. No company faced a greater patent cliff than LLY. The most significant portion of LLY's patent cliff is taking place this year (2014). Regardless of the headlines, LLY shares have almost doubled since 2010. We believe the shares will continue to reward shareholders with share price appreciation and an over 3 percent dividend yield.

We must note another reason we like owning LLY shares is that it is not playing the same financial engineering games that pharmaceutical companies (such as AbbVie (NYSE:ABBV) and Pfizer, Inc. (NYSE:PFE)) have been playing. LLY is not using a "tax inversion" loophole (like ABBV) by changing its domicile to a foreign country to lower its taxes. Nor is LLY engaging in multiple large-scale takeovers as PFE has, whereby a company takes over a large company and takes advantage of "synergies" (firing employees and closing down research and development projects). The results of PFE's takeovers have done little for its shares and ended up enriching its executives, while issuing billions of shares for its failed takeovers.

Background

LLY discovers, develops, manufactures and sells pharmaceutical products worldwide. The company operates in two divisions; human pharmaceutical products and animal health products. LLY offers endocrinology products to treat diabetes; osteoporosis in post-menopausal women; human growth hormone deficiency. The company's neuroscience products treat major depressive disorder, generalized anxiety disorder, schizophrenia, acute mixed or manic episodes associated with bipolar I disorder; attention-deficit hyperactivity disorder; depressive disorder, obsessive compulsive disorder, bulimia nervosa and panic disorder; and brain imaging of beta-amyloid neuritic plaques. The company's oncology products treat pancreatic, metastatic breast, non-small cell lung, ovarian, bladder, colorectal and more; and cardiovascular products are used to treat erectile dysfunction and benign prostatic hyperplasia and pulmonary arterial hypertension. In addition, LLY sells animal health products, including cattle feed additives; antibiotics to treat respiratory and other diseases in cattle, swine and poultry; and products that prevent flea infestations on dogs, kills fleas, prevent heartworm disease and control intestinal parasite infections.

Drug Pipeline

LLY's research and development spending has been over $5 billion a year in recent years, equaling about 23 percent of sales. LLY's research and development budget is among the highest in the industry, as the average is about 17 percent of sales. The company presently has an R&D pipeline of over 50 new chemical entities (or new molecular entities or new biotech entities). Of that total, about 30 compounds were in late-stage Phase II or Phase III or under regulatory review. Compounds comprise new treatments for psychosis, depression, cancer, diabetes and other conditions. Some of the more promising compounds are solanezumab treatment for Alzheimer's disease, ramucirumab anticancer, and dulaglutide for type 2 diabetes, Effient antiplatelet therapy, and various other compounds to treat cancer, arthritis, lupus and other conditions. LLY is developing many of its new drugs through research and development alliances with Takeda, Boehringer Ingelheim and other companies.

Second-quarter earnings

In July 2014, LLY reported second-quarter 2014 adjusted earnings per share of 68 cents, 41 percent below the 2013 second quarter. Second-quarter 2014 revenues fell 17 percent to about $4.9 billion, reflecting generic competition for LLY's best-selling drugs Cymbalta and Evista in the U.S. (due to the U.S. patent expiration for such drugs). Second-quarter revenues fell 17 percent due to lower volume. The lower volume was due to the December 2013 U.S. patent expiration for Cymbalta and the March 2014 U.S. patent expiration for Evista. U.S. revenues fell 30 percent to about $2.38 billion, reflecting the loss of patent protection on Cymbalta and Evista. Revenues outside the U.S. increased 1 percent to about $2.55 billion, due to higher volume that was offset in part by lower prices. During the second quarter, products which experienced an overall revenue decline included: 1) Zyprexa: a 14 percent revenue decline; 2) Cymbalta: a 73 percent revenue decline; and 3) Evista: a 61 percent revenue decline.

LLY products grew revenue in the second quarter included: 1) Alimta (up 6 percent to $711.6 million); 2) Humulin (up 8 percent to $352.4 million), Humalog (up 11 percent to $700.1 million), Cialis (up 7 percent to $567.8 million), Forteo (up 4 percent to $308.6 million) and Strattera (up 17 percent to $197.4 million). Eli Lilly's animal health division revenues were about $601 million (up 11 percent). Higher volume led to the increase. An acquisition also helped increase revenues. LLY's acquisition of Novartis' (NYSE:NVS) animal health business, which is expected to close in the first quarter of 2015, should strengthen this division in the future. LLY maintained its 2014 guidance of $2.72 to $2.80 per share on revenues of $19.4 billion to $20.0 billion.

Recent developments

LLY management has been consistent in their planning to support and grow revenues through multiple initiatives. Some of the most recent initiatives which will contribute to the revenue stream in the coming years include: 1) in April 2014, LLY entered a deal to buy Swiss drug maker Novartis AG's animal health business for $5.4 billion in cash to strengthen and diversify its Elanco animal health unit. LLY will fund the deal with about $3.4 billion of cash on hand and $2 billion of loans; 2) in May 2014, Sanofi entered an agreement to work with LLY to develop an over-the-counter version of Cialis, currently a prescription erectile dysfunction treatment; 3) in July 2014, Sanofi SA, whose top-selling Lantus helps diabetics control blood sugar levels, filed a patent infringement lawsuit accusing LLY of infringing patents related to insulin and devices used to deliver it. Sanofi is seeking to halt Lilly's proposed commercial marketing in the U.S. of a rival treatment known as Abasria (a generic version of Lantus, whose active ingredient is insulin glargine). Lantus is the world's most widely prescribed insulin, and sales totaled about $8 billion in 2013. A European regulator had recommended approval of LLY's rival drug in June 2014; and 4) in August 2014, the FDA approved a new LLY and Boehringer Ingelheim treatment named "Jardiance" for the most common form of diabetes. The drug approval will permit the tablets to be used by adult patients with type 2 diabetes who also are trying to control their condition with diet and exercise. European Union regulators had already approved the drug, also labeled empagliflozin, in May 2014.

Insider Purchases

One of the most positive signs to a potential investor in a company's stock is an insider purchase of shares on the open market that is substantial and not just a mandatory token purchase required by the company. Earlier in 2014, an insider made a substantial purchase of LLY shares on the open market. On May 12, 2014, LLY director Jackson P. Tai bought 17,157 shares of the stock on the open market. The stock was purchased at an average price of $59.19 per share, for a total transaction of $1,015,522.83. Following the transaction, the director now directly owns 32,180 shares of the company's stock, valued at about $2 million.

Risks

Pharmaceutical companies engage in the discovery, manufacturing, distribution and research of generic and branded drugs. The industry is capital-intensive, with extremely high research and development costs. Many companies are mature and have high margins and higher dividend distributions. Large participants in the industry include Pfizer, Bristol-Myers Squibb (NYSE:BMY), AbbVie, Merck (NYSE:MRK) and Eli Lilly. The industry faces major challenges from strict environmental regulations and patent expirations on billion-dollar products. The Food and Drug Administration (FDA) is rejecting more drugs on safety concerns, and a lack of significant evidence of that appending drug pending approval offered a definitive advancement over existing already approved drugs. The industry also depends on federal subsidies for cost reductions through federal subsidies that lower co-payments and deductibles for specialty drugs. To reduces costs and remain competitive, the U.S. pharmaceutical companies have outsourced some research to lower-cost countries such as India and China. The industry has begun to focus on treating specific disorders rather than trying to develop "blockbuster" drugs (chemical compound-based drugs). Drug sales in the U.S. will continue to increase as the population ages, inflation affects drug prices and the introduction of expensive new drugs continues.

Analysts' views and our views

As expected that LLY's second-quarter results would be adversely affected by the patent expirations for its best-selling drugs Cymbalta and Evista. 2014 is seen as a transitional challenging year given the dramatic sales decline for the two LLY best-sellers. Products such as Humalog, Trajenta, Cialis, Forteo and Alimta and the animal health business, however, should help partially offset the impact of the dramatic sales decline of two important drugs. In addition, analysts are encouraged by LLY's product pipeline progress, particularly for diabetes, where it has several compounds in late-stage trials. Also, LLY launched Cyramza in the U.S. for gastric cancer and received approval in the U.S. and Europe for Jardiance for type 2 diabetes. China revenue is expected to experience strong growth, while Japan revenue will be weaker due to currency fluctuation. LLY is expected to return to revenue growth in 2015. Currently, eight analysts have a "hold" rating on LLY, ten have a "buy" rating and one has a "sell" rating. The price targets among analysts range from $60 to $72 a share.

We believe that LLY is an excellent long-term investment for any investor. LLY's 2014 earnings represent an earnings trough due to its major patent cliff, and earnings are expected to rise again in 2015. LLY's earnings are expected to be $3.14 in 2015, giving the shares a price-to-earnings ratio of 19.3, based on the current price. Given that the overall markets have hit all-time highs recently, we would prefer that investors interested in purchasing LLY shares wait until the share price is within the $55 to $59 price range (with a price-to-earnings ratio of 17.5 to 18.8) before establishing a full position. Although LLY shares have almost doubled since their depressed 2010 share price, we believe that LLY shareholders will continue to be rewarded by an over 3 percent dividend and share price appreciation. A recent $1 million purchase of LLY shares by a LLY insider at about $59 a share gives us greater confidence that an investor in LLY shares will continue to be rewarded.

Disclosure: The author is long LLY, PFE, ABBV. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Eli Lilly: A Dividend Play And More