Eli Lilly Reaffirms Commitment to Innovation but Needs to Deliver

| About: Eli Lilly (LLY)

Reaffirming that it remains one of the staunchest advocates of innovation over diversification, Eli Lilly’s (NYSE:LLY) strategy update yesterday contained few surprises. The company reiterated its intention to continue investing in its pipeline to deliver fresh growth post-patent cliff, and explicitly ruled out moves into new areas like generics or any attempt to buy its way out of trouble with a big buck acquisition.

Big pharma’s productivity problems have prompted a variety of strategic moves and Lilly, along with Bristol-Myers Squibb (NYSE:BMY) and AstraZeneca (NYSE:AZN), has largely resisted pressure to add more reliable and less risky revenue generators. The next couple of years will contain crucial tests of conviction as they all attempt to deliver on pipeline promises – the analysis below suggests investors are still largely declining to bet on success.

Growth engines

Lilly has not completely shunned more stable revenue generators and has invested in what it terms three “counter-cyclical growth engines” – Japan, emerging markets and Elanco animal health.

Since the beginning of 2010 Lilly has purchased European animal health assets from Pfizer (NYSE:PFE) and Johnson & Johnson (NYSE:JNJ); the division now accounts for 7% of product sales. Japanese pharmaceutical sales meanwhile have grown 30% in the last two years, to constitute 7% of pharmaceutical sales, whilst emerging markets are contributing 14%.

So while the loss of blockbuster drugs including Zyprexa and Cymbalta will reduce revenues by approximately $7bn from 2010 to 2014, the company expects these three units could add more than $4bn of incremental revenue by 2015.

This will come in handy but a shortfall clearly remains, and post-patent cliff the company is betting on its pipeline to deliver fresh growth.

Lilly is certainly lining up plenty of shots on goal. It says it has 24 potential new medicines in Phase II, and nine more in Phase III; it is on track to meet a goal of 10 new molecular entities in pivotal trials by the end of this year.

This requires substantial investment and the company has said it expects R&D spending to be no more than 25% of revenue through the period – this implies a much higher ratio than its peers.

Big pharma R&D spend analysis
Pharma R&D ($bn) Pharma R&D as % of Rx & OTC sales Group R&D as % of Total Group Sales
2010 2016 change 2010 2016 2010 2016
Eli Lilly 4.7 5.0 5% 23% 30% 21% 23%
Merck & Co 8.1 8.6 6% 20% 20% 18% 18%
Bristol-Myers Squibb 3.3 3.4 3% 21% 20% 18% 20%
Roche 7.8 8.7 11% 22% 20% 19% 16%
Johnson & Johnson 4.5 5.3 17% 19% 20% 11% 10%
Novartis 7.9 9.8 25% 18% 18% 16% 15%
AstraZeneca 4.2 4.2 -1% 13% 16% 13% 15%
GlaxoSmithKline 5.7 7.8 37% 14% 15% 14% 14%
Sanofi 5.8 7.6 31% 15% 14% 14% 14%
Pfizer 9.1 7.1 -22% 16% 13% 14% 11%
Abbott Laboratories 2.3 2.7 20% 11% 11% 10% 9%
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The table above shows analysts were already anticipating this level of investment. So while the amount Lilly intends to spend on pharma R&D – the amount spent on pharmaceuticals and excluding other areas such as animal health – is expected to remain relatively flat, as a proportion to sales this is set to soar as its top-line is eroded.

Interestingly, it is the diversified companies like Glaxo, Sanofi and Novartis that are expected to up investment in R&D dollar terms over the coming years. Proportionately, their spend will stay stable as other divisions are set to grow their top lines.

The table below paints a picture of how analysts and investors are valuing these companies drug portfolios and pipeline investments.

The net present value figure is derived from consensus product sales forecasts, and does not include any valuation of other parts of the business. As such, a large proportion of the market value ascribed to companies like J&J and Abbott will be based on non-drug units like diagnostics and medtech.

But for a company like Eli Lilly, the majority of its valuation is linked to its pharmaceutical products, and the table shows that investors are not valuing its portfolio as highly as equity analysts.

Big pharma NPV analysis
Total Product NPV ($bn) Market cap ($bn) NPV as % of Share Price Marketed products NPV as % of SP R&D NPV as % of SP
Eli Lilly 58.5 43.4 135% 115% 20%
AstraZeneca 83.2 68.4 122% 115% 7%
GlaxoSmithKline 123.0 112.1 110% 99% 11%
Sanofi 115.2 108.2 108% 101% 7%
Merck & Co 117.3 108.9 108% 102% 6%
Roche 140.7 136.6 105% 100% 5%
Pfizer 151.8 162.8 93% 85% 9%
Novartis 129.0 142.2 91% 81% 9%
Bristol-Myers Squibb 44.7 49.4 91% 79% 11%
Abbott Laboratories 62.7 81.8 77% 75% 2%
Johnson & Johnson 80.8 182.3 44% 39% 5%
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This implies little faith in the market that the company will be able to deliver on its promises. Encouragingly, Bristol-Myers illustrates that this is achievable.

A series of pipeline successes, such as recent regulatory approval for Yervoy in melanoma and its new clot-buster apixaban looking particularly impressive, have driven shares 12% higher since the beginning of the year. As a result the company’s market value is now higher than its product NPV, a rare feat in this cohort, particularly for a company considered a pure pharma play.

Eli Lilly - and AstraZeneca - need to follow suit. The table below shows that Lilly has not actually performed that badly on the stock market compared to peers over the last 18 months. But with an explicit commitment to keep investing in its pipeline, returns need to be seen.

18-month share price performance
Novartis 20%
Bristol-Myers Squibb 16%
Pfizer 13%
Eli Lilly 9%
Sanofi 8%
Johnson & Johnson 4%
AstraZeneca 4%
GlaxoSmithKline 3%
Roche -8%
Merck & Co -15%
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All data sourced to EvaluatePharma