Billionaire activist investor Carl Icahn has made a fortune off of targeting declining biotech companies. He may have failed in taking over the board of Forest Laboratories (FRX), but this let down pales in comparison to his success at Biogen (BIIB) and Genzyme. Eli Lilly (LLY) is substantially undervalued and appears to many investors as a sinking ship. Moments like these are perfect for an activist entrance.
In this article, I will run you through a DCF model on Lilly and then triangulate the result with a review of the fundamentals against Abbott Laboratories (ABT) and Johnson & Johnson (JNJ). Lilly is trading well below intrinsic value even assuming that free cash flow decline.
First, let's start with an assumption about the top-line. Lilly grew 5.3% in FY2011 off of 5.7% growth in FY2010. I model per annum negative growth of 6% over the next half decade or so. Patent losses notwithstanding, this is a very bearish assumption.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 19.5% of revenue versus 31.9% for SG&A, 20% for R&D, and 5.4% for capex. Taxes are estimated at 23% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around -7.3% over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $48.33, implying 16.2%. If revenue holds flat over the explicitly projected time period and normalizes at 3% into perpetuity (reasonable for high-growth biotech), the stock would be worth $68.87 for 65.5%.
All of this falls within the context of an operational decline:
[R]evenue declined by 4% in Q1 to just over $5.6 billion. This decrease in revenue was due to the loss of patent exclusivity for Zyprexa in most major markets outside of Japan, partially offset by growth from other products. Excluding Zyprexa outside of Japan, the rest of our revenue actually grew 10%.
Gross margin as a percent of revenue decreased 1.2 percentage points from 79.8% to 78.6%. This decrease in gross margin percent was primarily due to lower sales of Zyprexa, partially offset by the impact of foreign exchange rates on international inventories sold.
This quarter's total operating expense, defined as the sum of R&D and SG&A, grew 3%. Within operating expenses, marketing, selling and administrative expenses grew 3%, while R&D expenses grew 2%.
But my model assumed per annum negative growth of 6% and still found at least 16.2% upside. For a company that is spending one-fifth of its revenue on R&D, the bull case is simply being ignored in the face of exclusivity losses. If Icahn invests around $2.4B in the company, his stake would be big enough to make him an "active investor" under Section 13D of the Securities Act. In my view, his presence alone would send the shares towards more reasonable levels and justify an investment.
After all, from a multiples perspective, Lilly certainly has room to expand. It trades at a respective 10.8x and 11.3x past and forward earnings with a dividend yield of 4.7%. Corresponding figures are 19.4x and 11.7x for Abbott and 17.8x and 11.9x for J&J.
Analysts are nevertheless not "buying" the long story, which may only increase the likelihood of Icahn launching a campaign. According to NASDAQ, the Street prefers J&J and Abbott over Lilly.
Consensus estimates for Abbott's EPS forecast that it will grow by 7.9% to $5.03 in 2012 and then by 6.6% and 6% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $5.33, the stock would hit $69.29 for 10.8% upside. The stock offers a dividend yield of 3.3% and is incredibly safe in light of its 0.4 beta.
Consensus estimates for J&J's EPS forecast that it will grow by 2.6% to $5.13 in 2012 and then by 6% and 8.1% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $5.41, the stock would hit $70.33 for 8.5% upside. The company currently has $32.3B of cash on its balance sheet. As many biotech's stagger under an environment of major patent losses, J&J should be looking into takeover activity as a way of preventing competitors from gaining substitute catalysts.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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