How Eli Lilly Will Outwit Patent Expirations

Sep.26.11 | About: Eli Lilly (LLY)

Eli Lilly & Company (NYSE:LLY) is a biotechnology company with an emphasis on cancer, cardiology, diabetes, men's health, growth disorders, neuroscience, and osteoporosis. The company's stock has traded in a consistent range between $32 - $38 since October 2008. The stock is currently trading at $36.07, after trending above its 3-year range on July 21, with a price of nearly $40.

The sell-off within the market has led to a loss of almost 9% since July 21, and I believe its current price now presents a great opportunity for investors that are looking to purchase a long term growing stock. Below is a look at the company's financials, concerns, and its potential gains.

The stock is trading with a market cap of $41.76 billion and a price-to-earnings ratio of 8.47. The stock trades with a beta of 0.76, which means it's less volatile than the markets, which I believe to be accurate, since the Dow Jones has lost twice as much in value since July 21, when the losses began. The stock has a yield of 5.43 and a one-year price target of $36.54. The $36.54 price target would be very modest in gains compared to its current price, yet the modest gains are of no surprise, analyst have not been particularly bullish of LLY with 13 of 18 analysts rating it a hold. I strongly disagree with the majority of analysts, and believe this stock will trend higher and separate itself from its 3-year range within the next year.

The one-year chart shows the stock pattern over the last year, with strong gains between the 2-month period of March 17 until May 17. The uptrend was initiated after the company announced that it had made an offer to acquire Johnson & Johnson's (NYSE:JNJ) animal health business, which is a global company in 75 countries.

The company also updated full-year revenue guidance to a range above analysts' estimates. The company was also awarded FDA approval for its new tablet for the treatment of Type 2 diabetes and announced a partnership with Medtronic for a drug device collaboration in the treatment of Parkinson's disease. As a result of these developments, and others, the stock traded in its new-found range for approximately 2 months, until strong selling within the markets pushed the stock lower. I believe the loss was entirely related to the market and not the company's fundamental performance, yet I will review the company's income statement and balance sheet for any significant weaknesses.

The chart above reflects the company's 5-year performance through its income statement. Despite a recession in 2008 along with economic uncertainty, the company has posted higher revenue year-over-year, and with the exception of 2008, the company has shown significant progress in profit margins. However, profit margins have recently declined in 2011, which can be seen on the chart below.

Since Q2 2010, profit margins have slightly decreased, especially between Q3 and Q4 of 2010. However, revenue continues to be strong, posting a gain of nearly 9% year-over-year during its most recent earnings report. The company's 11.2% loss in year-over-year earnings during Q2 is a result of several additional charges on its income statement, which include a $30 million loss posted under "other income" and a $132.50 million loss posted under "special income." In addition, the company had higher cost of sales, selling, general, and administrative expenses. Overall, the company's recent quarter proved that the company continues to grow but also has higher expenses.

The company's balance sheet is strong, which can be viewed on a quarterly basis on the above chart. Eli Lilly & Company had approximately $6.35 billion in cash after the second quarter, which is a gain from $5.19 during the previous year. In addition the company posted assets that totaled $14.95 billion an increase from $12.46 billion year-over-year. And the company lowered its debt by $160 million year-over-year which means the company significantly lowered its debt-to-assets ratio over a period of one year, which can be viewed on the above chart.

I believe that Eli Lilly's clinical strategy and pipeline has the potential to bring the company long-term financial success. The company had been working on a new drug for patients with Type 2 diabetes that lowers blood sugar with diet and exercise. The drug has now been approved in several countries and is expected to be very successful, and maybe challenge the drug Metformin's high sales. The company is also completing Byudureon, a once-weekly treatment for Type 2 diabetes that should be very successful because of its convenience of use. In addition to these two diabetic medications, the company has 70 clinical phase compounds with 33 in Phase II or III. The company is placing a high priority in the treatment of diabetes, Parkinsons disease, and various cancers.

The $36.54 one-year price target is unbelievably low for a company with such an abundance of promising products. In addition, the company is highly profitable and has a solid balance sheet that is constantly improving. However, analysts may justify a $36.54 price target because of the stock's long-term consistency, which never trends too high or too low. Other reasons may include patent expirations and the emergence of generic drugs and the potential for the drugs to affect Eli Lilly's best-selling products. There have even been rumors that investors are selling because of the potential for new policies and regulations that could affect the biotechnology industry.

I believe the potential rewards outweigh the speculative risks with Eli Lilly. The generic drug market is growing, and Eli Lilly has patents that are expiring in the near future. Yet Eli Lilly is among the best in the industry at drug delivery technologies, and I believe the company will find a way to extend the patents it desires. Therefore, I do not believe the company will be affected by generic drugs of its best selling products or the products that it does not want other companies to produce.

An example of my theory that the company will modify the drug delivery of its products is Reckitt Benckiser and its drug Suboxone. Suboxone is a medication that is used to help treat the addition of narcotic drug abuse. It's a partial opiate antagonist, which means it still contains an opiate (buprenorphine), but does not fall into the category of a full opiate, such as hydrocodone. The company has experienced incredible profits and revenue from the success of this drug, which continue to increase every year with the global issue of opiate abuse.

The company was faced with an expiring patent for its best-selling drug, and generic drug manufacturers were lining up to produce a cheaper drug that would return large profits. This would have been devastating to both the company and the stock of Reckitt Benckiser, since it would no longer control the market for opiate abuse medications. Therefore, the company evolved and simply changed the drug by creating a film that dissolves under the tongue rather than a pill that dissolves under the tongue. As a result, the company is now the only manufacturer of the particular combination of Naloxone and Buprenorphine which makes Suboxone.

The example of Reckitt Benckiser is a common method that large pharmaceutical companies use to extend the sole production of a highly successful drug. I believe Eli Lilly falls into the same category: The company has spent millions if not billions on new technologies for drug delivery. I believe Eli Lilly will utilize this technology, along with others, to continue the sole production of certain drugs of the company's desire. I believe that any drug the company allows to be manufactured in generic form is probably part of its plan.

The company's area of focus is highly profitable industries, such as cancer, diabetes, and Parkinsons Disease, and it has a strong pipeline of new drugs that are more effective than the old versions. And with so many of the company's pipeline drugs in the late phases of clinical trials, or near approval, I believe the company's future looks promising, regardless of any patent it allows to be generically manufactured.

The one-year price target of $36.54 is modest, yet I understand the reasoning behind the price. The stock has traded in a consistent range for 3 years and at $36.54 the stock would be greater than its average price during the last 3 years. So although it seems like a small price it's still the analysts' way of anticipating overall growth. Yet I believe the stock could easily reach $50 within one year.

I have already stated that I do not believe expiring patents will be an issue, and that LLY will obtain the patents that it foresees as a strong part of its future growth. But with 33 compounds in either Phase II or III, and several others near FDA approval, I believe that next year investors will be much more excited regarding the future of this company. Before the downtrend began in July, the stock had reached a price of nearly $40, which is high outside its normal trading range. Therefore, as the market recovers and optimism builds, over future approval dates and high earnings, I expect the stock to rise and for investors to be nicely rewarded.

Disclosure: I am long LLY.